[Senate Hearing 111-407]
[From the U.S. Government Publishing Office]
S. Hrg. 111-407
STRENGTHENING AND STREAMLINING PRUDENTIAL BANK SUPERVISION
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
STRENGTHENING AND STREAMLINING PRUDENTIAL BANK SUPERVISION TO BETTER
PROVIDE THE SAFETY, SOUNDNESS, AND STABILITY OF THE FINANCIAL MARKETS
__________
AUGUST 4 AND SEPTEMBER 29, 2009
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate/
senate05sh.html
U.S. GOVERNMENT PRINTING OFFICE
56-376 PDF WASHINGTON : 2010
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC
area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC
20402-0001
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 JUDD GREGG, New Hampshire
MICHAEL F. BENNET, Colorado
Edward Silverman, Staff Director
William D. Duhnke, Republican Staff Director
Amy S. Friend, Chief Counsel
Dean V. Shahinian, Senior Counsel
Charles Yi, Senior Policy Adviser
Brian Filipowich, Legislative Assistant
Deborah Katz, OCC Detailee
Matthew Green, FDIC Detailee
Mark Jickling, CRS Detailee
Mark Oesterle, Republican Chief Counsel
Jim Johnson, Republican Counsel
Andrew J. Olmem, Jr., Republican Counsel
Jeffery L. Stoltzfoos, Republican Counsel
Heath P. Tarbert, Republican Special Counsel
Chad Davis, Republican 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
----------
TUESDAY, AUGUST 4, 2009
Page
Opening statement of Chairman Dodd............................... 1
Opening statements, comments, or prepared statements of:
Senator Johnson
Prepared statement....................................... 43
Senator Reed
Prepared statement....................................... 43
WITNESSES
Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation.. 2
Prepared statement........................................... 44
Responses to written questions of:
Senator Bunning.......................................... 79
John C. Dugan, Comptroller of the Currency, Office of the
Comptroller of the Currency.................................... 4
Prepared statement........................................... 48
Responses to written questions of:
Senator Bunning.......................................... 82
Daniel K. Tarullo, Member, Board of Governors of the Federal
Reserve
System......................................................... 5
Prepared statement........................................... 66
Responses to written questions of:
Senator Bunning.......................................... 89
John E. Bowman, Acting Director, Office of Thrift Supervision.... 7
Prepared statement........................................... 72
Responses to written questions of:
Senator Bunning.......................................... 90
----------
TUESDAY, SEPTEMBER 29, 2009
Opening statement of Chairman Dodd............................... 99
Prepared statement........................................... 132
WITNESSES
Eugene A. Ludwig, Chief Executive Officer, Promontory Financial
Group, LLC..................................................... 101
Prepared statement........................................... 132
Martin N. Baily, Senior Fellow, Economic Studies, The Brookings
Institution.................................................... 104
Prepared statement........................................... 144
Richard S. Carnell, Associate Professor, Fordham University
School of Law.................................................. 107
Prepared statement........................................... 153
Richard J. Hillman, Managing Director, Financial Markets and
Community Investment Team, Government Accountability Office.... 109
Prepared statement........................................... 159
STRENGTHENING AND STREAMLINING PRUDENTIAL BANK SUPERVISION
----------
TUESDAY, AUGUST 4, 2009
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 9 a.m. in room SD-538, Dirksen Senate
Office Building, Senator Christopher J. Dodd (Chairman of the
Committee) presiding.
OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
Chairman Dodd. The Committee will come to order. Let me
welcome our guests who are in the hearing room this morning, as
well as to welcome our very distinguished panel of witnesses,
and we thank the four of you and the second panel that is going
to come as well.
I have informed our colleagues already, those who are here,
and others, we are under some time constraints. We have a
couple of votes around 10:30 that are coming up on the floor of
the Senate. There is a meeting that we are going to have that
begins a little after noon that many of us are going to have to
attend later. So we are not going to make any opening
statements, including the Chairman and the Ranking Member. We
have agreed this morning just to get right to our witnesses.
I know my colleague from Tennessee would like that
precedent, I tell you. He has been dying for that moment for 2
years.
[Laughter.]
Senator Shelby. Mr. Chairman, when he was mayor, nobody
spoke.
Chairman Dodd. No, no. Just the mayor spoke. We are not
setting precedent here, but we are certainly going to, this
morning, move in that direction.
So let me thank again everyone for being with us this
morning. Obviously, strengthening and streamlining prudential
bank supervision is a major subject matter. We have had I do
not know how many hearings. What is the number? Twenty-eight
hearings since January on this subject matter of financial
modernization regulations. And, obviously, this is a very
critical piece to the extent we are going to have consolidation
of our financial regulators.
And so I welcome our witnesses here this morning. Many--
well, all of you have been before us on numerous occasions to
talk about the various aspects of the financial troubles our
Nation has been in over the last number of years. And I just
want to make one point, and I know all of you at the table
pretty well, and I know you understand this because I believe
you care about this as well. Our job, obviously, here is not to
protect regulators. Our job is, obviously, to protect the
people who count on us and you and the system to provide the
safety and soundness and the stability of the financial
markets. That is what this is all about. And I know you get
that and understand that, but I sometimes think we need to
clear the air a little bit to make sure people understand what
we are talking about as we describe the structure and the
architecture that will provide that sense of stability and
safety and soundness that we are looking for.
So, with that, let me just turn directly, if I can, to you,
Sheila, to start in on this. I will ask you to try and be
brief. Again, all the documents and all of my colleagues'
opening statements will be included in the record at this point
here.
We will try and be a little more careful on the clock than
we might otherwise be because of time constraints.
Jim, I am just explaining we have got some votes in an hour
and a half or so. We are going to try and move along to the
extent possible.
Sheila, we thank you again for being with us.
STATEMENT OF SHEILA C. BAIR, CHAIRMAN, FEDERAL DEPOSIT
INSURANCE CORPORATION
Ms. Bair. Thank you, Senator Dodd, Ranking Member Shelby,
and Members of the Committee. Today you have asked us to
address the regulatory consolidation aspects of the
Administration's proposal and whether there should be further
consolidation.
The yardstick for any reform should be whether it deals
with the fundamental causes of the current crisis and helps
guard against future crises. Measured by that yardstick, we do
not believe the case has been made for regulatory consolidation
of State and Federal charters.
Among the many causes of the current crisis, the ability to
choose between a State and Federal charter was not one of them.
As a consequence, we see little benefit to regulatory
consolidation and the potential for great harm and its
disruptive impact and greater risk of regulatory capture and
dominance by large banking organizations.
The simplicity of a single bank regulator is alluring.
However, such proposals have rarely gained traction in the past
because prudential supervision of FDIC-insured banks has, in
fact, worked well compared to the regulatory structures used
for other U.S. financial sectors and to those used overseas.
Indeed, this is evidenced by the fact that large swaths of the
so-called ``shadow banking sector'' have collapsed back into
the healthier insured sector.
And U.S. banks, notwithstanding the current problems,
entered this crisis with stronger capital positions and less
leverage than their international competitors.
A significant cause of the crisis was the exploitation of
regulatory gaps between banks and the shadow nonbank financial
system and virtually no regulation of the over-the-counter
derivatives contracts. There were also gaps in consumer
protection. To address these problems, we have previously
testified in support of a systemic risk council that would help
assure coordination and harmonization of prudential standards
among all types of financial institutions.
And a council would address regulatory arbitrage among the
various financial sectors.
We also support a new consumer agency to assure strong
rules and enforcement of consumer protection across the board.
However, we do not see merit or wisdom in consolidating all
Federal banking supervision. The risk of weak or misdirected
regulation would be exacerbated by a single Federal regulator
that embarked on a wrong policy course. Prudent risk management
argues strongly against putting all your regulatory and
supervisory eggs in one basket.
One of the advantages of multiple regulators is that it
permits diverse viewpoints to be heard. For example, during the
discussion of Basel II, the FDIC voiced deep and strong
concerns about the reduction in capital that would have
resulted. Under a unified regulator, the advanced approaches of
Basel II could have been implemented much more quickly and with
fewer safeguards, and banks would have entered this crisis with
much lower levels of capital.
Also, there is no evidence that shows a single financial
regulatory structure was better at avoiding the widespread
economic damage of the past 2 years. Despite their single-
regulator approach, the financial systems in other countries
have all suffered during the crisis.
Moreover, a single-regulator approach would have serious
consequences for two mainstays of the American financial
system: the dual banking system and deposit insurance. The dual
banking system and the regulatory competition and diversity
that it generates is credited with spurring creativity and
innovation in financial products and the organization of
financial activities. State-chartered institutions tend to be
community-oriented and very close to the small businesses and
customers they serve. They provide the funding that supports
economic growth and job creation, especially in rural areas.
Main Street banks also are sensitive to market discipline
because they know they are not too big to fail and that they
will be closed if they become insolvent.
A unified supervisory approach would inevitably focus on
the largest banks to the detriment of community banking. In
turn, this could cause more consolidation in the banking
industry at a time when efforts are underway to reduce systemic
exposure to very large financial institutions and to end ``too
big to fail.''
Concentrating examination authority in a single regulator
also could hurt bank deposit insurance. The loss of an ongoing
and significant supervisory role would greatly diminish the
effectiveness of the FDIC's ability to perform a congressional
mandate. It would hamper our ability to reduce systemic risk
through risk-based premiums and to contain the costs of deposit
insurance by identifying, assessing, and taking actions to
mitigate risk to the Deposit Insurance Fund.
To summarize, the regulatory reforms should focus on
eliminating the regulatory gaps I have just outlined. Proposals
to create a unified supervisor would undercut the many benefits
of our dual banking system and would reduce the effectiveness
of deposit insurance, and, most importantly, they would not
address the fundamental causes of the current crisis.
Thank you.
Chairman Dodd. Thank you very much, and I apologize,
Sheila, for not properly introducing you here as the
Chairperson of the Federal Deposit Insurance Corporation. I
kind of assume everybody knows who you are, so I kind of jumped
into that, and I apologize.
John Dugan is the Comptroller of the Currency, and we thank
you very much, a well-known figure to this Committee, having
served on this side of the dais for a number of years and now
at the OCC. So we thank you, John.
STATEMENT OF JOHN C. DUGAN, COMPTROLLER OF THE CURRENCY, OFFICE
OF THE COMPTROLLER OF THE CURRENCY
Mr. Dugan. Thank you very much, Mr. Chairman.
Chairman Dodd, Ranking Member Shelby, and Members of the
Committee, I appreciate this opportunity to discuss the
Administration's proposal for regulatory reform.
The OCC supports many elements of the proposal, including
the establishment of a council of financial regulators to
identify and monitor systemic risk and enhanced authority to
resolve systemically significant financial firms. We also
believe it would be appropriate to establish a consolidated
supervisor of all systemically significant financial firms.
The Federal Reserve already plays this role for the largest
bank holding companies, but during the financial crisis, the
absence of a comparable supervisor for large securities and
insurance firms proved to be an enormous problem. The proposal
would fill this gap by extending the Federal Reserve's holding
company regulation to such firms, which we believe would be
appropriate.
However, one aspect of the proposal goes much too far,
which is to grant broad new authority to the Federal Reserve to
override the primary banking supervisor on standards,
examination, and enforcement applicable to the bank. Such
override power would fundamentally undermine the authority and
accountability of the banking supervisor.
We also support the proposal to effectively merge the OTS
into the OCC with a phase-out of the Federal Thrift Charter. My
written testimony responds in detail to the Chairman's
questions about options for additional banking agency
consolidation by: first, establishing either the Federal
Reserve or the FDIC as the single Federal agency responsible
for regulating State-chartered banks; second, establishing a
single prudential supervisor to supervise all national and
State banks; and, third, transferring all holding company
regulation from the Federal Reserve to the prudential
supervisor.
While there are significant potential benefits to be gained
from all three proposals, there are also potential costs,
especially with removing the Federal Reserve altogether from
the holding company regulation of systemically important
companies.
Finally, we support enhanced consumer financial protection
standards and believe that a dedicated consumer protection
agency could help to achieve that goal. However, we have
significant concerns with the parts of the proposed CFPA that
would consolidate all financial consumer protection
rulewriting, examination, and enforcement in a single agency
which would completely divorce these functions from safety and
soundness regulation.
It makes sense to consolidate all consumer protection
rulewriting in a single agency with the rules applying to all
financial providers of a product, both bank and nonbank. But we
believe the rules must be uniform and that banking supervisors
must have meaningful input into formulating them.
Unfortunately, the proposed CFPA falls short on both counts.
First, the rules would not be uniform because the proposal
would expressly authorize States to adopt different rules for
all financial firms, including national banks, by repealing the
Federal preemption that has always allowed national banks to
operate under uniform Federal standards. This repeal of a
uniform Federal standards option is a radical change that will
make it far more difficult and costly for national banks to
provide financial services to consumers in different States
having different rules, and these costs will ultimately be
borne by the consumer. The change will also undermine the
national banking charter and the dual banking system that have
served us well for nearly 150 years.
Second, the rules do not afford meaningful input from
banking supervisors, even on real safety and soundness issues,
because in the event of any disputes, the proposed CFPA would
always win. The new agency needs to have a strong mechanism for
ensuring meaningful bank supervisor input into CFPA rulemaking.
Finally, the CFPA should not take examination and
enforcement responsibilities away from the banking agencies.
The current bank supervisory process works well where the
integration of consumer compliance and safety and soundness
supervision provides real benefits for both functions.
Moreover, moving bank examination and enforcement functions to
the CFPA would only distract it from its most important and
daunting implementation challenge--that is, establishing an
effective enforcement regime for the shadow banking system of
the literally tens of thousands of nonbank providers that are
currently unregulated or lightly regulated, like mortgage
brokers and originators. The CFPA's resources should be focused
on this fundamental regulatory gap rather than on already
regulated depository institutions.
Thank you very much.
Chairman Dodd. Thank you very much.
Dan Tarullo, from the Federal Reserve Board, we thank you,
Dan, once again for coming before the Committee. Happy to hear
your testimony.
STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF GOVERNORS OF
THE FEDERAL RESERVE SYSTEM
Mr. Tarullo. Thank you, Mr. Chairman, Ranking Member
Shelby, and other Members of the Committee.
Before the final history of the financial crisis is
written, I am certain that supervisory shortcomings in all
kinds and sizes of financial institutions, will have been
revealed. The crisis has also shown that the framework for
prudential supervision and regulation has not kept pace changes
in the structure, activities, and interrelationships of the
financial sector.
In my prepared testimony, I have suggested and tried to
elaborate the elements of an effective framework for prudential
supervision, including a number of recommendations for
legislative actions. Knowing of your time constraints this
morning, let me confine these introductory remarks to three
quick points.
First, prudential supervision must be required for all
systemically important institutions. It is noteworthy that a
number of the firms at the heart of the crisis had not been
subject to mandatory prudential supervision of any sort.
Improving the quality of supervision will fall short of
realizing the maximum potential gains for financial stability
if important institutions can escape the rules and requirements
associated with the supervisory process.
Second, there must be effective supervision of the
companies that own insured depository institutions, a task that
is distinct from the supervision of the banks themselves. Large
organizations increasingly manage their businesses on an
integrated basis, with little regard for the corporate
boundaries that typically define the jurisdiction of individual
functional supervisors. There is need for close scrutiny of the
linkages between the banks and other affiliates within a
holding company--not just straightforward financial or
contractual ties, but also managerial, operational, and
reputational linkages. The premise of so-called ``functional
regulation''--that risks within a diversified organization can
be successfully evaluated and controlled through supervision
within each individual firm--has been belied by the experience
of the financial crisis.
Third, it is important to emphasize that much of what needs
to be done to improve and adapt our system of prudential
supervision lies within the existing authorities of the
agencies represented at this table. Together, we have acted to
shut down the practice of converting charters in order to
escape enforcement actions or adverse supervisory ratings. We
are working together in international fora to assure that all
internationally active financial institutions are subject to
effective regulation. The Federal Reserve is adjusting its
approach to prudential supervision, particularly of the largest
banking organizations.
Building on the experience of the unprecedented Supervisory
Capital Assessment Program, or SCAP, we are expanding our use
of horizontal examinations to assess key operations, risks, and
risk management of large institutions. We are creating an
enhanced quantitative surveillance mechanism that will draw on
a multidisciplinary group of economists and other experts to
create and evaluate scenarios that cross large firms. These
top-down analyses will provide an independent supervisory
perspective on the bottom-up work of supervisory teams. The two
perspectives will be joined in a well-coordinated process
involving both the supervisory teams and Washington staff.
Thank you all for your attention. I look forward to
discussing both agency and congressional initiatives to
strengthen further our prudential supervisory system.
Chairman Dodd. Thank you very much, Governor.
I will now turn to our last witness, John Bowman, who is
the Acting Director of the Office of Thrift Supervision. John,
we welcome you once again to the Committee.
STATEMENT OF JOHN E. BOWMAN, ACTING DIRECTOR, OFFICE OF THRIFT
SUPERVISION
Mr. Bowman. Good morning, Chairman Dodd, Ranking Member
Shelby, and other Members of the Committee. Thank you for the
opportunity to testify on the Administration's proposal for
financial regulatory reform. It is my pleasure to address this
Committee for the first time in my role as Acting Director of
the Office of Thrift Supervision. I will begin my testimony by
outlining the core principles I believe are essential to
accomplishing true and lasting reform. Then I will address
specific questions you asked regarding the Administration's
proposal.
Let me start with the four principles.
One, ensure that changes to the financial regulatory system
address real problems. We all agree that the system has real
problems and needs real reform. What we must determine, as we
consider each proposed change, is whether the proposal would
fix what is broken. In the rush to address what went wrong, let
us not try to fix nonexisting problems or try to fix real
problems with flawed solutions.
Two, ensure uniform regulation. One of the biggest lessons
learned from the current economic crisis is that all entities
offering financial products to consumers must be subject to the
same rules. Underregulated entities competing in the financial
marketplace have a corrosive, damaging impact on the entire
system. Also, complex derivative products such as credit
default swaps should be regulated.
Three, ensure that systemically important firms are
effectively supervised and, if necessary, wound down in an
orderly manner. No provider of financial products should be too
big to fail, achieving through size and complexity an implicit
Federal Government guarantee to prevent its collapse. The U.S.
economy operates on the principle of healthy competition.
Enterprises that are strong, industrious, well managed, and
efficient succeed and prosper. Those that fall short of the
mark struggle or fail, and other stronger enterprises take
their places. Enterprises that become too big to fail subvert
the system. When the Government is forced to prop up failing
systemically important computers, it is, in essence, supporting
poor performance and creating a moral hazard.
Let me be clear. I am not advocating a cap on size, just
effective, robust authority for properly regulating and
resolving the largest and most complex financial institutions.
Number four, ensure that consumers are protected. A single
agency should have the regulation of financial products as its
central mission. That agency should establish the rules and
standards for all consumer financial products, regardless of
the issuer of those products, rather than having multiple
agencies with fragmented authority and a lack of singular
accountability.
Regarding feedbacks on the questions the Committee asked,
the OTS does not support the Administration's proposal to
eliminate the Office of the Comptroller of the Currency and the
Office of Thrift Supervision, transferring the employees of
each into a national bank supervisory agency or for the
elimination of the Federal Thrift Charter. Failures by insured
depository institutions have been no more severe among thrifts
than among institutions supervised by other Federal banking
regulators.
If you look at the numbers of failed institutions, most
have been State-chartered banks whose primary Federal regulator
is not the OTS.
If you look at the size of failed institutions, you see
that the Federal Government prevented the failures of the
largest banks that collapsed by authorizing open bank
assistance. These too-big-to-fail institutions are not and were
not regulated by the OTS.
The argument about bank shopping for the most lenient
regulator is also without merit. Most financial institutions
and more assets have converted away from OTS supervision in the
last 10 years than have converted to OTS supervision.
In the same way the thrift charter is not part of the
problem, we do not see any reason to cause major disruptions
with the hundreds of legitimate, well-run financial businesses
that are operating successfully with the thrift charter and
making credit available to American consumers. My written
testimony contains detailed information you requested about the
proposed elimination of the exceptions in the Bank Holding
Company Act for thrifts and certain special-purpose banks and
about the Federal Reserve System's prudential supervision of
holding companies.
Thank you again, Mr. Chairman, and I would be happy to
answer any questions.
Chairman Dodd. Thank you very much, Mr. Bowman.
Let me ask the clerk to put the clock on here for about 6
minutes per Member, and I have two questions I want to raise
with you, if time permits, and then I will turn to Senator
Shelby.
First of all, for decades--and I have been on this
Committee for a number of years, and we have had commissions
and think tanks and regulators, presidents, Banking Committee
Chairs. John, you will remember sitting behind us back here at
that table with parties recommending the consolidation of
Federal banking supervision. Bill Proxmire, who sat in this
chair for a number of years, proclaimed the U.S. system of
regulation to be, and I quote, ``the most bizarre and tangled
financial regulatory system in the world.''
Former FDIC Chairman, Sheila, Chairman William Seidman,
called it ``complex, inefficient, outmoded, and archaic.''
In the wake of the last bank and thrift crisis, when
hundreds of institutions failed, the Clinton administration
urged Congress to consolidate the Federal banking regulators
into a single prudential regulator. So here we have seen
Administrations, Chairs of this Committee, and others over the
years, all at various times, in the wake of previous crises,
call for consolidation, and yet we did not act after those
crises. We sat back and basically left pretty much the system
we have today intact. And as a result, we have had some real
costs ranging from inefficiencies and redundancies to the lack
of accountability and regulatory laxity. We are now paying a
very high price for those shortcomings.
So my first question is--the Administration, as you all
know and you have commented on, has proposed the consolidation
of the OCC and OTS, but leaves in place the three Federal bank
regulators. My question is simply: Putting the safety and
soundness of the banking system first, is the Administration
proposal really enough? Or should we not be listening to the
admonition of previous Administrations? And people have sat in
this chair who have recommended greater consolidation that
ought to be the step taken.
Sheila, we will begin with you.
Ms. Bair. As I indicated in my opening statement, we do not
think that the ability to choose between the Federal and State
charter was any kind of a significant driver or had any kind of
an impact at all on the activities that led to this current
crisis. The key problems were arbitrage between more heavily
regulated banks and nonbanks, and then the OTC derivatives
sector, which was pretty much completely unregulated.
I do support merging OCC and OTS. That is reflective of
market conditions, but that doesn't need to be about whether
there is a weak regulator or strong regulator. I think that is
just a reflection of the market and the lack of current market
interest in a specialty charter to do just mortgage lending or
heavily concentrate on mortgage lending. In fact, some of the
restrictions on the thrift charter perhaps have impeded the
ability of those thrifts to undertake additional
diversification.
So, Mr. Chairman, I would have to respectfully disagree in
terms of drivers of what went on this time around. I really do
not see that as a symptom of the fact that you have four
different regulators overseeing different charters for FDIC-
insured institutions. And I do think that the banks held up
pretty well compared to the other sectors. They did have higher
capital standards and more extensive regulation.
Chairman Dodd. Let me just ask you and the other panelists
to comment on this. Clearly, we are looking back in the
rearview mirror as to what happened, and that is certainly a
motivation here. But it is not the sole motivation. It is not
just a question of addressing the problems that occurred, but
going forward, in the 21st century, in a very different time,
in a global economy today--we saw the implications of what
happened not only here in this country but around the world.
The idea that we would maintain the same architecture we have
for decades is not only a question about what has occurred and
whether or not the system responded well enough to it, but
looking forward as to whether or not this architecture and
structure is going to be sufficient to protect the safety and
soundness in a very different economic environment than existed
at the time these agencies emerged through the process of
growth over the years. It seems to me that is just as important
question as looking back.
Ms. Bair. I think it is a very important question, and I am
very glad you are having these hearings. But I do not think
that this is going to solve the problems that led to this
crisis. Looking at the performance of other models in European
countries that have a single regulator, the performance is not
particularly good.
I do think there is a profound risk of regulatory capture
by very large institutions if you collapse regulatory oversight
into one single entity. I think having multiple voices is
beautiful. We testified before this Committee on the Advanced
Approaches under Basel II. We resisted that, and we slowed it
down. And because of that, our banks--commercial banks, FDIC-
insured banks--had not transitioned into that new system, which
would have significantly lowered the amount of capital they
would have had going into this crisis, unlike what happened in
Europe and with investment banks.
So we think having multiple voices can actually strengthen
regulation and guard against regulatory capture. If you have a
single monopoly regulator, there is not going to be another
regulator out there saying, ``We are going to have a higher
standard,'' ``We are going to be stronger,'' or ``We are going
to question that.'' I think you lose that with a single
regulator. So you should look carefully at the European models
and how they functioned during the crisis.
Chairman Dodd. We are talking here--John, let me ask you,
we are talking about a consumer financial product safety
agency. Obviously, the Fed is very much here. We are talking
about that as well and having a prudential regulator. Why is
that not necessarily the kind of checks and balances we are
talking about in the system?
Mr. Dugan. I cannot really defend the current system of so
many regulators. As one of my predecessors used to say, it does
not work in theory, but we have worked hard to make it work in
practice.
And having said that, I think there is more you could do if
you were so inclined, and you have gone from four regulators to
three prudential regulators in the proposal. You could go the
next step to have a single regulator for State-chartered
institutions, which would bring you down to two. You could go
to one regulator for the banks, and you could even bring in the
holding company regulation to the prudential supervisor.
As I mentioned in my testimony, there are advantages and
disadvantages in each of those steps. I think at the end of the
day, if you put everything all in one place, it would be
probably too much. And so I think that is probably a bridge too
far, but there are things that you could do that would simplify
things for the future.
I do not believe, and agree with Sheila, that this was a
principal contributing cause of this crisis. But I think going
forward we do have to think hard about what is the best system
for the future, and giving those matters real thought is a good
thing.
Chairman Dodd. Dan and John, some quick responses to my
question.
Mr. Tarullo. Mr. Chairman, among the many reasons why
Members of this Committee will not be unhappy to see the summer
recess come is they will not have to listen to me say, for
about the third hearing in a row, that each proposal that comes
before us is going to have some advantages and some
disadvantages.
I do think, as John and Sheila have suggested, that nobody
would sit down and write the system we have now if they were
starting from scratch. But the system having been in place, you
have seen that there are some advantages to splitting bank
supervision. I personally think it would be a very bad idea not
to have the deposit insurer have a bank examination function,
so that the deposit insurer understands how banks are
functioning before they fail, and thus be better able to
resolve them.
I also think that it is important for the Federal Reserve,
as the central bank and as the holding company supervisor, to
have a window into how banks function.
Would there be efficiency gains in some sense from having a
single regulator? There probably would be, but I think my
colleagues to my right have already pointed out some of the
disadvantages as well.
Chairman Dodd. John.
Mr. Bowman. I would agree with some of the disadvantages
that have been pointed out. I think the other question that we
would have is the form that the current system holds, a
multiple of regulators, really the cause of the issue we are
dealing with today? And I would suggest that, in fact, the
principal cause, as the Administration says in its proposal--
high-cost loans, only 6 percent of the high-cost loans provided
American consumers were provided by depository institutions
that were regulated under the current system; 94 percent were
provided by the so-called ``shadow banking regulator.''
That is why we would suggest the focus really should be on
filling the regulatory gaps that exist today and that really
need to be filled.
Chairman Dodd. Senator Shelby.
Senator Shelby. Mr. Chairman, just for the record, just my
observation, I would think that if you look at the record here
of the failure of the regulatory bodies, that all roads seem to
lead to the Federal Reserve. They don't lead to the FDIC. They
don't lead to the Comptroller. They don't lead to the Community
Bank Supervisor. But just about all of them lead to the Fed,
and let us be honest about it.
I want to get into something else. Chairman Bernanke has
testified before this Committee that this crisis has revealed
that our Nation's ``too-big-to-fail'' problem is much worse
than many thought. After the bailouts of Bear Stearns, AIG,
Chrysler, and GM, our markets now have good reason to expect
that the Federal Government will bail out any prominent company
that gets into financial trouble, perhaps.
My question to you is, what steps need to be taken to
restore market discipline and minimize the moral hazard created
by the bailouts over the past year? Is this a problem that will
not be solved until the Federal Government actually allows
several prominent institutions to fail? In other words, we are
going down a road, a dead-end road on the ``too-big-to-fail''
thing.
Sheila.
Ms. Bair. Well, we very much agree with you, Senator, and
that is why when I have testified before this Committee
previously our priority focus has been on resolution authority.
We need a mechanism that can resolve very large financial
organizations in a way that is orderly, that protects the rest
from any systemic implications, but makes sure that their
creditors and shareholders take losses. We don't have that
right now and I don't think we are going to get that restored
market discipline until Congress puts something like that in
place.
Senator Shelby. John.
Mr. Dugan. I agree that we need a better mechanism to have
more orderly resolutions of companies that get into trouble so
that you can have more instances where you don't have threats
to the system just by resolving them. I think you need to do
more up front by way of capital requirements and liquidity
requirements so they don't get into that position. And I think
you will have more circumstances where larger institutions can
be failed in an orderly manner.
I do think, however, that you have to preserve some
flexibility for the Government----
Senator Shelby. Sure.
Mr. Dugan. ----in emergency circumstances where the entire
system is threatened, like we were last fall, to be able to
address that concern, and I know that is hard, but I think you
really need to do that.
Senator Shelby. Governor.
Mr. Tarullo. Senator, I certainly agree with the utility of
the resolution mechanism, but when you ask about market
discipline, I think there is more that we need to do. The
resolution mechanism comes at the end of the day. It comes at
the time of failure. It would be better to create additional
incentives that preclude the failure. We surely need more
transparency and disclosure by financial institutions,
particularly the largest.
And as I have indicated a couple of times in prepared
testimony, I think we also need to be looking at alternative
requirements for the capital structure of at least large
institutions. There are a number of ideas out there that would
require certain kinds of convertible debt to be in the capital
structure of a company. That is good because there is market
discipline as long as it is a debt instrument. The debt holders
want to be paid. And they know if the financial institution
gets into trouble, that that debt will be converted into
equity. It will provide a buffer against loss and they will be
subject to loss.
So I think that market discipline has a number of different
avenues that we should pursue, and market discipline itself
should be pursued alongside of some other regulatory
mechanisms.
Senator, if I could, you know I was not at the Federal
Reserve up until a few months ago, and as I have said
repeatedly, I really do believe here is plenty of blame to go
around everywhere. But I don't honestly think that all roads
lead to the Fed on this. I mean, Bear Stearns----
Senator Shelby. Well, which don't lead to them?
[Laughter.]
Mr. Tarullo. I would say, Senator, Bear Stearns, AIG,
Lehman, Fannie and Freddie. There were a lot of problems in
this system, and as I said earlier, I think before this crisis
is over, we are going to have seen a lot of failures in a lot
of kinds of institutions. I don't say that to try to deflect
any responsibility. In fact, I think part of what I was trying
to say in my prepared remarks and in the introductory remarks
was that I and everybody on the Board takes seriously where
things didn't get regulated as well as they should have and
where the structure needs work, and that is why we started to
make the changes we are already making.
Senator Shelby. Just for the record, and we all know this,
but who is the regulator, the primary regulator of the holding
companies, the big banks that got into trouble? You know it is
your Federal Reserve, and you are now--you weren't, but you are
now a member of the Board of Governors. Let us be honest about
it.
Mr. Tarullo. Well, that is absolutely true, Senator. In
some cases, the bank is regulated by other regulatory agencies
and there are also entities----
Senator Shelby. But the primary regulator of the----
Mr. Tarullo. Of the holding companies, right.
Senator Shelby. ----is the Federal Reserve.
I haven't got much time, but I want to pick up on a couple
of things. Today's Wall Street Journal had a tough article
dealing with Secretary Geithner when he met with a bunch of
you, where he told the financial regulators that they should
stop--can you imagine the gall here of the Secretary--that they
should stop criticizing the Obama administration regulatory
reform plan. My gosh. I hope you won't quit. I think your
honesty and your candor here is very important.
We recognize the role of the Treasury to set some policy
for financial regulation. But ultimately, it is going to be the
Congress up here. This Committee, both sides of the aisle, and
the House is going to set the tone and create the laws. And I
appreciate you bringing this independent perspective with all
kinds of pressure placed on you.
Does the testimony that you have given here today, that you
have provided, is that your own views, such as it was, not in
any way influenced by Secretary Geithner's tirade against you
the other day? It is a serious question. Is this your----
Chairman Dodd. Who are you asking the question of here?
Which one of these----
Senator Shelby. I was asking all of them.
Mr. Dugan. Yes, it is our own testimony. Congress requires
and prohibits the Treasury Department from intervening in any
legislative view we express to the Committee. We do not clear
our statements through the Treasury Department and we take that
independent function very, very seriously.
Senator Shelby. Sheila.
Ms. Bair. Yes. I don't think anybody thinks we are not
independent. It was absolutely our testimony.
Senator Shelby. We hope you are going to stay independent.
Ms. Bair. I will.
Senator Shelby. Governor.
Mr. Tarullo. Absolutely, Senator. The only people I
discussed this with are my fellow members of the Board and the
staff of the Federal Reserve.
Senator Shelby. Mr. Bowman.
Mr. Bowman. Senator Shelby, I think our testimony speaks
for itself and we do take exception to the Administration's
approval, and yes, we are independent.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much.
Senator Brown.
Senator Brown. Thank you. I was a little surprised by
Senator Shelby's question, considering the positions that you
have all taken.
Let me look at this in kind of a different way. The public
has a general understanding. The investing public and the
victims of this financial disaster, which is my whole State and
most of this country, has a general understanding that
regulation of financial institutions, putting it mildly, fell
far short. Some have the belief that the most, I think the most
egregious institutions found an agency that was too easy on
them. In Washington, we call that regulator shopping. They just
think that the Government, for whatever reason, was too easy on
Wall Street greed.
And I hear each of you. There may be some turf issues, and
that may be a cynical way to look at it and I apologize if that
is the way you take it, but I hear the--I see the President's
plan, the President's proposed bank supervision framework. I
hear each of you disputing major parts of it. How would you
explain to the American public what the next step is? How do we
fill the financial gaps in our financial regulatory system if
consolidation of regulators is not the best move? How do you
explain to the public why four very smart people playing very
important roles in our financial institution regulatory system
and an Administration that, I think, has equally smart people
that understand this, why is there not more agreement?
How do you explain in understandable terms, if you were
talking directly to the American people now, not to this
Committee, what we should do to fill these gaps so these kinds
of egregious, awful things don't happen again? I will start
with you, Ms. Bair.
Ms. Bair. Well, I think there was arbitrage, but it was
between the bank and the nonbank sectors. It was excess
leverage with investment banks and hedge funds and other types
of vehicles versus the higher leverage in risk-based capital
requirements that we had for commercial banks.
On consumer protection, it was third-party mortgage
originators that were not affiliated with insured depository
institutions originating loans being funded by Wall Street
funding vehicles. The third-party mortgage originators were
pretty much outside of any type of prudential or consumer
protection standards that were within the purview of the
banking regulators.
So I think it is unfortunate the word ``bank'' is used for
just about every institution, but in my world, a bank is an
FDIC-insured institution. While we all made mistakes, the
insured depository institution sector has held up pretty well.
This is why you saw in December so many financial companies
fleeing to become bank holding companies and trying to grow
their insured institutions, because that was the sector that
was left standing, which is hard for the FDIC because our
exposure has increased significantly. We have tried to do the
things we need to do to stabilize the system. But, this has
increased our exposure significantly.
As I have testified before, the arbitrage is between the
banks and the nonbanks. Having a consumer agency with a focus
especially on examination and enforcement of the nonbank sector
and having a Systemic Risk Council that would have the
authority to define systemic issues or systemic institutions,
whether or not they voluntarily want to come in under the more
stringent regulatory regime we have for banks and bank holding
companies.
The arbitrage was between the bank and the nonbank sectors.
It was not among different types of bank charters, and
certainly not between the choice of a State or Federal charter.
There are 8,000 community banks in this country. Most of them
have a State charter, so consequently, we regulate about 5,000
banks. I don't think they contributed to this, but you have
seen traditional resistance among community banks to regulatory
consolidation for fear, frankly, which I share, that inevitably
there would be a regulatory viewpoint that would be dominated
by the larger institutions if everyone was lumped in together.
There is a valid reason for State charters. The community
banks and State-chartered community banks tend to be more local
in their interest and how they conduct their lending. To try to
draw that issue into the much larger problems we had with
arbitrage between banks and nonbanks and then the lack of
regulation of derivatives, I think, is misguided and is not
where you should be focusing your efforts or the American
public should be focusing its efforts.
Senator Brown. Mr. Dugan, your thoughts?
Mr. Dugan. I agree with everything Sheila just said. I
would point out that we also regulate about a quarter of the
Nation's community banks, so we do all different sizes of
institutions. And most of the problems did not take place
inside of the insured depository institutions that we
supervise, which are the most extensively regulated parts of
the system.
Of course, we did make some mistakes and there were some
problems. I am not discounting that. But that is not where most
of them were.
The second thing I would say is I think there are a number
of very sound and strong proposals in the Administration's
reform proposal, which I do support, as I testified. There are
just some places where we think it should be shaped
differently, and carrying out our duty to provide our views
independently, that is what we are trying to suggest.
With the CFPA, for example, we agree that a strong Federal
consumer protection rulewriter to provide a single set of rules
that applies to everybody is a very powerful change. But we
think taking that same step and applying it to the enforcement
and examination of the depository institutions should stay with
the bank regulators where it works well, and instead, all of
that effort should go to the examination, enforcement, and
implementation of the nonbanking sector where there were very
substantial problems that have led to disproportionately higher
levels of foreclosures, for example, in your State and many of
the States represented in this room.
Senator Brown. Thank you.
Governor Tarullo.
Mr. Tarullo. Thank you, Senator. If you are asking, what
should the public be focused on, my suggestion would be too big
to fail. That is not the only problem by a long shot, but to
me, it continues to be the central problem--the ability to
avoid the moral hazard that comes with ``too-big-to-fail''
institutions. As I said a moment ago, I think we need a variety
of supervisory and regulatory tools to contain that problem,
whether it is resolution, bringing systemically important
institutions into the perimeter of regulation, making sure that
the kinds of capital and liquidity requirements that
systemically important institutions have will truly contain
untoward risk taking.
I think we are going to need a broad set of activities.
``Too big to fail'' was not the only cause, but it was at the
center of this crisis and that is, I think, what we all need to
focus on.
The only other thing I would say harks back to a colloquy
you and I had a couple of weeks ago when I was testifying. You
and I were talking about attitudes and orientation and how
people in the Congress and the regulatory agencies and the
Administration think about issues and problems. It is not easy
to ensure against people losing interest in issues. But I think
that is a role that, in a system of Government that has a lot
of checks and balances, we have to think about.
How do we try to institutionalize skepticism and critical
thinking, to look at developments in the financial world so
that we don't just say, well, that is just another market
development; it must be benign. But instead, we must begin to
distinguish intelligently between benign, useful innovations on
the one hand and building problems on the other.
Senator Brown. Thank you.
Mr. Bowman.
Mr. Bowman. Thank you, sir. One of the advantages of being
last on a panel like this is you usually get to agree and sort
of dispel the notion that we disagree on so many things. I
agree with what my colleagues have said, but I would also like
to focus on the arbitrage position between banks and nonbanks.
I think the CFPA provision of the Administration's bill
goes a long ways toward dealing with that situation. The
difference is that you don't get to sell a product at a
nonregulated entity under different terms and conditions, a
different regulatory structure, than you would if you were
doing so in a depository institution or otherwise regulated
entity. I think that is one of the critical components of this
Administration's proposal to fix that gap.
Senator Brown. Thank you. Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much, Senator Brown.
Senator Corker.
Senator Corker. Mr. Chairman, thank you, and as always, I
thank each of you for your testimony.
I also, like I am sure most people did, read the story this
morning in the Wall Street Journal regarding the meeting on
Friday, and generally speaking, did it capture the essence of
the attitude in the meeting?
Ms. Bair. Who is going to take that one?
[Laughter.]
Senator Corker. Very briefly. I just want to move on to
other----
Mr. Dugan. Senator, it was a candid conversation about our
agencies' different views on the different subjects and----
Senator Corker. It was a generally fair article?
Mr. Dugan. A lot of it was true.
Senator Corker. OK. So here is----
[Laughter.]
Senator Corker. I guess what I would like to get at, it is
my understanding that the original draft had the National
Banking Supervisor not being actually a part of Treasury. I
think we have seen today that--and we have known for some
time--Treasury can exercise--try to exercise influence over the
organizations, and my understanding is that, again, in the
beginning, the National Banking Supervisor was not a part of
Treasury and at the last minute it was put back in.
And I just wonder if one of the things we ought to be
looking at is absolutely ensuring that this Banking Supervisor
is not a part of Treasury and even more independent than has
been laid out, very briefly.
Mr. Dugan. May I respond to that?
Senator Corker. Yes.
Mr. Dugan. This may surprise you, but I was a strong
advocate of keeping it within the Treasury but subject to the
same firewalls that we have now, which does give the agency a
very strong ability to operate independently. I believe that
making it independent and creating a new board, if you have
three other regulators still in existence and everybody has got
boards, I think it will confuse things. It is critical,
however, that you do have those statutory firewalls that were
put in place. And that was a position that I advocated.
Senator Corker. Any differing opinions from the panel?
Ms. Bair. As an independent agency that does the types of
supervisory functions that the OCC and OTS perform, we look to
them to help protect the Deposit Insurance Fund through their
front line prudential supervision of banks that we insure. So,
I think there are some merits in making it independent. As an
independent agency, you do want to make sure it is as insulated
as possible from any type of influences that might not be
focused on prudential supervision and the safety and soundness
of the institution.
Senator Corker. OK. Thank you.
Mr. Tarullo, I think I have actually been very supportive
of our Chairman of the Federal Reserve, differing from some of
the folks on the panel. And yet at the same time, there is no
doubt the Federal Reserve had some failings in this last go
around.
I read your 2005, the Federal Reserve Service Purposes and
Function document, and it actually does, just for what it is
worth, state that one of your responsibilities is maintain the
stability of the financial system and containing systemic risk
that may arise in financial markets and providing financial
services to depository institutions. So I think it is fair to
say that, in essence, you sort of did have responsibility
there.
I am wondering how harboring all of that at the Federal
Reserve would alter, if you will, behavior. I think all of us
understand today that we need to be more concerned about
systemic risk. I am sure the Fed does, too. And again, I say
this with respect for the organization, but obviously with
concerns. I am just wondering what would be different if, in
fact, the Fed was the systemic regulator--the systemic
regulator.
Mr. Tarullo. Senator, I don't think there are any proposals
on the table that would really make the Fed a systemic risk
regulator in the sense of being able to swoop in anywhere,
anytime, and say, we want to do something about this. The
proposal that we have endorsed is making the Federal Reserve
the consolidated supervisor of systemically important
institutions.
I would say in direct response to your question, there is
certainly a responsibility there, and I would be the first to
say that responsibilities of all the financial regulators,
including the Fed, were not exercised as effectively as they
ought to have been. But I would also say that when you give an
entity responsibility, you do have to make sure that you give
it authority to achieve that responsibility, to fulfill it, and
that you have the mechanisms that will allow it to do the job.
And when you have a circumstance in which large
institutions that turned out to be systemically important--I
think in some cases to the surprise of many--and were not
within the perimeter of regulation, it was obviously not going
to be an easy matter to contain the activities of those
institutions, including a lot of the wholesale funding and a
lot of the very tightly wound, complex securitization that was
a major contributor to these problems.
So I would say, first, you need to make sure that the
appropriate legal authorities are present. Second, as I have
often said, there needs to be a reorientation of our regulatory
approach more generally toward systemic risk. And third, the
Federal Reserve, I think, needs to take more advantage of the
comparative abilities that it has. That is why we wanted to
move forward, to make use of the economic and financial
expertise to provide a monitoring of and a check upon the on-
the-ground supervisors. That is where the advantages lie and
that is where we ought to bring them together.
Senator Corker. Let me just ask one last question. I know
there are differing thoughts on ``too big to fail,'' but each
of you feel that that is a big issue, how to deal with that. I
know that I would like to see a resolution mechanism in place
where they resolve much like Chairman Bair proposes.
Mr. Dugan, I don't understand how, if you continue to give
Treasury the ability to solve the problem with taxpayer money
if they deem it an important thing to do, I don't understand
how that creates any market discipline. It seems to me that
leaving that vague line in place defeats all market discipline.
I don't understand how you can cause those to measure up or how
we could craft something that actually worked and caused people
like the Senator from Ohio's constituents and mine, which I
think are different in thinking about some things, but I think
they would agree that that is wrong, and yet you propose
keeping it in place and I don't understand that.
Mr. Dugan. I think there are ways that you have to limit
it. I think there are presumptions so that you make it more
difficult to exercise. I think there are measures that you have
to take up front so you don't get yourself in that position.
My only point, though, is this: when you are in a crisis
and you need to take action and you need to do it to protect
the financial stability of the system, I don't think we should
tie the hands of the Government from being able to do it in a
moment's notice if we have to. I don't ever want to be in some
of the weekend situations that I was in last fall, and we did
have mechanisms that ensured a wide variety of the Government
was involved in the decisions. People can second-guess some of
those judgments, but I really do not think it is a good idea to
completely forbid the ability to address systemic situations
and crises if we have to.
Senator Corker. Thank you.
Chairman Dodd. Thank you very much.
Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman. Thank you all
for your testimony.
I gather from the panel that, in fact, there is a sense
that beyond maybe what the Administration is proposing, which
is merging OTS into the OCC, there isn't a view that there
should be any further regulatory consolidation. So my question
is, if we don't do that, then there still seems to be the
opportunity for regulatory arbitrage where the regulated
companies would choose what they believe to be the most lax
regulator.
So what mechanisms can we put in place to prevent that, to
prevent the shopping? For example, the Administration's
restrictions that are proposed on the ability of a troubled
bank to switch charters, is that enough by themselves to
prevent a regulatory arbitrage that we want? I would like to
hear some of your ideas on that.
Mr. Tarullo. Senator, I will start if that is OK. Congress
has provided some mechanisms to contain regulatory arbitrage. A
lot of restrictions that apply to national banks are made by
Congress to apply to State banks if they are going to get
Federal deposit insurance. That is an important backdrop,
number one.
Number two, the provision you just referred to, I think is
an important one, and it is one on which the agencies have
already tried to act. Actually I was going to tell the Chairman
this--we had a break in your hearing in March during which
Chairman Bair turned to me and said, you know, we have to
figure out a way to do something about entities trying to get
different charters when they are under enforcement actions or
they see an enforcement action coming. And so she launched an
initiative among the agencies to have us all reaffirm that
charter conversion ought not to happen unless the institution
is sound, there are no enforcement actions pending, and it is
not being used to avoid supervisory ratings.
A couple of the institutions shifting charters over the
last several years that have become reasonably well known
engaged in that sort of flight from enforcement. So I think
this was a very important gap to plug.
Senator Menendez. Anything else? Is that enough?
Mr. Dugan. I think it is very important. We have seen over
the years, a number of situations in which people have switched
charters to avoid supervisory action. I totally support the
action we have taken. If we wanted to go further and put some
of that in legislative language, I would think that might be a
very good idea, just to make sure that we don't change it in
the future.
Senator Menendez. Chairman Bair.
Ms. Bair. I would agree with that, and we indicate that in
our written testimony. We are the insurer. We are not the
chartering entity. So, once deposit insurance is granted, if
the entity then decides later to shift charities, we really
don't have a role in that decision. We particularly feel that
it is in our interest to ensure good, strong, robust prudential
supervision. We do not want charter conversions to, in any way,
be used to undermine that process.
We would also be happy to work with you. Senator Reed and I
had a conversation a while back about putting something like
that in the statute to make sure the provision is there.
Senator Menendez. Well, I would join Senator Reed in that
effort.
Let me ask you, some big banks----
Mr. Bowman. Senator Menendez, if I could address that
question----
Senator Menendez. Surely.
Mr. Bowman. ----I think one of the charters, which I think
is being used as an example of an arbitrage opportunity was the
choice by Countrywide to move from regulation by the OCC and
the Fed to regulation by the OTS. This was in March of 2007. In
doing so, Countrywide brought approximately $92 billion in
assets to the OTS. We undertook a very extensive coordination
with the Fed, including the Fed Bank of San Francisco, the OCC,
and others, as well as State regulators of various affiliates
within the Fed's holding company jurisdiction. We granted the
charter to Countrywide.
But one of the facts that seemed to be sort of lost in a
lot of the discussion is that 3 months or 4 months before
Countrywide came to the OTS, Citibank took two historic thrift
charters totaling approximately $232 billion in assets to the
national bank charter from the Federal thrift charter shortly
after Countrywide came. Cap One took approximately $17 billion
in assets from a thrift charter to the OCC.
I would suggest that the mere action of an entity, a
business entity choosing to change its charter based upon its
business plan in and of itself does not necessarily suggest
that they fleeing a particular set of regulatory structures or
whatever else.
Senator Menendez. No, I appreciate that.
Mr. Bowman. I just wanted to make myself clear on that
point.
Senator Menendez. I appreciate that.
Let me ask the question, several big banks have come here
and argued before the Committee that we shouldn't have a
Consumer Financial Protection Agency because it is bad to
separate safety and soundness regulations from consumer
protection regulations. But that argue doesn't, at least to
make, make much sense because safety and soundness regulations
and consumer protection regulations are currently together in
the same agencies and that very system failed miserably to
protect middle-class American consumers.
So if there is concern about regulators having overlapping
responsibilities, can't that be solved by assigning clear
responsibilities to each regulator and creating some solid
procedures for resolving conflicts among regulators?
Ms. Bair. On the consumer protection side, rulewriting
traditionally has been divorced from enforcement, so the FDIC
and the OCC have no power to write consumer rules. We examine
and enforce, but we have never had rulewriting authority. That
is separate already. So I think the bank regulators generally--
I do not want to speak for others--are supportive of this
because the arbitrage, the choice, if you will, was not so much
among bank charters, but between being a bank or being a
nonbank. Mortgage brokers with very little regulation could
originate loans without anybody looking over their shoulders,
regarding undocumented income, or regressively marketing
teaser-rate 2/28s and 3/27s.
The value added with this new agency is providing rules
across the board for both banks and nonbanks. And as we have
all testified, keeping the examination and enforcement function
with the bank regulators for the banks and having this new
agency focus its examination and enforcement resources on the
nonbank sector where there is not much oversight would give
consumers protection across the board. So, whether they are
dealing with a bank or a nonbank, they have some baseline level
of protection and a regulator actually coming in and making
sure those rules are being enforced and adhered to.
Does that answer your question?
Senator Menendez. Yes. Mr. Dugan, do you want to jump in?
Mr. Dugan. I was just going to say I agree completely with
everything Sheila just said, and attached to my testimony are
examples of a number of the ways in which integrated safety and
soundness and consumer protection supervision has found issues
for both safety and soundness purposes and for consumer
protection purposes that otherwise would not have been found
under the current system. We believe that under the examination
and supervision system currently in place, bank examiners are
good at implementing rules that are written, and to the extent
that a new agency writes strong rules, they will be complied
with by banks through this function better than any other
alternative model.
Senator Menendez. So basically--and, Mr. Chairman, I will
end on this. My understanding from the panel is that you are
all in support of a consumer financial protection agency?
Mr. Tarullo. No, Senator, that is not true. The Federal
Reserve has not taken a position one way or another on the
creation of the----
Senator Menendez. Are you going to take a position?
Mr. Tarullo. If we were specifically asked, I guess we
would at least discuss among ourselves. I think our effort to
this point has been to point out the virtues of integrated
supervision and regulation of consumer products alongside the
obvious virtues of a separate agency.
Senator Menendez. Thank you, Mr. Chairman.
Chairman Dodd. Thank you, Senator Menendez.
Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
I am very happy to see all of you here today. After you
kissed the ring of the Secretary of the Treasury, you finally
got out of the room, and you are here in person to testify,
independently. It is really nice to see that.
Mr. Tarullo, I want to go back to something that you said
earlier. You said that the Fed would like to have the authority
and the power to enforce. We gave you that 14 years ago--more
than 14 years ago, actually. Now it is 15 or 16 years ago. And
you did not write a regulation for 14 years to govern the banks
that were under your control or the mortgage brokers that were
under your control. I know you were not at the Fed. That is not
the problem. The problem is the Fed had the ability to act and
did not.
So you might understand some of us not being agreeable to
giving you more power when you failed in enforcing the power we
gave you. So just for your information, you can take it back to
Chairman Bernanke and the rest of the board and say, ``You
know, it took you, Mr. Bernanke, 2 years after you became
Chairman to write a regulation on mortgages. And it took
Chairman Greenspan 12 years not to write it.'' So we are a
little reluctant to give the Fed new additional authority. I
just happen to agree with Chairman Bair on when the rubber hits
the road, they are there to make something happen.
Now, our panel is trying to figure out how to stop the
rubber hitting the road--in other words, how to prevent
systemic risk from becoming too big to fail. That seems to be
the major problem.
Senator Corker brought it up earlier today about, you know,
we really need ideas, because we seem to have failed by not
giving the authority to the right person or the right person
not enforcing the authority we gave them.
So my question to you is: What additional authority do you
think we should give the Fed?
Mr. Tarullo. Senator, as you know, I agree, personally--it
is not a Board position--with you that the Fed took too long to
use its existing authority to enact consumer protection
associated with mortgages. I was referring a few moments ago--
and I will elaborate on it now--to the authority to provide
consolidated supervision for any systemically important
institution.
As you know, a year-and-a-half ago, that statement would
have, in practical terms, meant that a whole set of
institutions--at that point, the five free-standing investment
banks--would likely have been brought in by law to the
consolidate supervision program.
Because of the financial crisis, and the fact that a couple
of those institutions are no longer with us and others have
become bank holding companies, the immediate practical
importance of the authority would not be as great as it would
have been a year-and-a-half or 2 years ago. However, there is
first the possibility that an institution which has become a
bank holding company in the middle of the crisis, in an effort
to get the imprimatur of having consolidated supervision,
would, when things calm down, decide it does not so much like
being a supervised entity, so it would dis-elect being a
holding company.
Senator Bunning. We could prevent that.
Mr. Tarullo. You could.
Senator Bunning. Yes.
Mr. Tarullo. Absolutely. And, second, if in the future
other institutions grow or activities migrate from the
regulated sector to other institutions, we would want to make
sure that any such institution which itself becomes
systemically important would also be subject to consolidated
supervision. That is what I referred to earlier.
Senator Bunning. Sheila, could you expound on the ability
of the FDIC to preempt, in other words, to get in front of the
foreclosure or the shutting down of our--in other words,
looking prior to, with your regulatory regime into banks that
you have under the FDIC jurisdiction? In other words,
preventing.
Ms. Bair. I think Congress gave the FDIC helpful new
tools--they were finalized in early 2006--to make risk-based
adjustments to our premiums that we charge for deposit
insurance, because at least for insured depository
institutions, this helps us provide economic disincentives to
high-risk behavior. This is a tool we are using and will
continue to further refine. But, it has been helpful, I think.
I think the big problem or the shortcoming that we have
found is that when these larger entities get into trouble, so
much of the activity is outside the insured depository
institution that our traditional resolution mechanism does not
work. We can only resolve what is in the FDIC-insured
institution, which is why we believe it would be very helpful
to us, at the FDIC collectively, to get ahead of this. First of
all, it would be a strong disincentive. We need more
regulation, clearly, of these very large institutions, but we
also need greater market discipline and the certainty that
investors and creditors will take losses if an institution gets
in trouble and would have come to the Government for help. They
will be put into a resolution regime.
Senator Bunning. Let me ask you this simple question. If an
entity is listed on an exchange, wouldn't the Securities and
Exchange Commission have some kind of ability to examine all
the aspects of that institution? I am looking at AIG, for
instance.
Ms. Bair. Well, generally it is the holding company.
Senator Bunning. Correct. It is the holding company.
Ms. Bair. It is the holding company, not the bank, that is
listed. The SEC's regime is focused not on prudential
supervision but on investor protection through a transparency
regime. They do not do any kind of safety and soundness
prudential oversight of listed companies. They are focused more
on ensuring appropriate financial disclosure for the benefit of
investors.
Senator Bunning. Thank you.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you.
Senator Tester.
Senator Tester. Thank you, Mr. Chairman, and I thank the
panelists for being here today. An interesting discussion. I
think we all agree that the gaps exist. I think we all agree
that we still have not sealed those gaps up. And so I guess
referring to the testimony from a gentleman on the second
panel, a former Comptroller of the Currency, Mr. Ludwig, he
writes and, in fact, recommends to ``streamline the current
`alphabet soup' of regulators by creating a single world-class
financial institution-specific regulator at the Federal level
while retaining the dual banking system,'' which is very, very
close to what, quite honestly, I have in mind. And he goes on
to lay out a system of critiques, and you guys have somewhat
addressed this in some of your other questions.
But going back to what Senator Menendez asked in that he
wanted to know if it could be laid out to seal these gaps by
rulemaking or some other method, I am not sure I got an answer
to that question.
So I want you to share your thoughts as concisely as
possible, because each one of you could burn 4 minutes and 50
seconds with one answer if you wanted.
As to why significant reform in this direction is not the
direction to go, taking off your hat as your individual
department leaders--because I know turf does play a role. If
somebody said, ``I am going to dissolve your farm,'' I would be
a little upset with it. But just tell me how we can get these
gaps closed without doing something like this and why this
would not be a good idea.
Go ahead, Sheila. We will just go down the line.
Ms. Bair. Again, I think the issue was not about the choice
among bank charters. It was between being a bank or not being a
bank and being much less regulated in the nonbanking sphere. I
think that is the arbitrage that needs to be addressed.
Senator Tester. And what you are saying is that could not
be addressed with one----
Ms. Bair. No, it would not, because you would just be
consolidating what we all do for insured depository
institutions. That would not expand beyond the already heavily
regulated sector.
Senator Tester. Could it?
Ms. Bair. I think with a systemic risk council it could, at
least for risks that are systemic in nature. You would be able
to give this new systemic risk council--which would also
include the SEC and the CFTC--some ability to look across
systems and to impose prudential requirements regarding capital
and leverage where needed to mitigate systemic risk. And, yes,
that would be across all sectors, not just for banks.
Mr. Dugan. Senator, I believe you could do more
streamlining. You could move more in the direction you are
talking about. We do not have an ideal system. But as my
testimony suggests, there are some issues you are going to have
to confront if you want to have an effective Federal Deposit
Insurance Corporation. If you go for long periods without
having any bank failures, they are not going to have a lot to
do and will not know the system very well if they do not
supervise banks.
Likewise, the Federal Reserve has some things to offer to
supervision, particularly of the very largest institutions at
the holding company level that are engaged in a lot of
nonbanking activities. And to think that a banking supervisor
would do all of that as well without having the benefit of
direct supervision raises some questions.
Senator Tester. OK.
Mr. Tarullo. Senator, I would say, trying to be succinct,
the two most important gaps to fill are: first, making sure
that every systemically important institution does come within
the perimeter of regulation; and, second, what we were
discussing earlier, which is to say the assurance that there
cannot be charter conversions motivated by efforts to escape
enforcement and escape bad ratings. And just to be clear, I
think it would be a perfectly good idea for the Congress to
legislate on that matter so that in the unlikely event that our
successors did not share the same view, they could not go in
the opposite direction in which charter conversions could be
done for the wrong reasons.
Senator Tester. I understand that, but what you are saying,
then, a world-class financial institution, a specific regulator
could work.
Mr. Tarullo. Well, I actually think, as Sheila suggested
early in the hearing, that what we have learned in this crisis
is that there were lots of different models of supervision and
regulation around the world, and none of them performed
particularly well. And that seemed to me more of a lesson than
anything about a particular structure or anything else. None of
them performed particularly well.
Senator Tester. OK. Go ahead.
Mr. Bowman. And I would also pick up on the point, your
concept is a world-class financial institution regulator. I
think one of the lessons that we have learned--and Sheila has
mentioned it a couple times--is that we have banks and nonbanks
who are providing the same kinds of services in a different
structure. If you are a financial institution, you do have
world-class regulators currently. If you do not, you operate in
a less than regulated or under-regulated environment.
One of the suggestions I would have is that if you wanted
to close that gap, there is a process by which you can do that.
It starts with the CFPA, the Administration's proposal. The
difficulty is how they carry out, how they enforce the
regulations. The Administration proposes to use the CFPA as
that. We suggest as bank regulators we can do it more
effectively. But that is the start, because then you have to
start looking at things like capital requirements, capital
structure for those who are not financial institutions.
Senator Tester. OK. Currently, have we made any progress,
and not necessarily--well, I think ``we'' as a general group as
well--towards regulation of derivatives, credit default swaps,
those kinds of things? Or are we in the same boat we were in a
year ago? Same boat, Mr. Bowman?
Mr. Bowman. Yes. I would say that we are.
Senator Tester. OK. Everybody agree with that?
Ms. Bair. Yes, and that does require legislation to fix.
Senator Tester. Yes. OK. Are we concerned about that?
Ms. Bair. I am. Yes, I think it is huge.
Mr. Dugan. I think it is very important.
Senator Tester. Mr. Chairman, have you gotten any
recommendations from any of these folks or anybody else on how
we should be regulating derivatives and credit default swaps?
Chairman Dodd. What we are trying to do here is fashion,
obviously, a piece of legislation that comprehensively deals
with all of this, and the hope is we are going to do that when
we get back in the fall. That is the purpose of these hearings,
to bring these ideas together.
Senator Tester. But has anybody given you any concrete
ideas or----
Chairman Dodd. Oh, there have been all sorts of suggestions
made on how to do it, clearinghouses and so forth. We have got
a lot of recommendations.
Senator Tester. Well, I just think it is--as we move
forward here, I can just real quickly----
Chairman Dodd. In fact, I would just say, John--and I will
leave you more time--Senator Reed and Senator Bunning, in fact,
are working on an idea that--in fact, a number of our
colleagues here are working on various ideas to be part of the
larger bill. The Subcommittee is working on it.
Senator Tester. I think it is good. It is somewhat
distressing that, quite frankly, from my perspective--and I am
not an expert in this field at all--we have a lot of people who
are trying to do good work; but there are still gaps, and
obvious gaps. And then at the banking level, we have got a
myriad of regulators out there. Quite frankly, if I was a
banker, I would be going crazy. I would. I would not know--I
really would not know which person to be--knowing who I have to
deal with, let us just put it that way, because we are coming
at it from a lot of different angles.
Then, you know, if you take into consideration--I think,
Sheila, you said this. Community banks were not really a
problem here, but yet they are getting pressed just as hard as
anybody, from my perspective, as far as regulation goes. And I
just think that this is an opportune time in the middle of a
potential--not a potential--in the middle of a crisis to really
take a lot at our regulation system and say let us simplify it,
let us make it lean and mean and simplified. And I do not think
that can happen unless we are willing to think outside the box
and do things differently than we have done in the past.
Thank you all for being here.
Chairman Dodd. Thank you very much.
Senator Vitter.
Senator Vitter. Thank you, Mr. Chairman.
Ms. Bair, I wanted to ask you a few things that are little
bit off topic but that are important, and that has to do with
the recent actions of the Financial Accounting Standards Board
with regard to bringing certain things that have been off
balance sheet, on balance sheet, and what impacts that will
have on institutions.
How will FDIC treat the consolidation of previously off-
balance-sheet entities? And, in particular, will the agency
require additional capital for assets that are brought on
balance sheet?
Ms. Bair. Well, yes, banks must follow U.S. GAAP. So if
those are the accounting rules, if more assets are coming on
balance sheet, capital levels are going to be impacted
accordingly.
Though we still have some concerns about the timing of all
this, we support the general direction of bringing assets back
on balance sheet. But the timing still gives me some
heartburn--whether they really need to be on this accelerated
framework.
I think it also could be very damaging to efforts to get
the securitization market back, because the way the rules are
written now, as I understand, even if you just retain some
portion of interest, the whole securitization might have to
come back on balance sheet. That also goes at cross-purposes
with our efforts to try to get originators to have some skin in
the game.
There are a lot of issues and questions we have about the
timing, but we cannot control that. FASB is not an entity that
we have any control over. We can file comment letters and that
is about it. But banks must follow U.S. GAAP.
Senator Vitter. So are the capital ratios set in law, or
are they----
Ms. Bair. Well, yes. Prompt Corrective Action capital
levels are set by statute, yes. There is not a lot of
flexibility there.
Senator Vitter. And so there is no flexibility for any
phase-in period?
Ms. Bair. Not very much at all, no.
Mr. Dugan. Senator, traditionally the leverage ratio
follows GAAP completely. The risk-based ratio has some
variations, and at times has been more restrictive than GAAP.
There also is some flexibility to look at this and phase it in
over some time. This is an issue all the regulators are looking
at now to try to address some of the issues that Chairman Bair
just raised.
The bottom line is this stuff is coming back on the balance
sheet. Banks are going to have to hold capital against it. It
is really a matter of timing and how it gets phased in.
Senator Vitter. Well, I do not think anybody is arguing
about the fundamental issue, but I am concerned with timing and
phase-in because it could have negative consequences if it
were, you know, here tomorrow overnight. So what is the current
thinking about how that should be handled?
Mr. Dugan. I think the regulators are still discussing how
this affects regulatory capital. The accounting rules become
effective at the end of this year, beginning of next year, and
how the regulatory capital rules respond is something that we
will be discussing and providing some notice to the public
shortly.
Senator Vitter. When do you think there will be fairly
clear guidance for institutions about what to expect and what
timetable and what phase-in, if you will?
Mr. Dugan. If I had to guess--and this is an interagency
process--I would say weeks, not months.
Senator Vitter. And I assume all of the agencies and
regulators involved are in discussions about this?
Mr. Dugan. It is an interagency rule, as capital
requirements like this always are. So there will be a
discussion among the agencies.
Senator Vitter. OK. Does anyone else have any comments
about that?
[No response.]
Senator Vitter. OK. Thank you. That is all I have, Mr.
Chairman. Thank you.
Chairman Dodd. Thank you very much, Senator.
Senator Reed.
Senator Reed. Thank you, Mr. Chairman.
Since Countrywide, was brought up, I just want to make sure
I have got some facts right. It started off with a national
bank subsidiary. You regulated the bank, Mr. Dugan, and the Fed
regulated the holding company?
Mr. Dugan. That is correct.
Senator Reed. And under your policy and case law, a
subsidiary mortgage company, an affiliate mortgage company was
not subject to California law.
Mr. Dugan. We regulated the bank, and it did a portion of
its business inside the bank. It did most of its subprime
lending outside the bank, not in the bank. The affiliate was
subject to California law.
Senator Reed. It was subject to California law.
Mr. Dugan. Yes, but the bank itself was subject to the
uniform Federal standards of the National Bank Act, and was not
subject to California law. They did not do their subprime
lending that caused a number of problems in the bank.
Senator Reed. Just to be clear, the subprime lending was in
an entity that was subject to California law.
Mr. Dugan. Correct.
Senator Reed. Attorney General review, everyone else like
that.
Mr. Dugan. Correct.
Senator Reed. The Fed would have responsibility to review
or inspect that mortgage company as an affiliate.
Mr. Dugan. At that time, before they switched charters,
yes.
Senator Reed. Right. And did they do that, to your
knowledge? Or what template did they use?
Mr. Dugan. You would have to ask the Federal Reserve. I
will say, as in my testimony, that philosophically,
historically, there has been this anomaly where the bank in a
holding company gets very heavily inspected and regulated and
is subject to the most intensive regulation, but the holding
company affiliates were not subject to the same requirements
for annual inspections. And that needs to be fixed, and the
Federal Reserve has recently been doing more in that area, but
it is not the same, and I believe it should be the same.
Senator Reed. Let me switch to Mr. Bowman. When Countrywide
came into your supervision, you were the holding company's
supervisor, and you were also the bank's--the FSB, I presume.
Mr. Bowman. Correct.
Senator Reed. And the company that did the bulk of the
subprime was a California-regulated mortgage entity.
Mr. Bowman. There were a number of State-related affiliates
within the holding company structure. I do not remember how
many or how many States. I do not remember the percentage of
California State versus New York versus other States.
Senator Reed. When you reviewed, your organization reviewed
and inspected these holding companies, did you notice
anything--did you inspect them or did you just inspect the FSB?
Mr. Bowman. We actually did a number of things. We spent a
lot of time with both the Fed and the OCC, as I mentioned
earlier, in previewing sort of what it was that was coming our
way.
We also convened shortly after granting the charter. Again,
the charter was granted March of 2007. We convened what I would
call a ``regulators conference,'' where we invited and, in
fact, had regulators from many, many States--I do not remember
the exact number--come in and discuss with us some of their
particular concerns, if any, related to the operation of the
affiliates within the holding company structure, including New
York, California, and others.
Senator Reed. And did that alert you to any potential
problems?
Mr. Bowman. Yes, it started to. Yes, it did, sir.
Senator Reed. OK. Thank you.
Let me switch gears. We had a few hearings ago Mr. Meltzer
and Dr. Rivlin, who have a long-time association with the
Federal Reserve. And their suggestion was that the Federal
Reserve essentially get out of the business of supervising and
regulating entities and concentrate on the issue of the
monetary policy and perhaps, you know, other issues.
My question is--and I will let you answer last, Governor. I
think you have an opinion about this. But to the other
panelists, if the Federal Reserve following this advice by two
very knowledgeable people and experienced people, does not
perform the role as the supervisor for large holding companies,
who would or should? Do we have to create another entity? What
is your general comment about that? Then I will conclude with
the Governor.
Ms. Bair. The Federal Reserve is the holding company
supervisor for the vast majority, but not all of the very
largest institutions. So, yes, I think you would have to create
a new agency to do it if the Federal Reserve was not doing it.
Senator Reed. Mr. Dugan, do you have a comment?
Mr. Dugan. I think you could put the holding company
supervisor and the bank supervisor in the same entity. That is
how the OTS works. You could do it. And I think, frankly, for
smaller institutions and a lot of institutions where the only
subsidiary of the company is the bank, there is some logic to
that. But where you have companies, as was talked about
earlier, where a lot of different businesses were engaged in
nonbanking kinds of activities, that is where the particular
expertise of the Fed--because of its closeness to the capital
markets, its open market operations, its international central
banking, all of that comes into play. Replicating that would be
the most difficult challenge for any agency that tried to re-
create it, either separately or inside a prudential supervisor.
Senator Reed. Mr. Bowman--and quickly, because I have to
give the Governor some----
Mr. Bowman. Yes, I would agree with that. We currently
regulate both the holding company underlying institution. I
think you could replicate that. The difficulty would be in
dealing with State-chartered organizations where you did not
already have a Federal regulator like the OCC or the OTS.
Senator Reed. Governor Tarullo, your comments, and I might
just throw in one other issue. If the Fed is the regulator--and
this is a common concern of all of you--you have to be able to
sort of work through what is now the deference to functional
regulators, which I think we have identified as a problem. So
you might put that into your answer, too, Governor.
Mr. Tarullo. Thank you, Senator. People are attracted--
particularly once they get out of Government or if they have
never been in Government--to neat solutions that look great on
paper. I think that anybody who has dealt with this crisis and,
indeed, dealt with financial supervision on an ongoing basis,
will tell you that the whole point about the financial sector
of our economy is that it reaches everywhere and it affects
everything.
And if one is looking to a central bank to perform the dual
mandate given to it by the Congress of trying to maximize
employment and achieve price stability, I do not think there is
any way to do that effectively without paying an awful lot of
attention to financial stability. And to achieve financial
stability, one has to have an influence upon the major kinds of
financial activities in the economy, which are, of course,
largely though not exclusively being performed by the larger
institutions. So the interrelationship between monetary policy
aims and the goals of financial stability really undergird the
case for our central bank, and central banks around the world,
being involved in supervision. That is point one.
Point two, a graphic illustration of what can happen when
the central bank is not closely involved in supervision was
observed a couple of years ago in the United Kingdom following
the decision to have a single financial services authority with
all supervisory responsibility for all kinds of financial
institutions. The Bank of England, the central bank, was not
involved in supervision at all, and when a significant
financial institution--Northern Rock--failed, the Bank of
England was not in a position to be able to make judgments
about the failure of Northern Rock or the ripple effects within
the system. I think it is for that reason that you have a
robust debate in the U.K. right now as to whether they need to
return some supervisory authority to the Bank of England, I
would assume, to coexist with the Financial Services Authority.
Now, there have been some proposals to put everything back
in the Bank of England. I personally would not think that would
be a particularly good idea.
You raised the question, and let me just address briefly,
the issue of ability to get information and to enforce where
necessary. I think it is important, if you are going to ask an
entity to perform a role of consolidated supervision, to make
sure that they have the tools to do so.
Now, as it happens right now there is--and I have no reason
to expect there will not be--quite a good relationship between
the Fed and the Comptroller with respect to banks within
holding companies. But we need to make sure that some kinds of
information that are not gathered in bank supervision or, for
that matter, certainly supervision of other kinds of regulated
entities--insurance entities or securities entities--can, if
necessary, be obtained in order to provide the kind of
supervisory oversight of the whole institution that you are
asking about or looking for.
I do not personally anticipate that there is going to be
much utilization of such an authority, but I think you do have
to have that kind of back-up.
Senator Reed. I have gone way over my time and I----
Mr. Dugan. Just very quickly----
Senator Reed. I am abusing the----
Mr. Dugan. Just if I could very quickly respond, just to
that last point. On the functional regulator point, it may go
too far the way it is now, but the way the Administration has
proposed it has pushed it too far in the other direction so
that you could override the authority of the primary supervisor
and that is too much.
Senator Reed. Pointed noted. Thank you, my colleagues.
Chairman Dodd. Thank you.
Senator Martinez.
Senator Martinez. Thank you, Mr. Chairman.
Good morning to all of you and thank you for being here. I
want to ask a question about the proposal of the Administration
regarding the elimination of restrictions to interstate banking
for national and State banks. I know that a lot of community
bankers in Florida would be greatly concerned about that and I
wonder if aggressive branching didn't contribute to excessive
risk taking in a desire to increase market share, which, in
fact, may have had a lot to do with a lot of the problems we
have seen lately.
So would a limit on branch banking, how would it change the
competitive landscape? Madam Chair?
Ms. Bair. Senator, the FDIC has not taken a position on
that particular provision. I do know that there are several
community bankers that are concerned about it, but I am sorry,
we don't have a corporate position on it.
Senator Martinez. Does anyone else care to comment?
Mr. Dugan. I do not think it would be a good idea to
reimpose limits on interstate branching. Right now, there are
some limits left on the first branch into a State. But
basically, the decades-long restrictions gradually evolved over
the years to permit interstate branching and I think it did
permit more diversification geographically which was helpful in
some circumstances. I personally would not be in favor of
further limits.
Senator Martinez. Any other thoughts on the matter? I
guess----
Mr. Tarullo. I would just say, Senator, that you alluded to
circumstances in which interstate operations became a problem,
and I think that can be the case. But that is where it is
important to focus upon the business model of the entity in
question. It ought not to be allowed to engage in unsafe and
unsound practices, whether they involve excessive branching
that is unsupported by a sound business plan or other
practices.
Mr. Bowman. I would just simply point out the fact that
thrifts do currently enjoy the ability to branch interstate
without restriction, and in terms of the impact upon the
community banks, my impression has been that that privilege
that thrifts currently enjoy has had some impact, but I am not
certain how great.
Senator Martinez. My colleague from Montana brought up the
testimony that we have in writing from Mr. Ludwig, and I wanted
to go into another area of his testimony that I found very
interesting. He makes the point, and I am sure he could make it
much better than I if he were making it, which he may get a
chance to do later, but that he would suggest avoiding a two-
tier regulatory system that elevates the largest ``too-big-to-
fail'' institutions over smaller institutions, and he makes the
point that perhaps there would be also two-tier regulators, the
best regulators in one system, the others in another, and so
anyway, he would urge not to create a ``too-big-to-fail''
category because it would, in fact, be contrary to what he
thinks would be the best interest of not creating a bias in the
system that would be in favor of those institutions considered
too big to fail at the expense of those that were not viewed
too big to fail. Again, could I just get a comment from each of
you on that.
Ms. Bair. Well, I think there are a couple of questions
there. One is whether there should be so-called ``Tier 1''
entities that are officially designated as too-big-to-fail,
regardless of who regulates them. There may be some combination
of OCC and Federal Reserve Board oversight. And second,
whether, as part of regulatory consolidation, you want to have
a regulator based on size as opposed to charter.
I think on the former, we have some concerns about
designating institutions formally as Tier 1. I think you can
probably say who is not, based on asset size--who may not be
systemic. But I think to have a clear line of who is
systemically important, does contribute to moral hazard.
Especially if you don't have a resolution mechanism, it would
be quite problematic. But I do believe the assumption is to
have stronger capital and leverage constraints for those very
large institutions than for the smaller institutions.
In terms of bank regulation, unlike consolidated holding
company supervision, I think you should maintain a Federal
charter and a State charter. That generally breaks out along
size lines, but not always. We have some fairly large State-
chartered entities. The OCC has many community banks, as well.
But the charter choice, I think, is good to maintain--not
different regulatory policies, but policies that are perhaps
more reflective of local conditions. With State charters, I
think having some sensitivity and more immediacy of being able
to deal with a State-level banking supervisor is helpful. So I
would maintain regulation based on State or Federal chartering
as opposed to employing size limitations.
Senator Martinez. I know we have a vote and I don't know
how much time we have left, so I will leave it at that, Mr.
Chairman.
Chairman Dodd. Thank you very much, Senator.
Senator Merkley.
Senator Merkley. Thank you very much, Mr. Chair.
I wanted to start by asking, Governor, it is my
understanding that some of the problems at Citigroup and other
major institutions resulted from moving risky activities back
and forth between the holding company and the national bank to
minimize supervision. So my question is whether by creating a
similar structure, but instead of the Fed and the OCC it would
be the Fed and the NBS, National Bank Supervisor, whether we
are creating the same risk in the new system of moving
activities back and forth.
Mr. Tarullo. Senator, I think under any approach, you must
have a common set of requirements across the system which
minimize the opportunities for regulatory arbitrage. That means
within institutions, and it also means between regulated
institutions and nonregulated institutions.
I would say, without talking about any specific
institution, there certainly were circumstances in which
institutions may have taken advantage of different applicable
capital requirements, or of bundling things in one form and
moving them around the entity and that part of what needs to be
done is to take regulatory steps that minimize those
opportunities.
Senator Vitter was asking earlier about bringing off-
balance sheet assets back onto the balance sheet. That is one
way to combat regulatory arbitrage.
Senator Merkley. Well, let me just ask this. Do you think
it would make more sense to have the holding companies and the
banks under the same regulatory agency?
Mr. Tarullo. I don't, actually. Now, with respect to
smaller holding companies, particularly those that have only a
bank--it is basically a shell and there is a bank, there are no
other entities--the amount of additional holding company
supervision is actually quite modest. As the bank holding
company picks up additional activities--if it does any of its
own capital raising, if it has even a small additional
subsidiary, if it does some management at the holding company
level--that is when an independent scrutiny of those activities
seems to me valuable.
As you get to an even bigger institution, an even more
complex institution, it does seem as though the task becomes
more specialized because you are now looking not just at
immediate impacts on the bank--although that is important
because we want to protect the deposit insurance fund--you now,
as we have learned in this crisis, also need to examine how the
whole entity, can be creating risk in and of itself. That
involves different kinds of activities, different kinds of
regulated entities that are, as you say, moving things back and
forth or acting in parallel, and that is where I think you do
need a different approach which looks at the holding company as
an integrated whole, supplementing and complementing the
rigorous functional regulation that takes place in the
subsidiaries.
Senator Merkley. Yes. Please be very quick, because I want
to get in my second question.
Mr. Dugan. OK, I will. I would say the one area, as I
mentioned earlier. I do think there are times where there are
activities going on in the bank and the holding company that
are the same types of activities but they are subject to
different levels of supervision. We ought to try to fix that.
Ms. Bair. I would just say two things. We have suggested in
prior testimony that large institutions have their own
resolution plans so that they could be liquidated very quickly
if they got into trouble and that a key to this would be
greater legal separateness of the insured depository
institution and what is in the insured depository institution
versus what is not. Our resolution process is very complicated
now with these large institutions because of the
interrelationships between the bank and the nonbank activities.
It is hard--you are right--to sometimes tell the difference.
There is a provision called 23(a), which is designed to
protect banks from being used as sources of strength for the
holding company. We are consulted by the Federal Reserve Board
regarding requests for exceptions to the 23(a) restrictions.
However, the Fed has the sole authority to approve these
requests that can move more higher-risk assets into banks where
they are funded with insured deposits. So in terms of an
incremental step, and I think that this is no surprise to the
Federal Reserve Board, we would very much like to have a
statutory role in the 23(a) approval process because this does
increase our exposure.
Chairman Dodd. Let me interrupt here. I want to make sure I
get Senator Bennett in before the vote.
Senator Merkley. Not at all, Mr. Chairman.
Chairman Dodd. I thank you very much, Senator Merkley. We
will leave the record open for further questions, by the way,
for all of you.
Senator Bennett.
Senator Bennett. Thank you very much. Probably, given the
time, this will be more of a statement that you can ponder than
questions that I want answers to, but I would like to get some
answers later on.
It will come as no surprise that I want to talk about ILCs,
and no one has discussed the ILC charter in their written
testimony. Let us point out that the growth of ILCs over the
last 20 years has been one of the great successes in the
financial services markets. They are the best capitalized and
safest banks in the country. They were in no part a contributor
to the financial crisis. They provide credit in places that it
has not been available before, niche markets, a diverse set of
products, and the Administration's proposal says, let us
eliminate them.
Now, I find that incredible, that something--we talk about
Conseco, Lehman Brothers, CIT. All had ILCs, and as they were
wound down, the ILCs were the assets that were the crown
jewels. The ILCs were the assets that had the most value. And
yet the proposal is, let us eliminate them. Let us eliminate
the charter.
Now, Mr. Tarullo, you made a comment that the center of
this crisis is too big to fail and much of this discussion has
been in that area of ``too big to fail.'' May I respectfully
suggest that the center of the crisis is not ``too big to
fail.'' ``Too big to fail'' is a manifestation that came out of
the center of the crisis, and to put it in my very much
layman's terms, the crisis was caused because of this game of
musical chairs with respect to risk. And we built more and more
risk into the system because while the music was playing, more
and more institutions passed the risk on to somebody else
thinking, to use the phrase that Sheila used, I have no skin in
this game anymore, this game being this particular instrument.
And you go with the change. It starts with the borrower. He
has no risk whatsoever because there is no equity in the house.
He is getting a 100 percent loan. Sometimes it is a liar loan.
The broker who arranges the loan has no risk in the game
because he passes it on to the lender. The lender has no risk
in the game because he passes it on to the GSE. The GSE has no
risk because with the rating agency that has no risk has rated
it, and he can pass it on, securitize it, to somebody else. And
at every step in the way, in the path, somebody makes money, on
a fee, on a commission, whatever it might be. And when the
music stops, it turns out that everybody had risk in the game
because the whole thing collapses.
And I would like to know a regulator who can focus on that
question, not how big you are, but where are you in this chain
of musical passing on of risk, musical chairs, if you will,
that says somebody can say, no more loans in the beginning. No
more liar loans. To brokers, no, you can't pass this on. You
have to have some kind of a risk if you get involved in
brokering this loan so you will then by market pressure do your
job better to see to it that you don't pass it on. To the
lender, you maintain some kind of risk as the chain goes
forward. The GSE, you maintain some kind of risk. The rating
agencies, you will get a risk.
But no one had any risk and the bubble, therefore, grew and
grew and grew because everybody was making money with no
exposure. And that is the problem that I want to solve with
this restructuring rather than working around some of the turf
battles that we have talked about.
Now I will go save the republic and you can respond to
Chairman Warner.
[Laughter.]
Senator Warner [presiding]. Does anybody want to respond?
Mr. Tarullo. I would just say a word, Senator, since this
will be recorded. I actually agree with everything Senator
Bennett said, except I think too-big-to-fail actually plays
exactly into the narrative that he gave us. He was talking
about the GSEs which were the biggest institutions of all that
in the end were regarded ``too big to fail?'' It was the GSEs.
It is not the only problem, but I think it is a very important
problem.
I should be careful about speaking for people on the panel,
but certainly making sure that risks are properly assessed by
entities--and I would add, making sure that compensation
systems and entities accurately reflect the risk that employees
are assuming--are important pieces of a reform package.
Ms. Bair. I will just say, speaking for myself, I would
agree that I don't to eliminate the ability to choose a State
charter instead of a Federal charter, including an ILC charter.
We don't think this was a driver or a contributor to this
crisis. We were unaware that the Administration was going to
propose that. But again, speaking for myself, I don't see that
the ILCs were in any significant way involved in what was going
on.
Senator Warner. Thank you. Let me go ahead and ask my
question and then I will call on Senator Schumer. Thank you,
Senator Schumer.
I want to go back to where Chairman Dodd started and
Senator Tester went with his direction. I am still struggling
with this question of whether we do a single end-to-end
depository regulator. I think some of you all have raised some
legitimate concerns. I know folks on the second panel will
perhaps have a different view. Paul Volcker has got a different
view. Past chairs have had a different view.
I think, Chairman Bair, your point was valid. How do you
make sure that you don't infringe upon your insurance function?
I do think you could achieve that by having backup authority
and your ability to continue to go in and check particularly
those institutions that got into trouble, to check on your
ongoing role both as an insurer and what Senator Corker and I
have talked about, an expanded resolution authority. I also
tend to think that the notion of an enhanced Systemic Risk
Council that would include the Fed, that would include the
Treasury, that would include the FDIC and this end-to-end bank
regulator as well as the SEC and others would give you that
ability to have those variety of voices heard.
And I would also just want to raise one other point that we
have talked a lot this morning about, the chartering and the
ability to change charters, and perhaps prohibiting that. I
think you all have raised appropriately those questions. But
since each of your organizations have had a licensing division,
there is also the question of a selection of a charter when you
start an institution.
I guess my first question would be, having that very nature
of that choice at the beginning, not switching midstream, but
that selection choice at the beginning, doesn't that create
regulatory arbitrage? Don't you by default find out who is
going to offer you the best deal on the front end and go to
that, within your respective agencies, that licensing
operation? Doesn't that create the arbitrage issue?
Mr. Tarullo. Well, first, Senator, Sheila and I don't have
any authority to charter institutions. The banks we supervise
are State chartered.
I would say, though, that--and she can respond to this
better than I--because we have similar regulatory
requirements----
Senator Warner. If we could do it fairly quickly, because I
do have another question I want to ask----
Mr. Tarullo. Sure. Some of the regulatory requirements are
for all institutions and the FDIC has to decide whether to
grant insurance to each depository institution, no matter by
whom chartered, that wants to be insured. There is a way to
contain that kind of arbitrage while permitting the useful,
innovative kinds of experimentation that States have engaged
in, such as allowing creation of NOW accounts, for example.
Senator Warner. Mr. Dugan, Mr. Bowman, do you want to----
Mr. Dugan. I would agree. We do have a licensing function
and I would just say that just because you have a choice when
you begin operating, it is not necessarily arbitrage. There are
differences that go along with the charters in terms of what
banks can do and how they can do it, and some prefer to have
local, State Government regulation even though we have local
examiners on the ground. There is a choice, but the FDIC does
grant deposit insurance to all of them.
I don't think that is where the arbitrage issue that we
have confronted most has been. It has been after banks have
been in operation where someone is facing a problem and they
seek to change their charter to avoid a downgrade or an
enforcement action. That is the thing that I think troubles all
of us a great deal.
Senator Warner. Mr. Bowman.
Mr. Bowman. Yes, I would agree with that. I mean, in terms
of people choosing a charter at the outset, the thrift charter
is somewhat unique in terms of some of the limitations that are
placed upon the kinds of business that an entity would want to
engage in. Our thought is that people choose a charter based
upon their business plan.
In terms of others who are attempting to switch charters
because of some perceived favorable difference between, say, a
State charter and a Federal charter, within the State charters
you have got 50 to choose from, or 52 to choose from. The
Federal charter, you have two, the Federal thrift charter and
the national bank charter. Anyone who is looking to avoid or
evade some kind of supervisory action or enforcement action, I
think as we have talked about here, we as a collective group,
interagency basis, have tried to take steps to avoid that from
happening or to slow it down, to make sure that it doesn't
happen for the wrong reasons.
Senator Warner. One common theme from all of you has been--
and I think accurately--reflecting that a great deal of the
source of the crisis has come from the nonbank financial
sector. Another issue I am struggling with and would like to
get all of your comments on is, assume whichever way,
consolidating a single entity or maintaining the current
structure, how do we get our arms around this nonbank financial
arena? Clearly, one approach the Administration has talked
about is on the consumer end, the consumer product end, looking
at specific financial products coming from this array of
institutions. Another is that if they kind of bump up to the
level of becoming systemically risky, the Council, or in the
Administration's proposal the Fed would have oversight.
What I am not clear on is should these nonbank--this
nonbank financial sector have some level of day-to-day
prudential regulation, and I have not seen anybody propose
where that--one, is it needed, and two, where that day-to-day
prudential regulation in terms of safety and soundness would
land. Comments?
Ms. Bair. You have prudential supervision of banks because
of deposit insurance and other vehicles as part of the safety
net. With the nonbanks, you do not have that. They are not
federally insured.
Senator Warner. Should you have some?
Ms. Bair. I don't think you need to. I don't think you need
to go that far. I think the consumer abuses for the smaller
entities were really more of a significant driver, the lax
underwriting which then spilled over into the larger
institutions because of the competitive situation it created.
But no, I don't think you do. I think if you have the
ability to impose prudential requirements on systemic
institutions or systemic practices, then I don't think you need
institutional----
Senator Warner. So the Council up here for systemic and the
consumer down here, but no need for----
Ms. Bair. Yes.
Mr. Dugan. I generally think that is a daunting challenge
to regulate the hundreds of thousands of different financial
providers all on a safety and soundness basis. But I think the
Administration would do so and have the authority to do so for
consumer protection, as you suggested. It doesn't get at what
really is, and was, a fundamental issue. To the extent they
engage in very banklike functions and there is a safety and
soundness issue, like an underwriting standard or downpayment
requirements, I would argue that is not really a consumer
protection function in its traditional sense----
Senator Warner. It almost goes to some of the comments
Senator Bennett was making about making sure you have got skin
in the game----
Mr. Dugan. Yes. That is the consumer having skin in the
game. But my point is, part of the mortgage legislation that
passed the House last year had some common standards that I
would say are prudential standards that apply. I think that
would have been helpful for mortgage providers, but not
necessarily all financial providers. So I think there may be
some instances where some of that is warranted.
Senator Warner. But wouldn't Senator Bennett's approach,
that if you originated a product, then you have to keep it in
there, that is not so much just protecting the consumer, but it
may be also protecting this--putting some requirements of
safety and soundness on the institution----
Mr. Dugan. Absolutely.
Senator Warner. ----quasi-prudential.
Mr. Dugan. Absolutely.
Mr. Tarullo. Senator, I would say a couple of things.
First, I do think that the question of where regulation stops,
how broadly the perimeter is cast, is an important one going
forward. We know that we are not going to have the same
problems as we had a few years ago. There are going to be new
problems, and that, I think, is what everybody is addressing.
How do we stop it?
I would have thought that one of the important roles of a
Council, of some sort of an interagency council, is precisely
to attend to issues that don't seem under anybody's regulatory
umbrella at that particular moment. If----
Senator Warner. Beyond just being whether they are
systemically risky, down to----
Mr. Tarullo. Well, I think you point out the problem. You
have systemically risky institutions addressed, you have
regulated institutions that are already regulated, and then you
have consumer. But if you have a practice which is troublesome,
then there ought to be a mechanism for somebody to be making an
evaluation of that practice. And then perhaps if the Council
saw that one of its members had authority to regulate, it could
suggest it. Congress could also think about giving some sort of
default or back-up authority to the Council in the event that
no one had----
Senator Warner. Very quickly, because the senior Senator
from New York is anxious.
Mr. Bowman. I think, Senator, that you really have hit the
nub of the issue, which is the ability to regulate or somehow
oversee this group in between the Council and the CFPA. Trust
me that whatever scheme might be brought up or passed into
legislation, there are very, very creative people out there who
are going to look at that legislation, the regulations that are
drafted by it and they are going to find a way to get around
it, whether it is at the State level, the Federal level,
whatever else.
People create businesses every day. They have a business
model of where they want to engage in a particular activity. I
think the preference for a lot of people is to engage in a
particular activity with a minimum of regulation attached to
it. So it is a very, very difficult issue.
Senator Warner. Senator Schumer.
Senator Schumer. Thank you, Mr. Chairman.
I want to thank all of you for being here, very important
subject. We have all gathered here today with one common goal,
to make our financial regulatory system strong enough to
prevent another severe financial crisis from happening. And I
have read the written testimony. If I were in your shoes, I
would probably make the same arguments. But some might argue
there is a bit of turf protection here. That is natural, but it
shouldn't be the dominant consideration as we move forward.
Mr. Bowman, in all due respect, almost everyone regards the
OTS as having failed in its responsibilities. We have seen
institution after institution after institution poorly
regulated, and you are saying, keep the OTS. So I think even
though, probably again, if I were sitting where you were, with
hard-working men and women working for you, I would say, keep
my agency, keep all the powers, don't do any consolidation, I
think we in the Committee have to see the testimony as coming
from at least partially that perspective.
So I would ask you this. There are reasons for one strong,
powerful, efficient regulator, and I think people who are
objective, who don't have any turf considerations, when they
look up from on high, tend to think that should happen in the
banking area. There is more discussion in the Systemic Risk
Regulator. I think there is a good argument that the insurer
should be separate from the regulator because there are
different concerns.
So let me ask you this, though, all of you. Here are four
arguments for a consolidated regulator. One is that a
consolidated regulator would prevent charter shopping, so a
bank can't flip its charter and pick up its own regulator--
Countrywide did that, remember that, Mr. Bowman?
A hodgepodge of different regulators adds to conflicts in
regulation and creates confusing burdens for the banks. We have
all heard from institutions who were told one thing by one
regulator and another thing by another regulator, each of whom
has authority.
Third, a single regulator could keep better tabs of
industry-wide risks, dangers, and developments. That is pretty
apparent.
And fourth, a single consolidated regulator can eliminate
agency and regulatory arbitrage and gaps, and no bank could
escape from being held accountable for violations or poor
practices.
So my question to you is, do you disagree that one
consolidated regulator would avoid these four problems, or have
these four benefits, even if you think other mechanisms might
be better for other reasons? Who wants to go first?
Mr. Tarullo. I will start, Senator.
Senator Schumer. Thank you.
Mr. Tarullo. I would say that each of the four things you
mentioned is an important aim. Some of them, like avoiding
charter conversion arbitrage, can be addressed short of a
single regulator. That is one thing that the four of us at this
table have tried to do already.
The only thing I would add to what you say is there are
also some costs to going the single regulator route. So one of
the costs is that the Fed, for example, loses some insight into
how banks are actually functioning, how they are moving money,
why the volatility of money is what it is.
I think, also, another potential cost is you have a single
all-encompassing regulator and sometimes it loses perspective
because it is the only game in town----
Senator Schumer. Right. Look, I wouldn't deny there are
arguments on the other side, but you would agree that these
four arguments make some sense for a consolidated regulator?
Mr. Tarullo. Right. I think a couple of them are stronger
than others, but yes.
Senator Schumer. Mr. Dugan is shaking his head. You agree?
Mr. Dugan. Yes, I would agree with that. Those benefits are
definitely there and real, I think. This is the right equation.
You have to ask, what are the costs, and again, I think there
are certain things that the Federal Reserve brings to the table
in terms of closeness to the markets and expertise from the
open market operations that would be difficult, but not
impossible, to replicate, but that are real, and you have to
consider that.
And second, as I have mentioned earlier with my colleague
for the FDIC, it is hard to be----
Senator Schumer. Yes.
Mr. Dugan. ----good at it if you are not doing it all the
time, and so you have to take those things into account.
Senator Schumer. Ms. Bair.
Ms. Bair. Yes. I think on the monitoring, if you look at
the jurisdictions that had a single regulator, they really
weren't any better. If you have a single monopoly regulator,
that can contribute to regulatory laxity as opposed to having
competition among regulators.
Also, regarding regulatory arbitrage it is not just a
matter of picking bank charters. If you don't include
securities firms, derivatives dealers, hedge funds, and
insurance companies, you still have the ability to choose a
business model, on a legal model that would fall outside of the
existing regulatory regime. So unless you include all of the
various types of financial firms, I think you are going to
still have some degree of arbitrage.
Senator Schumer. Right. Mr. Bowman.
Mr. Bowman. Yes, Senator Schumer. I would agree that the
single form of regulator really hasn't proven to be any more
effective in terms of what we have now. And I would also be
remiss to point if I did not point out that since 2008, 79
financial institutions, State chartered financial institutions
have failed----
Senator Schumer. Yes.
Mr. Bowman. ----15 national banks, and 11 thrifts. I think
I also need to point out that OTS chartered Countrywide in
March of 2007. We had the market impact in August of 2007, and
5 months later, Countrywide was sold to Bank of America. The
ability of we as the regulator to impact the events at
Countrywide in a 10-month period was very, very limited.
Senator Schumer. OK. I have another question if I might,
Mr. Chairman, and this relates to the point Mr. Bowman just
made. As you said, 54 out of the 69 banks that have failed this
year were State chartered banks. This one thing, I mean, I
guess it is a historical anomaly, but why the Fed supervises
State chartered banks and Mr. Dugan supervises federally
chartered banks. I mean, when I first got to the Banking
Committee in 1981, I didn't understand that. It just sort of
happened, I guess.
And so let me ask both, first Mr. Tarullo, it is true that
most of this year's failed banks were not regulated by the
national supervisor, the OCC, or the national thrift
supervisor, OTS. Explain to me--and then Ms. Bair could answer,
as well--could you explain to me why the FDIC and the Fed
should keep State chartered banking supervision, particularly
if we are giving the Fed more responsibilities in other areas?
If you think those functions should be kept apart from the
proposed National Bank Supervisor, why shouldn't we at the very
least merge FDIC and Fed supervision of the State chartered
banks, if you are not going to have the same supervisor? Mr.
Tarullo.
Senator Warner. Excuse me. Could I just, Senator Schumer,
just ask the panel all to try to answer quickly because we do
want to try to get the second panel, at least get their
statements in.
Senator Schumer. You know what, I will ask unanimous
consent that each panelist be asked to answer that question in
writing, because I didn't realize we had a second panel and I
was the last one here. Thanks.
[Pause.]
Senator Warner. It looks like we are going to have to
reschedule the second panel, so I am anxious for you all to
respond to Senator Schumer's question.
Senator Schumer. Mr. Chairman, I am deeply grateful.
[Laughter.]
Mr. Tarullo. Senator, I would start by saying, as you
noted, the national banks would be supervised by the OCC as
well as chartered. State banks that are members of the Federal
Reserve System are supervised by the Fed as their Federal
supervisors, and if they are nonmember banks, then their
primary Federal regulator is the FDIC.
I think that there are two answers to the question. One is,
as you suggest, history. The Comptroller was started in 1863 to
create a new national charter and we have had a dual banking
system ever since. I think there is probably some concern on
the part of State Banking Commissioners that they not have as
their overseer at the Federal level the same entity that
charters national banks----
Senator Schumer. That is a little bit of what we would say
in Brooklyn is turf.
[Laughter.]
Mr. Tarullo. It is, there is no question. But I think their
concern is, Senator, whether or not there would be the same
kind of treatment of national and State chartered institutions.
Second, the question is, are there gains from having the
FDIC and the Fed supervising banks as well as performing their
other functions, and I would suggest that there are.
Ms. Bair. I would want to comment on the previous statement
that 54 of the 69 banks were State-chartered. There are a lot
more State-chartered banks, and a lot of these are very, very
small institutions.
Senator Schumer. A lot of the biggest failures were under
not Mr. Bowman, I don't blame him, but his predecessor's watch.
Ms. Bair. We also have provided a lot of support for the
larger institutions, as well, on an open bank basis. So I think
that all needs to be taken into account. I do think--Senator, I
know it is confusing that we have these multiple regulators and
it is frustrating because it is hard to explain to the public.
On the other hand, as a deposit insurer, we find it extremely
helpful to have people on the ground in banks all the time. It
helps us a lot. It gives us a window into seeing what is going
on in banking, what emerging risks there might be.
You are right, we could perhaps pick some of that up
through a backup supervisory process, but I think if we were
going to shift to that model, give up primary regulation of
State chartered banks and go up just to that, we would have to
be much more robust and on-site with our backup examination to
keep those data points continually into our risk assessment of
what our risks are. So that would, in turn, add to regulatory
burden.
So I think that supervisor perspective we get by regulating
State-chartered banks is very helpful to us in our insurance
function.
Mr. Bowman. Senator, if I could just add to the confusion,
as you know, the OTS is the back-up regulator for State
chartered savings associations, so you have a Federal regulator
regulating the same charter at the State level.
Senator Warner. I would like to thank the panel for a very
interesting morning and one that has been very helpful, I know,
to all the Members.
I want to also apologize to the next panel, Mr. Ludwig, Mr.
Carnell, and Mr. Baily. I understand staff will be back to you
about rescheduling. We do want to hear your views. I know some
of the second panel views perhaps were more sympathetic to the
single end-to-end depository regulator and we want to make sure
we get those views on the record and get a chance to press
questions, as well. But thank you very much of the first panel
and we will reschedule the second.
The hearing is adjourned.
[Whereupon, at 11:11 a.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF SENATOR TIM JOHNSON
Thank you Chairman Dodd for holding today's hearing. As we all
know, the regulatory structure overseeing U.S. financial markets has
proven unable to keep pace with innovative, but risky, financial
products; this has had disastrous consequences. Congress is now faced
with the task of looking at the role and effectiveness of the current
regulators and fashioning a more responsive system.
To date, it appears one of the Committee's biggest challenges will
be to create legislation that better protects consumers. I very much
look forward to hearing from today's panels of current and former
regulators to see if they believe a new agency is needed to better
protect consumers, or if consumer protection should remain a function
of the prudential regulator.
I am also interested in hearing from the regulators their views on
ways to make the regulatory system more effective. For example, does it
make sense to eliminate any of the bank charters to streamline the
system? Last, I would also like to know from the witnesses if they
believe the regulatory gaps that caused our current crisis would be
filled by the Administration's regulatory restructuring proposal. We
must get this right, and the proposal we craft must target the most
pressing problems in our financial regulatory system.
As this Committee works through many issues to fashion what I hope
will be a bipartisan proposal that creates an updated system of good,
effective regulations that balance consumer protection and allow for
sustainable economic growth, I will continue to advocate for increases
in transparency, accountability, and consumer protection.
______
PREPARED STATEMENT OF SENATOR JACK REED
Today's hearing addresses a critical part of this Committee's work
to modernize the financial regulatory system--strengthening regulatory
oversight of the safety and soundness of banks, thrifts, and holding
companies. These institutions are the engine of our economy, providing
loans to small businesses and helping families buy homes and cars, and
save for retirement. But in recent years, an outdated regulatory
structure, poor supervision, and misaligned incentives have caused
great turmoil and uncertainty in our financial markets.
Bank regulators failed to use the authority they had to mitigate
the financial crisis. In particular, they failed to appreciate and take
action to address risks in the subprime mortgage market, and they
failed to implement robust capital requirements that would have helped
soften the impact of the recession on millions of Americans. Regulators
such as the Federal Reserve also failed to use their rulemaking
authority to ban abusive lending practices until it was much too late.
I will work with my colleagues to ensure that any changes to the
financial system are focused on these failings in order to prevent them
from reoccurring (including by enhancing capital, liquidity, and risk
management requirements).
Just as importantly, however, we have to reform a fragmented and
inefficient regulatory structure for prudential oversight. Today we
have an inefficient system of five Federal regulators and State
regulators that share prudential oversight of banks, thrifts, and
holding companies. This oversight has fallen short in many significant
ways. We can no longer ignore the overwhelming evidence that our system
has led to problematic charter shopping among institutions looking to
find the most lenient regulator, and has allowed critical market
activities to go virtually unregulated.
Regulators under the existing system acted too slowly to stem the
risks in the subprime mortgage market, in large part because of the
need to coordinate a response among so many supervisors. The Federal
Reserve itself has acknowledged that the different regulatory and
supervisory regimes for lending institutions and mortgage brokers made
monitoring such institutions difficult for both regulators and
investors.
It is time to reduce the number of agencies that share
responsibility for bank oversight. I support the Administration's plan
to merge the Office of the Comptroller of the Currency and the Office
of Thrift Supervision, but I think we should also seriously consider
consolidating all Federal prudential bank and holding company
oversight. Right now, a typical large holding company is overseen by
the Federal Reserve or the Office of Thrift Supervision at the holding
company level, and then the banks and thrifts within the company can be
overseen by the Office of the Comptroller of the Currency, the Federal
Deposit Insurance Corporation, and often many others.
Creating a new consolidated prudential regulator would bring all
such oversight under one agency, streamlining regulation and reducing
duplication and gaps between regulators. It would also bring all large
complex holding companies and other systemically significant firms
under one regulator, allowing supervisors to finally oversee
institutions at the same level as the companies do to manage their own
risks.
I appreciate the testimony of the witnesses today and I look
forward to discussing these important issues.
______
PREPARED STATEMENT OF SHEILA C. BAIR
Chairman, Federal Deposit Insurance Corporation
August 4, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
I appreciate the opportunity to testify on behalf of the Federal
Deposit Insurance Corporation (FDIC) on the importance of reforming our
financial regulatory system. Specifically, you have asked us to address
the regulatory consolidation aspects of the Administration's proposal
and whether there should be further consolidation.
The proposals put forth by the Administration regarding the
structure of the financial system and the supervision of financial
entities provide a useful framework for discussion of areas in vital
need of reform. The goal of any reforms should be to address the
fundamental causes of the current crisis and to put in place a
regulatory structure that guards against future crises.
There have been numerous proposals over the years to consolidate
the Federal banking regulators. This is understandable given the way in
which the present system developed, responding to new challenges as
they were encountered. While appealing in theory, these proposals have
rarely gained traction because prudential supervision of FDIC insured
banks has held up well in comparison to other financial sectors in the
United States and against non-U.S. systems of prudential supervision.
Indeed, this is evidenced by the fact that large swaths of the so-
called ``shadow banking sector'' have collapsed back into the healthier
insured sector, and U.S. banks--notwithstanding their current
problems--entered this crisis with less leverage and stronger capital
positions than their international competitors.
Today, we are again faced with proposals to restructure the bank
regulatory system, including the suggestion of some to eliminate
separate Federal regulators for national- and State-chartered
institutions. We have previously testified in support of a systemic
risk council which would help assure coordination and harmonization in
prudential standards among all types of financial institutions,
including commercial banks, investment banks, hedge funds, finance
companies, and other potentially systemic financial entities to address
arbitrage among these various sectors. We also have expressed support
for a new consumer agency to assure strong rules and enforcement of
consumer protection across the board. However, we do not see merit or
wisdom in consolidating Federal supervision of national and State
banking charters into a single regulator for the simple reason that the
ability to choose between Federal and State regulatory regimes played
no significant role in the current crisis.
One of the important causes of the current financial difficulties
was the exploitation of the regulatory gaps that existed between banks
and the nonbank shadow financial system, and the virtual nonexistence
of regulation of over-the-counter (OTC) derivative contracts. These
gaps permitted lightly regulated or, in some cases, unregulated
financial firms to engage in highly risky practices and offer toxic
derivatives and other products that eventually infected the financial
system. In the absence of regulation, such firms were able to take on
risks and become so highly levered that the slightest change in the
economy's health had deleterious effects on them, the broader financial
system, and the economy.
Gaps existed in the regulation and supervision of commercial
banks--especially in the area of consumer protection--and regulatory
arbitrage occurred there as well. Despite the gaps, bank regulators
maintained minimum standards for the regulation of capital and leverage
that prevented many of the excesses that built-up in the shadow
financial sector.
Even where clear regulatory and supervisory authority to address
risks in the system existed, it was not exercised in a way that led to
the proper management of those risks or to provide stability for the
system, a problem that would potentially be greatly enhanced by a
single Federal regulator that embarked on the wrong policy course.
Prudent risk management argues strongly against putting all your
regulatory and supervisory eggs in one basket. Moreover, a unified
supervisor would unnecessarily harm the dual banking system that has
long served the financial needs of communities across the country and
undercut the effectiveness of the deposit insurance system.
In light of these significant failings, it is difficult to see why
so much effort should be expended to create a single regulator when
political capital could be better spent on more important and
fundamental issues which brought about the current crisis and the
economic harm it has done. In addition, a wholesale reorganization of
the bank regulatory and supervisory structure would inevitably result
in a serious disruption to bank supervision at a time when the industry
still faces major challenges. Based on recent experience in the Federal
Government with such large scale agency reorganizations, the proposed
regulatory and supervisory consolidation, directly impacting the
thousands of line examiners and their leadership, would involve years
of career uncertainty and depressed staff morale. At a time when the
supervisory staffs of all the agencies are working intensively to
address challenges in the banking sector, the resulting distractions
and organizational confusion that would follow from consolidating the
banking agency supervision staffs would not result in long term
benefits. Any benefits would likely be offset by short term risks and
the serious disadvantages that a wholesale reorganization poses for the
dual banking system and the deposit insurance system.
My testimony will discuss the issues raised by the creation of a
single regulator and supervisor and the impact on important elements of
the financial system. I also will discuss the very important roles that
the Financial Services Oversight Council and the Consumer Financial
Protection Agency (CFPA) can play in addressing the issues that the
single Federal regulator and supervisor apparently seeks to resolve,
including the dangers posed by regulatory arbitrage through the closing
of regulatory gaps and the application of appropriate supervisory
standards to currently unregulated nonbank financial companies.
Effects of the Single Regulator Model
The current financial supervisory system was created in a series of
ad hoc legislative responses to economic conditions over many years. It
reflects traditional themes in U.S. history, including the observation
in the American experience that consolidated power, financial or
regulatory, has rarely resulted in greater accountability or
efficiency.
The prospect of a unified supervisory authority is alluring in its
simplicity. However, there is no evidence that shows that this
regulatory structure was better at avoiding the widespread economic
damage that has occurred over the past 2 years. The financial systems
of Austria, Belgium, Hungary, Iceland and the United Kingdom have all
suffered in the crisis despite their single regulator approach.
Moreover, it is important to point out that the single regulator system
has been adopted in countries that have highly concentrated banking
systems with only a handful of very large banks. In contrast, our
system, with over 8,000 banks, needs a regulatory and supervisory
system adapted to a country of continental dimensions with 50 separate
States, with significantly different economies, and with a multiplicity
of large and small banks.
Foreign experience suggests that, if anything, the unified
supervisory model performed worse, not better than a system of multiple
regulators. It should be noted that immediately prior to this crisis,
organizations representing large financial institutions were calling
aggressively for a move toward the consolidated model used in the U.K.
and elsewhere. \1\ Such proposals were viewed by many at the time as
representing an industry effort to replicate in this country single
regulator systems viewed as more accommodative to large, complex
financial organizations. It would indeed be ironic if Congress now
succumbed to those calls. A regulatory structure based on this approach
would create serious issues for the dual banking system, the survival
of community banks as a competitive force, and the strength of the
deposit insurance system that has served us so well during this crisis.
---------------------------------------------------------------------------
\1\ See, New York City Economic Development Corporation and
McKinsey & Co., Sustaining New York's and the U.S.'s Global Financial
Services Leadership, January 2007. See, also Financial Services
Roundtable, Effective Regulatory Reform, Policy Statement, May 2008.
---------------------------------------------------------------------------
The Dual Banking System
Historically, the dual banking system and the regulatory
competition and diversity that it generates has been credited with
spurring creativity and innovation in financial products and the
organization of financial activities. State-chartered institutions tend
to be community-oriented banks that are close to their communities'
small businesses and customers. They provide the funding that supports
economic growth and job creation, especially in rural areas. They stay
close to their customers, they pay special personal attention to their
needs, and they are prepared to work with them to solve unanticipated
problems. These community banks also are more accountable to market
discipline in that they know their institution will be closed if they
become insolvent rather than being considered ``too big to fail.''
A unified supervisory approach would inevitably focus on the
largest banks to the detriment of the community banking system. This
could, in turn, feed further consolidation in the banking industry--a
trend counter to current efforts to reduce systemic exposure to very
large financial institutions and end too big too fail.
Further, if the single regulator and supervisor is funded, as the
national bank regulator and supervisor is now funded, through fees on
the State-chartered banks it would examine, this would almost certainly
result in the demise of the dual banking system. State-chartered
institutions would quickly switch to national charters to escape paying
examination fees at both the State and Federal levels.
The undermining of the dual banking system through the creation of
a single Federal regulator would mean that the concerns and challenges
of community banks would inevitably be given much less attention or
even ignored. Even the smallest banks would need to come to Washington
to try to be heard. In sum, a unified regulatory and supervisory
approach could result in the loss of many benefits of the community
banking system.
The Deposit Insurance System
The concentration of examination authority in a single regulator
would also have an adverse impact on the deposit insurance system. The
FDIC's ability to directly examine the vast majority of financial
institutions enables it to identify and evaluate risks that should be
reflected in the deposit insurance premiums assessed on individual
institutions. The loss of an ongoing significant supervisory role and
the associated staff would greatly diminish the effectiveness of the
FDIC's ability to perform its congressionally mandated role--reducing
systemic risk through risk based deposit insurance assessments and
containing the potential costs of deposit insurance by identifying,
assessing and taking actions to mitigate risks to the Deposit Insurance
Fund.
If the FDIC were to lose its supervisory role to a unified
supervisor, it would need to rely heavily on the examinations of that
supervisor. In this context, the FDIC would need to expand the use of
its backup authority to ensure that it is receiving information
necessary to properly price deposit insurance assessments for risk.
This would result in duplicate exams and increased regulatory burden
for many financial institutions.
The FDIC as a bank supervisor also brings the perspective of the
deposit insurer to interagency discussions regarding important issues
of safety and soundness. During the discussions of the Basel II
Advanced Approaches, the FDIC voiced deep concern about the reductions
in capital that would have resulted from its implementation. Under a
system with a unified supervisor, the perspective of the deposit
insurer might not have been heard. It is highly likely that the
advanced approaches of Basel II would have been implemented much more
quickly and with fewer safeguards, and banks would have entered the
crisis with much lower levels of capital. In particular, the
longstanding desire of many large institutions for the elimination of
the leverage ratio would have been much more likely to have been
realized in a regulatory structure in which a single regulator plays
the predominant role. This is a prime example of how multiple
regulators' different perspectives can result in a better outcome.
Regulatory Capture
The single regulator approach greatly enhances the risk of
regulatory capture should this regulator become too closely tied to the
goals and operations of the regulated banks. This danger becomes much
more pronounced if the regulator is focused on the needs and problems
of large banks--as would be highly likely if the single regulator is
reliant on size-based fees for its funding. The absence of the
existence of other regulators would make it much more likely that such
a development would go undetected and uncorrected since there would be
no standard against which the actions of the single regulator could be
compared. The end result would be that the damage to the system would
be all the more severe when the problems produced by regulatory capture
became manifest.
One of the advantages of multiple regulators is that they provide
standards of performance against which the conduct of their peers can
be assessed, thus preventing any single regulator from undermining
supervisory standards for the entire industry.
Closing the Supervisory Gaps
As discussed above, the unified supervisor model does not provide a
solution to the fundamental causes of the economic crisis, which
included regulatory gaps between banks and nonbanks and insufficiently
proactive supervision. As a result of these deficiencies, insufficient
attention was paid to the adequacy of complex institutions' risk
management capabilities. Too much reliance was placed on mathematical
models to drive risk management decisions. Notwithstanding the lessons
from Enron, off-balance-sheet vehicles were permitted beyond the reach
of prudential regulation, including holding company capital
requirements. The failure to ensure that financial products were
appropriate and sustainable for consumers caused significant problems
not only for those consumers but for the safety and soundness of
financial institutions. Lax lending standards employed by lightly
regulated nonbank mortgage originators initiated a downward competitive
spiral which led to pervasive issuance of unsustainable mortgages.
Ratings agencies freely assigned AAA credit ratings to the senior
tranches of mortgage securitizations without doing fundamental analysis
of underlying loan quality. Trillions of dollars in complex derivative
instruments were written to hedge risks associated with mortgage backed
securities and other exposures. This market was, by and large, excluded
from Federal regulation by statute.
To prevent further arbitrage between the bank and nonbank financial
systems, the FDIC supports the creation of a Financial Services
Oversight Council and the CFPA. Respectively, these agencies will
address regulatory gaps in prudential supervision and consumer
protection, thereby eliminating the possibility of financial service
providers exploiting lax regulatory environments for their activities.
The Council would oversee systemic risk issues, develop needed
prudential policies and mitigate developing systemic risks. A primary
responsibility of the Council should be to harmonize prudential
regulatory standards for financial institutions, products and practices
to assure that market participants cannot arbitrage regulatory
standards in ways that pose systemic risk. The Council should evaluate
differing capital standards which apply to commercial banks, investment
banks, investment funds, and others to determine the extent to which
differing standards circumvent regulatory efforts to contain excess
leverage in the system. The Council also should undertake the
harmonization of capital and margin requirements applicable to all OTC
derivatives activities--and facilitate interagency efforts to encourage
greater standardization and transparency of derivatives activities and
the migration of these activities onto exchanges or central
counterparties.
The CFPA would eliminate regulatory gaps between insured depository
institutions and nonbank providers of financial products and services
by establishing strong, consistent consumer protection standards across
the board. It also would address another gap by giving the CFPA
authority to examine nonbank financial service providers that are not
currently examined by the Federal banking agencies. In addition, the
Administration's proposal would eliminate the potential for regulatory
arbitrage that exists because of Federal preemption of certain State
laws. By creating a floor for consumer protection and allowing more
protective State consumer laws to apply to all providers of financial
products and services operating within a State, the CFPA should
significantly improve consumer protection.
A distinction should be drawn between the macroprudential oversight
and regulation of developing risks that may pose systemic risks to the
U.S. financial system and the direct supervision of financial firms.
The macroprudential oversight of systemwide risks requires the
integration of insights from a number of different regulatory
perspectives--banks, securities firms, holding companies, and perhaps
others. Only through these differing perspectives can there be a
holistic view of developing risks to our system.
Prudential supervisors would regulate and supervise the
institutions under their jurisdiction, and enforce consumer standards
set by the CFPA and any additional systemic standards established by
the Council. Entities that are already subject to a prudential
supervisor, such as insured depository institutions and financial
holding companies, should retain those supervisory relationships. In
addition, for systemic entities not already subject to a Federal
prudential supervisor, and to avoid the regulatory arbitrage that is a
source of the current problem, the Council should be empowered to
require that they submit to such oversight. Presumably this could take
the form of a financial holding company under the Federal Reserve--
without subjecting them to the activities restrictions applicable to
these companies.
There is not always a clear demarcation of these roles and they
will need to coordinate to be effective. Industry-wide standards for
safety and soundness are based on the premise that if most or all
banking organizations are safe, the system is safe. However, practices
that may be profitable for a few institutions may not be prudent if
that same business model is adopted by a large number of institutions.
From our recent experience we know that there is a big difference
between one regulated bank having a high concentration of subprime
loans and concentrations of subprime lending across large sections of
the regulated and nonregulated financial system. Coordination of the
prudential and systemic approaches will be vital to improving
supervision at both the bank and systemic level.
Risk management is another area where there should be two different
points of view. Bank supervisors focus on whether a banking
organization has a reasonable risk management plan for its
organization. The systemic risk regulator would look at how risk
management plans are developed across the industry. If everyone relies
on similar risk mitigation strategies, then no one will be protected
from the risk. In other words, if everyone rushes to the same exit at
the same time, no one will get out safely.
Some may believe that financial institutions are able to arbitrage
between regulators by switching charters. This issue has been addressed
directly by recent action by the Federal banking regulators to
coordinate prudential supervision so institutions cannot evade uniform
enforcement of regulatory standards. The agencies all but eliminated
any possibility of this in the recent issuance of a Statement on
Regulatory Conversions that will not permit charter conversions that
undermine the supervisory process. The FDIC would support legislation
making the terms of this agreement binding by statute. We also would
support time limits on the ability to convert. The FDIC has no
statutory role in the charter conversion process. However, as insurer
of all depository institutions, we have a vital interest in protecting
the integrity of the supervisory process and guarding against any
possibility that the choice of a Federal or State charter could
undermine that process.
Conclusion
The focus of efforts to reform the financial system should be the
elimination of the regulatory gaps between banks and nonbank financial
providers outside the traditional banking system, as well as between
commercial banks and investment banks. Proposals to create a unified
supervisor would undercut the benefits of diversity that are derived
from the dual banking system and that are so important to a very large
country with a very large number of banks chartered in multiple
jurisdictions with varied local needs. As evidenced by the experience
of other much smaller countries with much more concentrated banking
systems, such a centralized, monolithic regulation and supervision
system has significant disadvantages and has resulted in greater
systemic risk. A single regulator is no panacea for effective
supervision.
Congress should create a Financial Services Oversight Council and
Consumer Financial Protection Agency with authority to look broadly at
our financial system and to set minimum uniform rules for the financial
sector. In addition, the Administration's proposal to create a new
agency to supervise federally chartered institutions will better
reflect the current composition of the banking industry. Finally, but
no less important, there needs to be a resolution mechanism that
encourages market discipline for financial firms by imposing losses on
shareholders and creditors and replacing senior management in the event
of failure.
I would be pleased respond to your questions.
______
PREPARED STATEMENT OF JOHN C. DUGAN
Comptroller of the Currency, Office of the Comptroller of the Currency
August 4, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
I appreciate this opportunity to discuss the modernization of financial
services regulation in the context of the Administration's Proposal for
regulatory reform. \1\ The events of the last 2 years--including the
unprecedented distress and failure of financial firms, the accumulation
of toxic subprime mortgage assets in our financial system, and the
steep rise in foreclosures--have exposed gaps and weaknesses in our
regulatory framework. The Proposal put forward by the Treasury
Department for strengthening that framework is thoughtful and
comprehensive, and I support many of its proposed reforms. But I also
have significant concerns with two parts of it, i.e., (1) the proposed
broad authority of the Federal Reserve, as systemic risk regulator, to
override authority of the primary prudential banking supervisor; and
(2) the elimination of uniform national consumer protection standards
for national banks in connection with establishing the newly proposed
Consumer Financial Protection Agency (CFPA), and the transfer of all
existing consumer protection examination and enforcement from the
Federal banking agencies to the new CFPA. Both concerns relate to the
way in which important new authorities would interact with the
essential functions of the dedicated prudential banking supervisor.
---------------------------------------------------------------------------
\1\ See, U.S. Department of the Treasury, ``Financial Regulatory
Reform--A New Foundation: Rebuilding Financial Supervision and
Regulation'' (June 2009) (the ``Proposal''), available at
www.financialstability.gov/docs/regs/FinalReport.web.pdf. Treasury also
has released legislative language to implement most components of the
Proposal. That proposed legislation is available at www.treas.gov/
initiatives/regulatoryreform.
---------------------------------------------------------------------------
My testimony begins with a brief summary of the key parts of the
Proposal we generally support. The second section focuses on the topics
pertaining to regulatory structure on which the Committee has
specifically invited our views; this portion includes a discussion of
the Federal Reserve's role and authority. The last section addresses
our second area of major concern--uniform national standards and the
CFPA.
I. Key Provisions Supported by the OCC
We believe many of the Administration's proposed reforms will
strengthen the financial system and help prevent future market
disruptions of the type we witnessed last year, including the
following:
Establishment of a Financial Stability Oversight Council.
This council would consist of the Secretary of the Treasury and
all of the Federal financial regulators, and would be supported
by a permanent staff. Its general role would be to identify and
monitor systemic risk, and it would have strong authority to
gather the information necessary for that mission, including
from any entity that might pose systemic risk. We believe that
having a centralized and formalized mechanism for gathering and
sharing systemically significant information, and making
recommendations to individual regulators, makes good sense. It
also could provide a venue or mechanism for resolving
differences of opinions among regulators.
Enhanced authority to resolve systemically significant
financial firms. The Federal Deposit Insurance Corporation
(FDIC) currently has broad authority to resolve a distressed
systemically significant depository institution in an orderly
manner. No comparable resolution authority exists for large
bank holding companies, or for systemically significant
financial companies that are not banks, as we learned painfully
with the problems of such large financial companies as Bear
Stearns, Lehman Brothers, and AIG. The Proposal would extend
resolution authority like the FDIC's to such nonbanking
companies, while preserving the flexibility to use the FDIC or
another regulator as the receiver or conservator, depending on
the circumstances. This is a sound approach that would help
maximize orderly resolutions of systemically significant firms.
Strengthened regulation of systemically significant firms,
including requirements for higher capital and stronger
liquidity. We support the concept of imposing more stringent
prudential standards on systemically significant financial
firms to address their heightened risk to the system and to
mitigate the competitive advantage they could realize from
being designated as systemically significant. But these
standards should not displace the standard-setting and
supervisory responsibilities of the primary banking supervisor
with respect to bank subsidiaries of these companies. And in
those instances where the largest asset of the systemically
significant firm is a bank--as may often be the case--the
primary banking supervisor should have a strong role in helping
to craft the new standards for the holding company.
Changes in accounting standards that would allow banks to
build larger loan loss reserves in good times to absorb more
losses in bad times. One of the problems that has impaired
banks' ability to absorb increased credit losses while
continuing to provide appropriate levels of credit is that
their levels of loan loss reserves available to absorb such
losses were not as high as they should have been entering the
crisis. One reason for this is the currently cramped accounting
regime for building loan loss reserves, which is based on the
concept that loan loss provisions are permissible only when
losses are ``incurred.'' The Proposal calls for accounting
standard setters to improve this standard to make it more
forward looking so that banks could build bigger loan loss
reserves when times are good and losses are low, in recognition
of the fact that good times inevitably end, and large loan loss
reserves will be needed to absorb increased losses when times
turn bad. The OCC strongly supports this part of the Proposal.
In fact, I cochaired an international task force under the
auspices of the Financial Stability Board to achieve this very
objective on a global basis, which we hope will contribute to
stronger reserving policy both here and abroad.
Enhanced consumer protection. The Proposal calls for
enhanced consumer protection standards for consumer financial
products through new rules that would be written and
implemented by the new Consumer Financial Protection Agency.
The OCC supports strong, uniform Federal consumer protection
standards. While we generally do not have rulewriting authority
in this area, we have consistently applied and enforced the
rules written by the Federal Reserve (and others), and, in the
absence of our own rulewriting authority, have taken strong
enforcement actions to address unfair and deceptive practices
by national banks. We believe that an independent agency like
the CFPA could appropriately strengthen consumer protections,
but we have serious concerns with the CFPA as proposed. We
believe the goal of strong consumer protection can be
accomplished better through CFPA rules that reflect meaningful
input from the Federal banking agencies and are truly uniform,
rather than resulting in a patchwork of different rules amended
and enforced differently by individual States. We also believe
that these rules should continue to be implemented by the
Federal banking agencies for banks, under the existing, well-
established regulatory and enforcement regime, and by the CFPA
and the States for nonbank financial providers, which today are
subject to different standards and far less actual oversight
than federally regulated depository institutions. This is
discussed in greater detail below.
Stronger regulation of payments systems, hedge funds, and
over-the-counter derivatives, such as credit default swaps. The
Proposal calls for significant enhancements in regulation in
each of these areas, which we generally support in concept. We
will provide more detailed comments about each, as appropriate,
once we have had more time to review the implementing
legislative language.
II. Regulatory Structure Issues
1. Proposed Establishment of the National Bank Supervisor and
Elimination of the Federal Thrift Charter
In proposing to restructure the banking agencies, the Proposal
appropriately preserves an agency whose only mission is banking
supervision. This new agency, the National Bank Supervisor (NBS), would
serve as the primary regulator of federally chartered depository
institutions, including the national banks that comprise the dominant
businesses of many of the largest financial holding companies. To
achieve this goal, the Proposal would effectively merge the Office of
Thrift Supervision (OTS) into the OCC.
It would eliminate the Federal thrift charter--and also, as I will
shortly discuss, the separate treatment of savings and loan holding
companies--with all Federal thrifts required to convert to a national
bank, a State bank, or a State thrift, over the course of a reasonable
transition period. (State thrifts would then be treated as State
``banks'' under Federal law.) We believe this approach to the agency
merger is preferable to one that would preserve the Federal thrift
charter, with Federal thrift regulation being conducted by a division
of the merged agency. With the same deposit insurance fund, same
prudential regulator, same holding company regulator, same branching
powers, and a narrower charter (a national bank has all the powers of a
Federal thrift plus many others), there would no longer be a need for a
separate Federal thrift charter. In addition, the approach in the
Proposal avoids the considerable practical complexities and costs of
administering two separate statutory and regulatory regimes that are
largely redundant in many areas, and needlessly different in others.
Finally, the legislation implementing this aspect of the Proposal
should be unambiguously clear--as we believe is intended--that the new
agency is independent from the Treasury Department and the
Administration to the same extent that the OCC and OTS are currently
independent. \2\
---------------------------------------------------------------------------
\2\ For example, current law provides the OCC with important
independence from political interference in decision making in matters
before the Comptroller, including enforcement proceedings; provides for
funding independent of political control; enables the OCC to propose
and promulgate regulations without approval by the Treasury; and
permits the agency to testify before Congress without the need for the
Administration's clearance of the agency's statements.
---------------------------------------------------------------------------
2. Enhancement of the Federal Reserve's Supervision of Systemically
Significant Financial Holding Companies
The Federal Reserve Board already has strong authority as
consolidated supervisor to identify and address problems at large,
systemically significant bank holding companies. In the financial
crisis of the last 2 years, the absence of a comparable authority with
respect to large securities firms, insurance companies, and Government-
sponsored enterprises that were not affiliated with banks proved to be
an enormous problem, as a disproportionate share of the financial
stress in the markets was created by these institutions. The lack of a
consistent and coherent regulatory regime applicable to them by a
single regulator helped mask problems in these nonbanking companies
until they were massive. And gaps in the regulatory regime constrained
the Government's ability to deal with them once they emerged. The
Proposal would extend the Federal Reserve's consolidated bank holding
company regulation to systemically significant nonbanking companies in
the future, which would appropriately address the regulatory gap.
However, as discussed below, one aspect of this part of the proposal
goes too far, i.e., the new Federal Reserve authority to ``override''
key functions of the primary banking supervisor, which would undermine
the authority--and the accountability--of the banking supervisor for
the soundness of the banks that anchor systemically significant holding
companies.
3. Elimination of the Thrift Holding Company and Industrial Loan
Company Exceptions to Bank Holding Company Act Regulation
Under the law today, companies that own thrifts or industrial loan
companies (ILCs) are exempt from regulation under the Bank Holding
Company Act. The Proposal would eliminate these exemptions, making
these types of firms subject to supervision by the Federal Reserve
Board.
Thrift holding companies, unlike bank holding companies, are not
subject to consolidated regulation; for example, no consolidated
capital requirements apply at the holding company level. This
difference between bank and thrift holding company regulation created
arbitrage opportunities for companies that were able to take on greater
risk under a less rigorous regulatory regime. Yet, as we have seen -
AIG is the obvious example--large nonbank firms can present similar
risks to the system as large banks. This regulatory gap should be
closed, and these firms should be subject to the same type of oversight
as bank holding companies.
Companies controlling ILCs also are not subject to bank holding
company regulation, but admittedly, ILCs have not been the source of
the same kinds of problems as thrift holding companies. For that
reason, it may be appropriate to continue to exempt small ILCs from
bank holding company regulation. If this approach were pursued, the
exemption should terminate once the ILC exceeds a certain size
threshold, however, because the same potential risks can arise as with
banks. Alternatively, if the ILC exemption were repealed altogether,
appropriate grandfathering of existing ILCs and their parent companies
should be considered.
4. The Merits of Further Regulatory Consolidation
It is clear that the United States has too many bank regulators. We
have four Federal bank regulators, 12 Federal Reserve Banks, and 50
State regulators, nearly all of which have some type of overlapping
supervisory responsibilities. This system is largely the product of
historical evolution, with different agencies created for different
legitimate purposes reflecting a much more segmented financial system
from the past. No one would design such a system from scratch, and it
is fair to say that, at times, it has not been the most efficient way
to establish banking policy or supervise banks.
Nevertheless, the banking agencies have worked hard over the years
to make the system function appropriately despite its complexities. On
many occasions, the diversity in perspectives and specialization of
roles has provided real value. And from the agencies has been a primary
driver of recent problems in the banking system.
That said, I recognize the considerable interest in reducing the
number of bank regulators. The impulse to simplify is understandable,
and it may well be appropriate to streamline our current system. But we
ought not approach the task by prejudging the appropriate number of
boxes on the organization chart. The better approach is to determine
what would be achieved if the number of regulators were reduced. What
went wrong in the current crisis that changes in regulatory structure
(rather than regulatory standards) will fix? Will accountability be
enhanced? Will the change result in greater efficiency and consistency
of regulation? Will gaps be closed so that opportunities for regulatory
arbitrage in the current system are eliminated? Will overall market
regulation be improved?
In testimony provided earlier this year, I strongly urged that
Congress, in reforming financial services regulation, preserve a
robust, independent bank supervisor that is solely dedicated to the
prudential oversight of depository institutions. Banks are the anchor
of most financial holding companies, including the very largest, and I
continue to believe that the benefits of dedicated, strong prudential
supervision are significant--indeed, necessary. Dedicated supervision
assures there is no confusion about the supervisor's goals and
objectives, and no potential conflict with competing objectives.
Responsibility is well defined, and so is accountability. Supervision
takes a back seat to no other part of the organization, and the result
is a strong culture that fosters the development of the type of
seasoned supervisors that are needed to confront the many challenges
arising from today's banking business. The strength of national banks
at the core of many of the largest financial holding companies has been
an essential anchor to the ability of those companies to weather recent
financial crises--and to absorb distressed securities and thrift
companies.
While there is arguably an agreement on the need to reduce the
number of bank regulators, there is no such consensus on what the right
number is or what their roles should be. As I have mentioned, we
support reducing the number of Federal banking regulators from four to
three by effectively merging the OTS into the OCC, leaving just one
Federal regulator for federally chartered banks. There are reasonable
arguments for streamlining the regulatory structure even further, but
there would be advantages and disadvantages at each step.
For example, the number of banking regulators could be further
reduced from three to two by creating a single Federal regulator for
State-chartered banks, whose Federal supervision is now divided between
the Federal Reserve Board and the FDIC, depending on whether the State
bank is a member of the Federal Reserve System. Today there is
virtually no difference in the regulation applicable to State banks at
the Federal level based on membership in the System and thus no real
reason to have two different Federal regulators. It would be simpler to
have one. Opportunities for regulatory arbitrage--resulting, for
example, from differences in the way Federal activities restrictions
are administered by one or the other regulator--would be reduced.
Policymaking would be streamlined. Fewer decision-makers would have to
agree on the implementation of banking policies and restrictions that
Congress has required to be carried out on a joint basis.
On the other hand, whichever agency loses supervisory authority
over State banks also would lose the day-to-day ``window'' into the
condition of the banking industry that today informs the conduct of
other aspects of its mission. This may present a greater problem for
the FDIC, which would have much less engagement with the banking sector
during periods with few bank failures, especially if the Federal
Reserve retained holding company jurisdiction, an issue I discuss
below.
Still further consolidation could be achieved by reducing the
number of bank regulators to one dedicated prudential supervisor. If
this were done, the single Federal supervisor should be structured to
be independent from the Treasury Department and headed by a board of
directors, with the Chairmen of the FDIC and the Federal Reserve Board
serving as board members. This is the simplest, and arguably the most
logical, approach. It would afford the most direct accountability--
there would be no confusion about which regulator was responsible for
the Federal supervision of a bank--and it would end opportunities for
regulatory arbitrage. Moreover, it could be done within the framework
of the dual banking system by preserving both State and national
charters. It would be desirable, however, for the single regulator to
maintain separate divisions for the supervision of large and small
institutions, given the differences in complexity and types of risk
that banks of different sizes present.
The disadvantages of such an approach include removing both the
Federal Reserve and the FDIC from day-to-day bank supervision (although
that concern would be mitigated for the Federal Reserve to the extent
it retained holding company regulation). In addition, States may be
concerned that the State charter would be significantly less attractive
if the same Federal regulator supervised both State and Federal
institutions, especially if State-chartered institutions were required
to pay for Federal supervision in addition to the assessments charged
by the State (although that issue could be addressed separately).
Finally, the Committee has asked whether a consolidated prudential
bank supervisor also could regulate the holding company. While this
could be done, and has significant appeal with respect to small and
``bank-only'' holding companies, there would be significant issues
involved with such an approach in the case of the largest companies
where the challenges would be the greatest.
Little need remains for separate holding company regulation where
the bank is small or where it is the holding company's only, or
dominant, asset. (The previously significant role of the Federal
Reserve, as holding company supervisor, in approving new activities was
dramatically reduced by the provisions in the Gramm-Leach-Bliley Act
that authorized financial holding companies and specifically identified
and approved in advance the types of activities in which they could
engage.) For these firms, the holding company regulator's other
authorities are not necessary to ensure effective prudential
supervision to the extent that they duplicate the Federal prudential
supervisor's authority to set standards, examine, and take appropriate
enforcement action with respect to the bank. Elimination of a separate
holding company regulator thus would eliminate duplication, promote
simplicity and accountability, and reduce unnecessary compliance burden
for institutions as well.
The case is harder and more challenging for the very largest bank
holding companies engaged in complex capital markets activities,
especially where the company is engaged in many, or predominantly,
nonbanking activities, such as securities and insurance. Given its
substantial role and direct experience with respect to capital markets,
payments systems, the discount window, and international central
banking, the Federal Reserve Board provides unique resources and
perspective to supervision. Eliminating the Board as holding company
regulator would mean losing the direct effect of that expertise. The
benefits of the different perspectives of holding company regulator and
prudential regulator would be lost. The focus of a dedicated, strong
prudential banking supervisor could be significantly diluted by
extending its focus to nonbanking activities. It also would take time
for the consolidated banking supervisor to acquire and maintain a
comparable level of expertise, especially in nonbanking activities.
5. Delineation of Responsibilities Between the Systemic Supervisor and
Prudential Supervisor
If, as under the Administration's Proposal, the Board is the
systemic holding company supervisor, then it is essential that clear
lines be drawn between the Board's authority and the authority of the
prudential banking supervisor. As I will explain, the Proposal goes too
far in authorizing the systemic supervisor to override the prudential
supervisor's role and authorities.
The Proposal would establish the Federal Reserve Board as the
systemic supervisor by providing it with enhanced, consolidated
authority over a ``Tier 1'' financial holding company--that is, a
company that poses significant systemic risk--and all of its
subsidiaries. In essence, this structure builds on and expands the
current system for supervising bank holding companies, where the Board
already has consolidated authority over the company, and the prudential
bank supervisor is responsible for direct bank supervision.
In practice, many of the companies likely to be designated as Tier
1 financial holding companies will have at their heart very large
banks, many of which are national banks. Because of their core role as
financial intermediaries, large banks have extensive ties to the
``Federal safety net'' of deposit insurance, the discount window, and
the payments system. Accordingly, the responsibility of the prudential
bank supervisor must be to ensure that the bank remains a strong anchor
within the company as a whole. Indeed, this is our existing
responsibility at the OCC, which we take very seriously through our
continuous on-site supervision by large teams of resident examiners in
all of our largest national banks. As a result, the bank is by far the
most intensively regulated part of the largest bank holding companies,
which has translated into generally lower levels of losses of banks
within the holding company versus other companies owned by that holding
company--including those large bank holding companies that have
sustained the greatest losses.
In the context of regulatory restructuring for systemically
significant bank holding companies, preserving the essential role of
the prudential supervisor of the bank means that its relationship with
the systemic supervisor should be complementary; it should not be
subsumed or overtaken by the systemic supervisor. Conflating the two
roles undermines the bank supervisor's authority, responsibility, and
accountability. Moreover, it would impose major new responsibilities on
and further stretch the role of the Board.
Parts of the Proposal are consistent with this type of
complementary relationship between the Board and the prudential bank
supervisor. For example, the Board would be required to rely, as far as
possible, on the reports of examination prepared by the prudential bank
supervisors. This approach reflects the practical relationship that the
OCC has with the Board today, a relationship that works, in part
because the lines of authority between the two regulators are
appropriately defined. And it has allowed the Board to use and rely on
our work to perform its role as supervisor for complex banking
organizations that are often involved in many businesses other than
banking. It is a model well suited for use in a new regulatory
framework where the Board assumes substantial new responsibilities,
including potential authority over some Tier 1 companies that do not
have bank subsidiaries at all.
In one crucial respect, however, the Proposal departs dramatically
from that model and is not consistent with its own stated objective of
maintaining a robust, responsible, and independent prudential
supervisor that will be accountable for its safety and soundness
supervision. That is, the Proposal provides the Board with authority to
establish, examine, and enforce more stringent standards with respect
to the ``functionally regulated'' subsidiaries of Tier 1 financial
holding companies--which under the proposal would include bank
subsidiaries--in order to mitigate systemic risk posed by those
subsidiaries. This open-ended authorization would allow the Board to
impose customized requirements on virtually any aspect of the bank's
operations at any time, subject only to a requirement for
``consultation'' with the Secretary of the Treasury and the bank's
primary Federal or State supervisor. This approach is entirely
unnecessary and unwarranted in the case of banks already subject to
extensive regulation. It would fundamentally alter the relationship
between the Board and the bank supervisor by superseding the bank
supervisor's authority over bank subsidiaries of systemically
significant companies, and would be yet another measure that
concentrates more authority in, and stretches the role of, the Board.
In addition, while the Proposal centralizes in the Board more
authority over Tier 1 financial holding companies, it does not address
the current, significant gap in supervision that exists within bank
holding companies. In today's regulatory regime, a bank holding company
may engage in a particular banking activity, such as mortgage lending,
either through a subsidiary that is a bank or through a subsidiary that
is not a bank. If engaged in by the banking subsidiary, the activity is
subject to required examination and supervision on a periodic basis by
the primary banking supervisor. However, if it is engaged in by a
nonbanking subsidiary, it is potentially subject to examination by the
Federal Reserve, but regular supervision and examination is not
required. As a policy matter, the Federal Reserve had previously
elected not to subject such nonbanking subsidiaries to full bank-like
examination and supervision on the theory that such activities would
inappropriately extend ``the safety net'' of Federal protections from
banks to nonbanks. \3\ The result has been the application of uneven
standards to bank and nonbank subsidiaries of bank holding companies.
For example, in the area of mortgage lending, banks were held to more
rigorous underwriting and consumer compliance standards than nonbank
affiliates in the same holding company. While the Board has recently
indicated its intent to increase examination of nonbank affiliates, it
is not clear that such examinations will be required to be as regular
or extensive as the examination of the same activities conducted in
banks.
---------------------------------------------------------------------------
\3\ See, e.g., Chairman Alan Greenspan, ``Insurance Companies and
Banks Under the New Regulatory Law'', Remarks Before the Annual Meeting
of the American Council of Life Insurance (November 14, 1999) (``The
Gramm-Leach-Bliley Act is designed to limit extensions of the safety
net, and thus to eliminate the need to impose banklike regulation on
nonbank subsidiaries and affiliates of organizations that contain a
bank.''), available at www.federalreserve.gov/boarddocs/speeches/1999/
19991115.htm.
---------------------------------------------------------------------------
I believe that such differential regulation and supervision of the
same activity conducted in different subsidiaries of a single bank
holding company--whether in terms of safety and soundness or consumer
protection--doesn't make sense and is an invitation to regulatory
arbitrage. Indeed, leveling the supervision of all subsidiaries of a
bank holding company takes on added importance for a ``Tier 1''
financial holding company because, by definition, the firm as a whole
presents systemically significant risk.
One way to address this problem would be to include in legislative
language an explicit direction to the Board to actively supervise
nonbanking subsidiaries engaged in banking activities in the same way
that a banking subsidiary is supervised by the prudential supervisor,
with required regular exams. Of course, adding new required
responsibilities for the direct supervision of more companies may serve
as a distraction both from the Board's other new assignments under the
Proposal as well as the continuation of its existing responsibilities.
An alternative approach that may be preferable would be to assign
responsibility to the prudential banking supervisor for supervising
certain nonbank holding company subsidiaries. In particular, where
those subsidiaries are engaged in the same business as is conducted, or
could be conducted, by an affiliated bank--mortgage or other consumer
lending, for example--the prudential supervisor already has the
resources and expertise needed to examine the activity. Affiliated
companies would then be made subject to the same standards and examined
with the same frequency as the affiliated bank. This approach also
would ensure that the placement of an activity in a holding company
structure could not be used to arbitrage between different supervisory
regimes or approaches.
III. The Proposed Consumer Financial Protection Agency and the
Elimination of Uniform National Standards for National Banks
Today's severe consumer credit problems can be traced to the
multiyear policy of easy money and easy credit that led to an asset
bubble, with too many people getting loans that could not be repaid
when the bubble burst. With respect to these loans--especially
mortgages--the core problem was lax underwriting that relied too
heavily on rising house prices. Inadequate consumer protections--such
as inadequate and ineffective disclosures--contributed to this problem,
because in many cases consumers did not understand the significant
risks of complex loans that had seductively low initial monthly
payments. Both aspects of the problem--lax underwriting and inadequate
consumer protections--were especially acute in loans made by nonbank
lenders that were not subject to Federal regulation. \4\
---------------------------------------------------------------------------
\4\ Some have suggested that the Community Reinvestment Act (CRA)
caused the subprime lending crisis. That is simply not true. As the
Administration's Proposal expressly recognizes, and as I have testified
before, far fewer problem mortgages were made by institutions subject
to CRA--that is, federally regulated depository institutions--than were
made by mortgage brokers and originators that were not depository
institutions. The Treasury Proposal specifically notes that CRA-covered
depository institutions made only 6 percent of recent higher-priced
mortgages provided to lower-income borrowers or in areas that are the
focus of CRA evaluations. Proposal, supra, note 1, at 69-70. Moreover,
our experience with the limited portion of subprime loans made by
national banks is that they are performing better than nonbank subprime
loans. This belies any suggestion that the banking system, and national
banks in particular, were any sort of haven for abusive lending
practices.
---------------------------------------------------------------------------
In terms of changes to financial consumer protection regulation,
legislation should be targeted to the two types of fundamental gaps
that fueled the current mortgage crisis. The first gap relates to
consumer protection rules themselves, which were written under a
patchwork of authorities scattered among different agencies; were in
some cases not sufficiently robust or timely; and importantly, were not
applied to all financial services providers, bank or nonbank,
uniformly. The second gap relates to implementation of consumer
protection rules, where there was no effective mechanism or framework
to ensure that nonbank financial institutions complied with rules to
the same extent as regulated banks. That is, the so-called ``shadow
banking system'' of nonbank firms, such as finance companies and
mortgage brokers, provides products comparable to those provided by
banks, but is not subject to comparable oversight. This shadow banking
system has been widely recognized as central to the most abusive
subprime lending that fueled the mortgage crisis.
A new Consumer Financial Protection Agency could be one mechanism
to target both the rulewriting gap and the implementation gap. In terms
of the rulewriting gap, all existing consumer financial protection
authority could be centralized in the CFPA and strengthened as Congress
sees fit, and that authority could be applied to all providers of a
particular type of financial product with rules that are uniform. In
terms of the implementation gap, the CFPA could be focused on
supervision and/or enforcement mechanisms that raise consumer
protection compliance for nonbank financial providers to a similar
level as exists for banks--but without diminishing the existing regime
for bank compliance. And in both cases, the CFPA could be structured to
recognize legitimate bank safety and soundness concerns that in some
cases are inextricably intertwined with consumer protection--as is the
case with underwriting standards.
Unfortunately, the Proposal's CFPA falls short in addressing these
two fundamental consumer protection regulatory gaps. Let me address
each in turn.
1. Rulewriting
a. Lack of Uniform Rules and National Bank Preemption--To address the
rulewriting gap, the Proposal's CFPA provides a mechanism for
centralized authority and stronger rules that could be applied
to all providers of financial products. But the rules would not
be uniform; that is, because the Proposal authorizes States to
adopt different rules, there could be 50 different standards
that apply to providers of a particular product or service,
including national banks.
A core principle of the Proposal is its recognition that consumers
benefit from uniform rules. \5\ Yet this very principle is expressly
undermined by the specific grant of authority to States to adopt
different rules; by the repeal of uniform standards for national banks;
and by the empowerment of individual States, with their very differing
points of view, to enforce Federal consumer protection rules--under all
Federal statutes--in ways that might vary from State to State. In
effect, the resulting patchwork of Federal-plus-differing-State
standards would effectively distort and displace the Federal agency's
rulemaking, even though the CFPA's rule would be the product of an open
public comment process and the behavioral research and evaluative
functions that the Proposal highlights.
---------------------------------------------------------------------------
\5\ See, e.g., Proposal, supra note 1, at 69 (discussing the
proposed CFPA, observing that ``[f]airness, effective competition, and
efficient markets require consistent regulatory treatment for similar
products,'' and noting that consistent regulation facilitates
consumers' comparison shopping); and at 39 (discussing the history of
insurance regulation by the States, which ``has led to a lack of
uniformity and reduced competition across State and international
boundaries, resulting in inefficiency, reduced product innovation, and
higher costs to consumers.'').
---------------------------------------------------------------------------
In particular, for the first time in the nearly 150-year history of
the national banking system, federally chartered banks would be subject
to this multiplicity of State operating standards, because the Proposal
sweepingly repeals the ability of national banks to conduct any retail
banking business under uniform national standards.
This is a profound change and, in my view, the rejection of a
national standards option is unwise and unjustified, especially as it
relates to national banks. Given the CFPA's enhanced authority and
mandate to write stronger consumer protection rules, and the thorough
and expert processes described as integral to its rulemaking, there
should no longer be any issue as to whether sufficiently strong Federal
consumer protection standards would be in place and applicable to
national banks. In this context there is no need to authorize States to
adopt different standards for such banks. Likewise, there is no need to
authorize States to enforce Federal rules against national banks--which
would inevitably result in differing State interpretations of Federal
rules--because Federal regulators already have broad enforcement
authority over such institutions and the resources to exercise that
authority fully.
More fundamentally, we live in an era where the market for
financial products and services is often national in scope. Advances in
technology, including the Internet and the increased functionality of
mobile phones, enable banks to do business with customers in many
States. Our population is increasingly mobile, and many people live in
one State and work in another--the case for many of us in the
Washington, DC, metropolitan area.
In this context, regressing to a regulatory regime that fails to
recognize the way retail financial services are now provided, and the
need for an option for a single set of rules for banks with multistate
operations and multistate customers, would discard many of the benefits
consumers reap from our modern financial product delivery system. The
Proposal's balkanized approach could give rise to significant
uncertainty about which sets of standards apply to institutions
conducting a multistate business, generating major legal and compliance
costs, and major impediments to interstate product delivery.
This issue is very real for all banks operating across State
lines--not just national banks. Recognizing the importance of
preserving uniform interstate standards for all banks operating in
multiple States, Congress expressly provided in the ``Riegle-Neal II''
Act enacted in 1997 that State banks operating through interstate
branches in multiple States should enjoy the same Federal preemption
and ability to operate with uniform standards as national banks. \6\
---------------------------------------------------------------------------
\6\ 12 U.S.C. 1831a(j); See, also id. at 1831d (interest rates;
parity for State banks).
---------------------------------------------------------------------------
Accordingly, repealing the uniform standards option would create
fundamental, practical problems for all banks operating across State
lines, large or small. For example, there are a number of areas in
which complying with different standards set by individual States would
require a bank to determine which State's law governs--the law of the
State where a person providing a product or service is located, the law
of the home State of the bank employing that person, or the law of the
State where the customer is located. It is far from clear how a bank
could do this based on objective analysis, and any conflicts could
result in penalties and litigation in multiple jurisdictions.
Consider the following practical examples of the potential for
multiple State standards:
Different rules regarding allowable terms and conditions of
particular products;
Different standards for how products may be solicited and
sold (including the internal organizational structure of the
provider selling the product);
Different duties and responsibilities for individuals
providing a particular financial product;
Different limitations on how individuals offering
particular products and services may be compensated;
Different standards for counterparty and assignee liability
in connection with specified products;
Different standards for risk retention (``skin in the
game'') by parties in a chain of origination and sale;
Different disclosure standards;
Different requirements, or permissible rates of interest,
for bank products; and
Different licensing and product clearance requirements.
Taking permissible interest rates as an example, today the maximum
permissible interest rate is derived from the bank's home State. Under
the proposal, States could claim that the permissible rate should be
the rate of the State in which the customer resides, or the rate of the
location where the loan is made, or someplace else. States could also
have different rules about the types of charges that constitute
``interest'' subject to State limits. And States could have different
standards for exerting jurisdiction over interest rates, creating the
potential for the laws of two or more States to apply to the same
transaction. And even if the bank figures all this out for a particular
customer, and for all the product relationships it has with the
customer, that could all change if the customer moved. Does that mean
the customer would have to open a new account to incorporate the new
required terms?
Such uncertainties have the real potential to confuse consumers,
subject providers to major new potential liabilities, and significantly
increase the costs of doing business in ways that will be passed on to
consumers. It could also cause product providers to pull back where
increased costs erase an already thin profit margin--for example, with
``indirect'' auto lending across State lines--or where they see
unacceptable levels of uncertainty and potential risk.
Moreover, a bank with multistate operations might well decide that
the only sensible way to conduct a national business is to operate to
the most stringent standard prevailing in its most significant State
market. It should not be the case that a decision by one State
legislature about how products should be designed, marketed, or sold
should effectively replace a national regulatory standard established
by the Federal Government based on thorough research and an open and
nationwide public comment process.
Finally, subjecting national banks to state laws and state
enforcement of Federal laws is a potentially crippling change to the
national bank charter and a rejection of core principles that form the
bedrock of the dual banking system. For nearly 150 years, national
banks have been subject to a uniform set of Federal rules enforced by
the OCC, and State banks have been subject to their own States' rules.
This dual banking system has worked, as it has allowed an individual
State to serve as a ``laboratory'' for new approaches to an issue--
without compelling adoption of a particular approach by all States or
as a national standard. That is, the dual banking system is built on
individual States experimenting with different kinds of laws, including
new consumer protection laws, that apply to State banks in a given
State, but not to State banks in all States and not to national banks.
Some of these individual State laws have proven to be good ideas, while
others have not. When Congress has believed that a particular State's
experiment is worthwhile, it has enacted that approach to apply
throughout the country, not only to all national banks, but to State
banks operating in other States that have not yet adopted such laws. As
a result of this system, national banks have always operated under an
evolving set of Federal rules that are at any one time the same,
regardless of the State in which the banks are headquartered, or the
number of different States in which they operate. This reliable set of
uniform Federal rules is a defining characteristic of the national bank
charter, helping banks to provide a broader range of financial products
and services at lower cost, which in turn can be passed along to the
consumer.
The Proposal's CFPA, by needlessly eliminating this defining
characteristic, will effectively ``de-nationalize'' the national
charter and undermine the dual banking system. What will be the point
of a national charter if all banks must operate in every State as if
they were chartered in that State? In such circumstances there would be
a strong impetus to convert to a State bank regulated by the Federal
Reserve in order to obtain the same regulator for the bank and the
holding company, while avoiding any additional cost associated with
national bank supervision--and that would further concentrate
responsibilities in, and stretch the mission of, the Federal Reserve.
In short, with many consumer financial products now commoditized
and marketed nationally, it is difficult to understand the sense of
replacing the existing, long-standing option of enhanced and reliable
Federal standards that are uniform, with a balkanized ``system'' of
differing State standards that may be adopted under processes very
different from the public-comment and research-based rulemaking process
that the CFPA would employ as a Federal agency.
b. Safety and Soundness Implications of CFPA Rulemaking--The Proposal
would vest all consumer protection rulewriting authority in the
CFPA, which in turn would not be constrained in any meaningful
way by safety and soundness concerns. That presents serious
issues because, in critical aspects of bank supervision, such
as underwriting standards, consumer protection cannot be
separated from safety and soundness. They are both part of
comprehensive and effective banking supervision. Despite this
integral relationship, the Proposal as drafted would allow the
CFPA, in writing rules, to dismiss legitimate safety and
soundness concerns raised by a banking supervisor. That is, if
a particular CFPA rule conflicts with a safety and soundness
standard, the CFPA's views would always prevail, because the
legislation provides no mechanism for striking an appropriate
balance between consumer protection and safety and soundness
objectives.
For example, the CFPA could require a lender to offer a
standardized mortgage that has simple terms, but also has a low down
payment to make it more beneficial to consumers. That type of rule
could clearly raise safety and soundness concerns, because lower down
payments are correlated with increased defaults on loans--yet a safety
and soundness supervisor would have no ability to stop such a rule from
being issued.
In short, as applied to depository institutions, the CFPA rules
need to have meaningful input from banking supervisors--both for safety
and soundness purposes and because bank supervisors are intimately
familiar with bank operations and can help ensure that rules are
crafted to be practical and workable. A workable mechanism needs to be
specifically provided to incorporate legitimate operational and safety
and soundness concerns of the banking agencies into any final rule that
would be applicable to insured depository institutions. Moreover, I do
not believe it is sufficient to have only one banking supervisor on the
agency's board, as provided under the Proposal; instead, all the
banking agencies should be represented, even if that requires expanding
the size of the board.
2. Implementation: Supervision, Examination, and Enforcement
Consumer protection rules are implemented through examination,
supervision, and/or enforcement. In this context, the Proposal fails to
adequately address the implementation gap I have previously described
because it fails to carefully and appropriately target the CFPA's
examination, supervision, and enforcement jurisdiction to the literally
tens of thousands of nondepository institution financial providers that
are either unregulated or very lightly regulated. These are the firms
most in need of enhanced consumer protection regulation, and these are
the ones that will present the greatest implementation challenges to
the CFPA. Yet rather than focus the CFPA's implementation
responsibilities on these firms, the Proposal would effectively dilute
both the CFPA's and the States' supervisory and enforcement authorities
by extending them to already regulated banks. To do this, the Proposal
would strip away all consumer compliance examination and supervisory
responsibilities--and for all practical purposes enforcement powers as
well--from the Federal banking agencies and transfer them to the CFPA.
And, although the legislation is unclear about the new agency's
responsibilities for receiving and responding to consumer complaints,
it would either remove or duplicate the process for receiving and
responding to complaints by consumers about their banks.
The likely results will be that: (1) nonbank financial providers
will not receive the degree of examination, supervision, and
enforcement attention required to achieve effective compliance with
consumer protection rules; and (2) consumer protection supervision of
banks will become less rigorous and less effective.
In relative terms, it will be easy for the CFPA to adopt consumer
protection rules that apply to all providers of financial products and
services. But it will be far harder to craft a workable supervisory and
enforcement regime to achieve effective implementation of those rules.
In particular, it will be a daunting challenge to implement rules with
respect to the wide variety and huge number of unregulated or lightly
regulated providers of financial services over which the new CFPA would
have jurisdiction, i.e., mortgage brokers; mortgage originators; payday
lenders; money service transmitters; check cashers; real estate
appraisers; title, credit, and mortgage insurance companies; credit
reporting agencies; stored value providers; financial data processing,
transmission, and storage firms; debt collection firms; investment
advisers not subject to SEC regulation; financial advisors; and credit
counseling and tax preparation services, among other types of firms.
Likewise, it will be daunting to respond to complaints from consumers
about these types of firms.
Yet, although the Proposal would give the CFPA broad consumer
protection authority over these types of financial product and service
providers, it contains no framework or detail for examining them or
requiring reports from them--or even knowing who they are. No functions
are specified for the CFPA to monitor or examine even the largest of
these nonbank firms, much less to supervise and examine them as
depository institutions would be when they engaged in the same
activities. No provision is even made for registration with the CFPA so
that the CFPA could at least know the number and size of firms for
which it has supervisory, examination, and enforcement
responsibilities. Nor is any means specified for the CFPA to learn this
information so that it may equitably assess the costs of its
operations--and lacking that, there is a very real concern that
assessments will be concentrated on already regulated banks, for which
size and operational information is already available.
In short, the CFPA has a full-time job ahead to supervise, examine,
and take enforcement actions against nonbank firms in order to effect
their compliance with CFPA rules. In contrast, achieving effective
compliance with such rules by banks is far more straightforward, since
an extensive and effective supervisory and enforcement regime is
already in place at the Federal banking agencies. It therefore makes
compelling sense for the new CFPA to target its scarce implementation
resources on the part of the industry that requires the most attention
to raise its level of compliance--the shadow banking system--rather
than also try to assume supervisory, examination, and enforcement
functions with respect to depository institutions.
Similarly, State consumer protection resources would be best
focused on examining and enforcing consumer protection laws with
respect to the nonbank financial firms that are unregulated or lightly
regulated--and have been the disproportionate source of financial
consumer protection problems. If States targeted their scarce resources
in this way, and drew on new examination and enforcement resources of
the CFPA that were also targeted in this way, the States could help
achieve significantly increased compliance with consumer protection
laws by nonbank financial firms. Unfortunately, rather than have this
focus, the Proposal's CFPA would stretch the States' enforcement
jurisdiction to federally chartered banks, which are already subject to
an extensive examination and enforcement regime at the Federal level.
We believe this dilution of their resources is unnecessary, and it will
only make it more difficult to fill the implementation gap that
currently exists in achieving effective compliance of nonbank firms
with consumer protection rules.
Finally, I firmly believe that, by transferring all consumer
protection examination, supervision, and enforcement functions from the
Federal banking agencies to the CFPA, the Proposal would create a
supervisory system for banks that would be a less effective approach to
consumer protection than the integrated approach to banking supervision
that exists today. Safety and soundness is not divorced from consumer
protection--they are two aspects of comprehensive bank supervision that
are complementary. As evidence of this, attached to my testimony are
summaries of our actual supervisory experience, drawn from supervisory
letters and examination conclusion memoranda, which show the real life
linkage between safety and soundness and consumer protection
supervision. These summaries demonstrate that the results would be
worse for consumers and the prudential supervision of these banks if
bank examiners were not allowed to address both safety and soundness
and consumer protection issues as part of their integrated supervision.
Indeed, we believe that transferring bank examination and
supervision authority to the CFPA will not result in more effective
supervision of banks--or consumer protection--because the new agency
will never have the same presence or knowledge about the institution.
Our experience at the OCC has been that effective, integrated safety
and soundness and compliance supervision grows from the detailed, core
knowledge that our examiners develop and maintain about each bank's
organizational structure, culture, business lines, products, services,
customer base, and level of risk; this knowledge and expertise is
cultivated through regular on-site examinations and contact with our
community banks, and close, day-to-day focus on the activities of
larger banks. An agency with a narrower focus, like that envisioned for
the CFPA, would be less effective than a supervisor with a
comprehensive grasp of the broader banking business.
Conclusion
The OCC appreciates the opportunity to testify on proposed
regulatory reform, and we would be pleased to provide additional
information as the Committee continues its consideration of this
important Proposal.
PREPARED STATEMENT OF DANIEL K. TARULLO
Member, Board of Governors of the Federal Reserve System
August 4, 2009
Chairman Dodd, Ranking Member Shelby, and other Members of the
Committee, thank you for your invitation to testify this morning. The
financial crisis had many causes, including global imbalances in
savings and capital flows, the rapid integration of lending activities
with the issuance, trading, and financing of securities, the existence
of gaps in the regulatory structure for the financial system, and
widespread failures of risk management across a range of financial
institutions. Just as the crisis had many causes, the response of
policymakers must be broad in scope and multifaceted.
Improved prudential supervision--the topic of today's hearing--is a
necessary component of the policy response. The crisis revealed
supervisory shortcomings among all financial regulators, to be sure.
But it also demonstrated that the framework for prudential supervision
and regulation had not kept pace with changes in the structure,
activities, and growing interrelationships of the financial sector.
Accordingly, it is essential both to refocus the regulation and
supervision of banking institutions under existing authorities and to
augment those authorities in certain respects.
In my testimony today, I will begin by suggesting the elements of
an effective framework for prudential supervision. Then I will review
actions taken by the Federal Reserve within its existing statutory
authorities to strengthen supervision of banks and bank holding
companies in light of developments in the banking system and the
lessons of the financial crisis. Finally, I will identify some gaps and
weaknesses in the system of prudential supervision. One potential gap
has already been addressed through the cooperative effort of Federal
and State banking agencies to prevent insured depository institutions
from engaging in ``regulatory arbitrage'' through charter conversions.
Others, however, will require congressional action.
Elements of an Effective Framework for Prudential Supervision
An effective framework for the prudential regulation and
supervision of banking institutions includes four basic elements.
First, of course, there must be sound regulation and supervision of
each insured depository institution. Applicable regulations must be
well-designed to promote the safety and soundness of the institution.
Less obvious, perhaps, but of considerable importance, is the
usefulness of establishing regulatory requirements that make use of
market discipline to help confine undue risk taking in banking
institutions. Supervisory policies and techniques also must be up to
the task of enforcing and supplementing regulatory requirements.
Second, there must be effective supervision of the companies that
own insured depository institutions. The scope and intensity of this
supervision should vary with the extent and complexity of activities
conducted by the parent company or its nonbank subsidiaries. When a
bank holding company is essentially a shell, with negligible activities
or ownership stakes outside the bank itself, holding company regulation
can be less intensive and more modest in scope. But when material
activities or funding are conducted at the holding company level, or
when the parent owns nonbank entities, the intensity of scrutiny must
increase in order to protect the bank from both the direct and indirect
risks of such activities or affiliations and to ensure that the holding
company is able to serve as a source of strength to the bank on a
continuing basis. The task of holding company supervision thus involves
an examination of the relationships between the bank and its affiliates
as well as an evaluation of risks associated with those nonbank
affiliates. Consolidated capital requirements also play a key role, by
helping ensure that a holding company maintains adequate capital to
support its groupwide activities and does not become excessively
leveraged.
Third, there cannot be significant gaps or exceptions in the
supervisory and regulatory coverage of insured depository institutions
and the firms that own them. Obviously, the goals of prudential
supervision will be defeated if some institutions are able to escape
the rules and requirements designed to achieve those goals. There is a
less obvious kind of gap, however, where supervisors are restricted
from obtaining relevant information or reaching activities that could
pose risks to banking organizations.
Fourth, prudential supervision--especially of larger institutions--
must complement and support regulatory measures designed to contain
systemic risk and the too-big-to-fail problem, topics that I have
discussed in previous appearances before this Committee. \1\ One clear
lesson of the financial crisis is that important financial risks may
not be readily apparent if supervision focuses only on the exposures
and activities of individual institutions. For example, the liquidity
strategy of a banking organization may appear sound when viewed in
isolation but, when examined alongside parallel strategies of other
institutions, may be found to be inadequate to withstand periods of
financial stress.
---------------------------------------------------------------------------
\1\ See, Daniel K. Tarullo (2009), ``Regulatory Restructuring'',
statement before the Committee on Banking, Housing, and Urban Affairs,
U.S. Senate, July 23, www.federalreserve.gov/newsevents/testimony/
tarullo20090723a.htm; and Daniel K. Tarullo (2009), ``Modernizing Bank
Supervision and Regulation'', statement before the Committee on
Banking, Housing, and Urban Affairs, U.S. Senate, March 19,
www.federalreserve.gov/newsevents/testimony/tarullo20090319a.htm.
---------------------------------------------------------------------------
Strengthening Prudential Supervision and Regulation
The crisis has revealed significant risk-management deficiencies at
a wide range of financial institutions, including banking
organizations. It also has challenged some of the assumptions and
analysis on which conventional supervisory wisdom has been based. For
example, the collapse of Bear Stearns, which at the end was unable to
borrow privately even with U.S. Government securities as collateral,
has undermined the widely held belief that a company can readily borrow
against high-quality collateral, even in stressed environments.
Moreover, the growing codependency between financial institutions and
markets--evidenced by the significant role that investor and
counterparty runs played in the crisis--implies that supervisors must
pay closer attention to the potential for financial markets to
influence the safety and soundness of banking organizations. These and
other lessons of the financial crisis have led to changes in regulatory
and supervisory practices in order to improve prudential oversight of
banks and bank holding companies, as well as to advance a
macroprudential, or systemic, regulatory agenda.
Working with other domestic and foreign supervisors, the Federal
Reserve has taken steps to require the strengthening of capital,
liquidity, and risk management at banking organizations. There is
little doubt that, in the period before the crisis, capital levels were
insufficient to serve as a needed buffer against loss, particularly at
some of the largest financial institutions, both in the United States
and elsewhere. Measures to strengthen the capital requirements for
trading activities and securitization exposures--two areas where
banking organizations have experienced greater losses than
anticipated--were recently announced by the Basel Committee on Banking
Supervision. Additional efforts are under way to improve the quality of
the capital used to satisfy minimum capital ratios, to strengthen the
capital requirements for other types of on- and off-balance-sheet
exposures, and to establish capital buffers in good times that can be
drawn down as economic and financial conditions deteriorate. Capital
buffers, though not easy to design or implement in an efficacious
fashion, could be an especially important step in reducing the
procyclical effects of the current capital rules. Further review of
accounting standards governing valuation and loss provisioning also
would be useful, and might result in modifications to the accounting
rules that reduce their procyclical effects without compromising the
goals of disclosure and transparency.
The Federal Reserve also helped lead the Basel Committee's
development of enhanced principles of liquidity risk management, which
were issued last year. \2\ Following up on that initiative, on June 30,
2009, the Federal banking agencies requested public comment on new
Interagency Guidance on Funding and Liquidity Risk Management, which is
designed to incorporate the Basel Committee's principles and clearly
articulate consistent supervisory expectations on liquidity risk
management. \3\ The guidance reemphasizes the importance of cash flow
forecasting, adequate buffers of contingent liquidity, rigorous stress
testing, and robust contingent funding planning processes. It also
highlights the need for institutions to better incorporate liquidity
costs, benefits, and risks in their internal product pricing,
performance measurement, and new product approval process for all
material business lines, products, and activities.
---------------------------------------------------------------------------
\2\ See, Basel Committee on Banking Supervision (2008),
``Principles for Sound Liquidity Risk Management and Supervision''
(Basel, Switzerland: Bank for International Settlements, September),
www.bis.org/publ/bcbs144.htm.
\3\ See, Office of the Comptroller of the Currency, Board of
Governors of the Federal Reserve System, Federal Deposit Insurance
Corporation, Office of Thrift Supervision, and National Credit Union
Administration (2009), ``Agencies Seek Comment on Proposed Interagency
Guidance on Funding and Liquidity Risk Management'', joint press
release, June 30, www.federalreserve.gov/newsevents/press/bcreg/
20090630a.htm.
---------------------------------------------------------------------------
With respect to bank holding companies specifically, the
supervisory program of the Federal Reserve has undergone some basic
changes. As everyone is aware, many of the financial firms that lay at
the center of the crisis were not bank holding companies; some were not
subject to mandatory prudential supervision of any sort. During the
crisis a number of very large firms became bank holding companies--in
part to reassure markets that they were subject to prudential oversight
and, in some cases, to qualify for participation in various Government
liquidity support programs. The extension of holding company status to
these firms, many of which are not primarily composed of a commercial
bank, highlights the degree to which the traditional approach to
holding company supervision must evolve.
Recent experience also reinforces the value of holding company
supervision in addition to, and distinct from, bank supervision. Large
organizations increasingly operate and manage their businesses on an
integrated basis with little regard for the corporate boundaries that
typically define the jurisdictions of individual functional
supervisors. Indeed, the crisis has highlighted the financial,
managerial, operational, and reputational linkages among the bank,
securities, commodity, and other units of financial firms.
The customary focus on protecting the bank within a holding
company, while necessary, is clearly not sufficient in an era in which
systemic risk can arise wholly outside of insured depository
institutions. Similarly, the premise of functional regulation that
risks within a diversified organization can be evaluated and managed
properly through supervision focused on individual subsidiaries within
the firm has been undermined further; the need for greater attention to
the potential for damage to the bank, the organization within which it
operates, and, in some cases, the financial system generally, requires
a more comprehensive and integrated assessment of activities throughout
the holding company.
Appropriate enhancements of both prudential and consolidated
supervision will only increase the need for supervisors to be able to
draw on a broad foundation of economic and financial knowledge and
experience. That is why we are incorporating economists and other
experts from nonsupervisory divisions of the Federal Reserve more
completely into the process of supervisory oversight. The insights
gained from the macroeconomic analyses associated with the formulation
of monetary policy and from the familiarity with financial markets
derived from our open market operations and payments systems
responsibilities can add enormous value to holding company supervision.
The recently completed Supervisory Capital Assessment Program
(SCAP) heralds some of the changes in the Federal Reserve's approach to
prudential supervision of the largest banking organizations. This
unprecedented process involved, at its core, forward-looking, cross-
firm, and aggregate analyses of the 19 largest bank holding companies,
which together control a majority of the assets and loans within the
financial system. Bank supervisors in the SCAP defined a uniform set of
parameters to apply to each firm being evaluated, which allowed us to
evaluate on a consistent basis the expected performance of the firms
under both a baseline and more-adverse-than-expected scenario, drawing
on individual firm information and independently estimated outcomes
using supervisory models.
Drawing on this experience, we are prioritizing and expanding our
program of horizontal examinations to assess key operations, risks, and
risk-management activities of large institutions. For the largest and
most complex firms, we are creating an enhanced quantitative
surveillance program that will use supervisory information, firm-
specific data analysis, and market-based indicators to identify
developing strains and imbalances that may affect multiple
institutions, as well as emerging risks to specific firms. Periodic
scenario analyses across large firms will enhance our understanding of
the potential impact of adverse changes in the operating environment on
individual firms and on the system as a whole. This work will be
performed by a multidisciplinary group composed of our economic and
market researchers, supervisors, market operations specialists, and
accounting and legal experts. This program will be distinct from the
activities of on-site examination teams so as to provide an independent
supervisory perspective as well as to complement the work of those
teams.
Capital serves as an important bulwark against potential unexpected
losses for banking organizations of all sizes, not just the largest
ones. Accordingly, internal capital analyses of banking organizations
must reflect a wide range of scenarios and capture stress environments
that could impair solvency. Earlier this year, we issued supervisory
guidance for all bank holding companies regarding dividends, capital
repurchases, and capital redemptions. \4\ That guidance also
reemphasized the Federal Reserve's long-standing position that bank
holding companies must serve as a source of strength for their
subsidiary banks.
---------------------------------------------------------------------------
\4\ See, Board of Governors of the Federal Reserve System (2009),
Supervision and Regulation Letter SR 09-4, ``Applying Supervisory
Guidance and Regulations on the Payment of Dividends, Stock
Redemptions, and Stock Repurchases at Bank Holding Companies'',
February 24 (as revised on March 27, 2009), www.federalreserve.gov/
boarddocs/srletters/2009/SR0904.htm.
---------------------------------------------------------------------------
Commercial real estate (CRE) is one area of risk exposure that has
gained much attention recently. We began to observe rising CRE
concentrations earlier this decade and, in light of the central role
that CRE lending played in the banking problems of the late 1980s and
early 1990s, led an interagency effort to issue supervisory guidance
directed at the risks posed by CRE concentrations. This guidance, which
generated significant controversy at the time it was proposed, was
finalized in 2006 and emphasized the need for banking organizations to
incorporate realistic risk estimates for CRE exposures into their
strategic- and capital-planning processes, and encouraged institutions
to conduct stress tests or similar exercises to identify the impact of
potential CRE shocks on earnings and capital. Now that weaker housing
markets and deteriorating economic conditions have, in fact, impaired
the quality of CRE loans at many banking organizations, we are
monitoring carefully the effect that declining collateral values may
have on CRE exposures and assessing the extent to which banking
organizations have been complying with the CRE guidance. At the same
time, we have taken actions to ensure that supervisory and regulatory
policies and practices do not inadvertently curtail the availability of
credit to sound borrowers.
While CRE exposures represent perhaps an ``old'' problem, the
crisis has newly highlighted the potential for compensation practices
at financial institutions to encourage excessive risk taking and unsafe
and unsound behavior--not just by senior executives, but also by other
managers or employees who have the ability, individually or
collectively, to materially alter the risk profile of the institution.
Bonuses and other compensation arrangements should not provide
incentives for employees at any level to behave in ways that
imprudently increase risks to the institution, and potentially to the
financial system as a whole. The Federal Reserve worked closely with
other supervisors represented on the Financial Stability Board to
develop principles for sound compensation practices, which were
released earlier this year. \5\ The Federal Reserve expects to issue
soon our own guidance on this important subject to promote compensation
practices that are consistent with sound risk-management principles and
safe and sound banking.
---------------------------------------------------------------------------
\5\ See, Financial Stability Forum (2009), FSF Principles for
Sound Compensation Practices, April 2, www.financialstabilityboard.org/
publications/r_0904b.pdf. The Financial Stability Forum has
subsequently been renamed the Financial Stability Board.
---------------------------------------------------------------------------
Finally, I would note the importance of continuing to analyze the
practices of financial firms and supervisors that preceded the crisis,
with the aim of fashioning additional regulatory tools that will make
prudential supervision more effective and efficient. One area that
warrants particular attention is the potential for supervisory agencies
to enlist market discipline in pursuit of regulatory ends. For example,
supervisors might require that large financial firms maintain specific
forms of capital so as to increase their ability to absorb losses
outside of a bankruptcy or formal resolution procedure. Such capital
could be in contingent form, converting to common equity only when
necessary because of extraordinary losses. While the costs, benefits,
and feasibility of this type of capital requires further study,
policymakers should actively seek ways of motivating the private owners
of banking organizations to monitor the financial positions of the
issuing firms more effectively.
Addressing Gaps and Weaknesses in the Regulatory Framework
While the actions that I have just discussed should help make
banking organizations and the financial system stronger and more
resilient, the crisis also has highlighted gaps and weaknesses in the
underlying framework for prudential supervision of financial
institutions that no regulatory agency can rectify on its own. One,
which I will mention in a moment, has been addressed by the banking
agencies working together. Others require congressional attention.
Charter Conversions and Regulatory Arbitrage
The dual banking system and the existence of different Federal
supervisors create the opportunity for insured depository institutions
to change charters or Federal supervisors. While institutions may
engage in charter conversions for a variety of sound business reasons,
conversions that are motivated by a hope of escaping current or
prospective supervisory actions by the institution's existing
supervisor undermine the efficacy of the prudential supervisory
framework.
Accordingly, the Federal Reserve welcomed and immediately supported
an initiative led by the Federal Deposit Insurance Corporation (FDIC)
to address such regulatory arbitrage. This initiative resulted in a
recent statement of the Federal Financial Institutions Examination
Council reaffirming that charter conversions or other actions by an
insured depository institution that would result in a change in its
primary supervisor should occur only for legitimate business and
strategic reasons. \6\ Importantly, this statement also provides that
conversion requests should not be entertained by the proposed new
chartering authority or supervisor while serious or material
enforcement actions are pending with the institution's current
chartering authority or primary Federal supervisor. In addition, it
provides that the examination rating of an institution and any
outstanding corrective action programs should remain in place when a
valid conversion or supervisory change does occur.
---------------------------------------------------------------------------
\6\ See, Federal Financial Institutions Examination Council
(2009), ``FFIEC Issues Statement on Regulatory Conversions'', press
release, July 1, www.ffiec.gov/press/pr070109.htm.
---------------------------------------------------------------------------
Systemically Important Financial Institutions
The Lehman experience clearly demonstrates that the financial
system and the broader economy can be placed at risk by the failure of
financial firms that traditionally have not been subject to the type of
consolidated supervision applied to bank holding companies. As I
discussed in my most recent testimony before this Committee, the
Federal Reserve believes that all systemically important financial
firms--not just those affiliated with a bank--should be subject to, and
robustly supervised under, a statutory framework for consolidated
supervision like the one embodied in the Bank Holding Company Act (BHC
Act).
Doing so would help promote the safety and soundness of these firms
individually and the stability of the financial system generally.
Indeed, given the significant adverse effects that the failure of such
a firm may have on the financial system and the broader economy, the
goals and implementation of prudential supervision and systemic risk
reduction are inextricably intertwined in the case of these
organizations. For example, while the strict capital, liquidity, and
risk-management requirements that are needed for these organizations
are traditional tools of prudential supervision, the supervisor of such
firms will need to calibrate these standards appropriately to account
for the firms' systemic importance.
Industrial Loan Companies and Thrifts
Another gap in existing law involves industrial loan companies
(ILCs). ILCs are State-chartered banks that have full access to the
Federal safety net, including FDIC deposit insurance and the Federal
Reserve's discount window and payments systems; have virtually all of
the deposit-taking powers of commercial banks; and may engage in the
full range of other banking services, including commercial, mortgage,
credit card, and consumer lending activities, as well as cash
management services, trust services, and payment-related services, such
as Fedwire, automated clearinghouse, and check-clearing services.
A loophole in current law, however, permits any type of firm--
including a commercial company or foreign bank--to acquire an FDIC-
insured ILC chartered in a handful of States without becoming subject
to the prudential framework that the Congress has established for the
corporate owners of other full-service insured banks. Prior to the
crisis, several large firms-including Lehman Brothers, Merrill Lynch,
Goldman Sachs, Morgan Stanley, GMAC, and General Electric--took
advantage of this opportunity by acquiring ILCs while avoiding
consolidated supervision under the BHC Act.
The Federal Reserve has long supported closing this loophole,
subject to appropriate ``grandfather'' provisions for the existing
owners of ILCs. Such an approach would prevent additional firms from
acquiring a full-service bank and escaping the consolidated supervision
framework and activity restrictions that apply to bank holding
companies. It also would require that all firms controlling an ILC,
including a grandfathered firm, be subject to consolidated supervision.
For reasons of fairness, the Board believes that the limited number of
firms that currently own an ILC and are not otherwise subject to the
BHC Act should be permitted to retain their nonbanking or commercial
affiliations, subject to appropriate restrictions to protect the
Federal safety net and prevent abuses.
Corporate owners of savings associations should also be subject to
the same regulation and examination as corporate owners of insured
banks. In addition, grandfathered commercial owners of savings
associations should, like we advocate for corporate owners of ILCs, be
subject to appropriate restrictions to protect the Federal safety net
and prevent abuses.
Strengthening the Framework for Consolidated Supervision
Consolidated supervision is intended to provide a supervisor the
tools necessary to understand, monitor, and, when appropriate, restrain
the risks associated with an organization's consolidated or groupwide
activities. Risks that cross legal entities and that are managed on a
consolidated basis cannot be monitored properly through supervision
directed at any one, or even several, of the legal entity subdivisions
within the overall organization.
To be fully effective, consolidated supervisors need the
information and ability to identify and address risks throughout an
organization. However, the BHC Act, as amended by the so-called ``Fed-
lite'' provisions of the Gramm-Leach-Bliley Act, places material
limitations on the ability of the Federal Reserve to examine, obtain
reports from, or take actions to identify or address risks with respect
to both nonbank and depository institution subsidiaries of a bank
holding company that are supervised by other agencies. Consistent with
these provisions, we have worked with other regulators and, wherever
possible, sought to make good use of the information and analysis they
provide. In the process, we have built cooperative relationships with
other regulators--relationships that we expect to continue and
strengthen further.
Nevertheless, the restrictions in current law still can present
challenges to timely and effective consolidated supervision in light
of, among other things, differences in supervisory models--for example,
between the safety and soundness approach favored by bank supervisors
and the approaches used by regulators of insurance and securities
subsidiaries--and differences in supervisory timetables, resources, and
priorities. Moreover, the growing linkages among the bank, securities,
insurance, and other entities within a single organization that I
mentioned earlier heighten the potential for these restrictions to
hinder effective groupwide supervision of firms, particularly large and
complex organizations. To ensure that consolidated supervisors have the
necessary tools and authorities to monitor and address safety and
soundness concerns in all parts of an organization on a timely basis,
we would urge statutory modifications to the Fed-lite provisions of the
Gramm-Leach-Bliley Act. Such changes, for example, should remove the
limits first imposed in 1999 on the scope and type of information that
the Federal Reserve may obtain from subsidiaries of bank holding
companies in furtherance of its consolidated supervision
responsibilities, and on the ability of the Federal Reserve to take
action against subsidiaries to address unsafe and unsound practices and
enforce compliance with applicable law.
Limiting the Costs of Bank Failures
The timely closing and resolution of failing insured depository
institutions is critical to limiting the costs of a failure to the
deposit insurance fund. \7\ The conditions governing when the Federal
Reserve may close a failing State member bank, however, are
significantly more restrictive than those under which the Office of the
Comptroller of the Currency may close a national bank, and are even
more restrictive than those governing the FDIC's backup authority to
close an insured depository institution after consultation with the
appropriate primary Federal and, if applicable, state banking
supervisor. The Federal Reserve generally may close a state member bank
only for capital-related reasons. The grounds for which the OCC or FDIC
may close a bank include a variety of non-capital-related conditions,
such as if the institution is facing liquidity pressures that make it
likely to be unable to pay its obligations in the normal course of
business or if the institution is otherwise in an unsafe or unsound
condition to transact business. We hope that the Congress will consider
providing the Federal Reserve powers to close a state member bank that
are similar to those possessed by other Federal banking agencies.
---------------------------------------------------------------------------
\7\ Similarly, the creation of a resolution regime that would
provide the Government the tools it needs to wind down a systemically
important nonbank financial firm in an orderly way and impose losses on
shareholders and creditors where possible would help the Government
protect the financial system and economy while reducing the potential
cost to taxpayers and mitigating moral hazard.
---------------------------------------------------------------------------
In view of the number of bank failures that have occurred over the
past 18 months and the resulting costs to the deposit insurance fund,
policymakers also should explore whether additional triggers--beyond
the capital ratios in the current Prompt Corrective Action framework--
may be more effective in promoting the timely resolution of troubled
institutions at lower cost to the insurance fund. Capital is a lagging
indicator of financial difficulties in most instances, and one or more
additional measures, perhaps based on asset quality, may be worthy of
analysis and consideration.
Conclusion
Thank you for the opportunity to testify on these important
matters. We look forward to working with the Congress, the
Administration, and the other banking agencies to ensure that the
framework for prudential supervision of banking organizations and other
financial institutions adjusts, as it must, to meet the challenges our
dynamic and increasingly interconnected financial system.
______
PREPARED STATEMENT OF JOHN E. BOWMAN
Acting Director, Office of Thrift Supervision
August 4, 2009
I. Introduction
Good morning, Chairman Dodd, Ranking Member Shelby, and Members of
the Committee. Thank you for the opportunity to testify today on the
Administration's Proposal for Financial Regulatory Reform. It is my
pleasure to address the Committee for the first time in my role as
Acting Director of the Office of Thrift Supervision (OTS).
We appreciate this Committee's efforts to improve supervision of
financial institutions in the United States. We share the Committee's
commitment to reforms to prevent any recurrence of our Nation's current
financial problems.
We have studied the Administration's Proposal for Financial
Regulatory Reform and are pleased to address the questions you have
asked us about specific aspects of that Proposal. Specifically, you
asked for our opinion of the merits of the Administration's Proposal
for a National Bank Supervisor and the elimination of the Federal
thrift charter. You also requested our opinion on the elimination of
the exceptions in the Bank Holding Company Act for thrifts and certain
special purpose banks and about the Federal Reserve System's prudential
supervision of holding companies.
II. Goals of Regulatory Restructuring
The recent turmoil in the financial services industry has exposed
major regulatory gaps and other significant weaknesses that must be
addressed. Our evaluation of the specifics of the Administration's
Proposal is predicated on whether or not those elements address the
core principles OTS believes arc essential to accomplishing true and
lasting reform:
1. Ensure Changes to Financial Regulatory System Address Real
Problems--Proposed changes to financial regulatory agencies
should be evaluated based on whether they would address the
causes of the economic crisis or other true problems.
2. Establish Uniform Regulation--All entities that offer financial
products to consumers must be subject to the same consumer
protection rules and regulations, so under-regulated entities
cannot gain a competitive advantage over their more regulated
counterparts. Also, complex derivative products, such as credit
default swaps, should be regulated.
3. Create Ability To Supervise and Resolve Systemically Important
Firms--No provider of financial products should be too big to
fail, achieving through size and complexity an implicit Federal
Government backing to prevent its collapse--and thereby gaining
an unfair advantage over its more vulnerable competitors.
4. Protect Consumers--One Federal agency should have as its central
mission the regulation of financial products and that agency
should establish the rules and standards for all consumer
financial products rather than the current, multiple number of
agencies with fragmented authority and a lack of singular
accountability.
As a general matter the OTS supports all of the fundamental
objectives that are at the heart of the Administration's Proposal. By
performing an analysis based on these principles, we offer OTS' views
on specific provisions of the Administration's Proposal.
III. Administration Proposal To Establish a National Bank Supervisor
We do not support the Administration's Proposal to establish a new
agency, the National Bank Supervisor (NBS), by eliminating the Office
of the Comptroller of the Currency, which charters and regulates
national banks, and the OTS, which charters Federal thrifts and
regulates thrifts and their holding companies.
There is little dispute that the ad hoc framework of financial
services regulation cobbled together over the last century-and-a-half
is not ideal. The financial services landscape has changed and the
economic crisis has revealed gaps in the system that must be addressed
to ensure a sustainable recovery and appropriate oversight in the years
ahead. We believe other provisions within the Administration's proposal
would assist in accomplishing that goal.
While different parts of the system were created to respond to the
needs of the time, the current system has generally served the Nation
well over time, despite economic downturns such as the current one. We
must ensure that in the rush to address what went wrong, we do not try
to ``fix'' nonexistent problems nor attempt to fix real problems with
flawed solutions.
I would like to dispel the two rationales that have been alleged to
support the proposal to eliminate the OTS: (1) The OTS was the
regulator of the purportedly largest insured depository institutions
that failed during the current economic turmoil, and, (2) Financial
institutions ``shopping'' for the most lenient regulator allegedly
flocked to OTS supervision and the thrift charter. Both of those
allegations are false.
There are four reasons why the first allegation is untrue:
First, failures by insured depository institutions have been no
more severe among OTS-regulated thrifts than among institutions
supervised by other Federal banking regulators. OTS-regulated
Washington Mutual, which failed in September 2008 at no cost to the
deposit insurance fund, was the largest bank failure in U.S. history
because anything larger has been deemed ``too big to fail.'' By law,
the Federal Government can provide ``open-bank assistance'' only to
prevent a failure. Institutions much larger than Washington Mutual, for
example, Citigroup and Bank of America, had collapsed, but the Federal
Government prevented their failure by authorizing open bank assistance.
The ``too big to fail'' institutions are not regulated by the OTS. The
OTS did not regulate the largest banks that failed; the OTS regulated
the largest banks that were allowed to fail.
Second, in terms of numbers of bank failures during the crisis,
most banks that have failed have been State-chartered institutions,
whose primary Federal regulator is not the OTS.
Third, the OTS regulates financial institutions that historically
make mortgages for Americans to buy homes, By law, thrift institutions
must keep most of their assets in home mortgages or other retail
lending activities, The economic crisis grew out of a sharp downturn in
the residential real estate market, including significant and sustained
home price depreciation, a protracted decline in home sales and a
plunge in rates of real estate investment. To date, this segment of the
market has been hardest hit by the crisis and OTS-regulated
institutions were particularly affected because their business models
focus on this segment.
Fourth, the largest failures among OTS-regulated institutions
during this crisis concentrated their mortgage lending in California
and Florida, two of the States most damaged by the real estate decline,
These States have had significant retraction in the real estate market,
including double-digit declines in home prices and record rates of
foreclosure, \1\ Although today's hindsight is 20/20, no one predicted
during the peak of the boom in 2006 that nationwide home prices would
plummet by more than 30 percent.
---------------------------------------------------------------------------
\1\ See, Office of Thrift Supervision Quarterly Market Monitor,
May 7, 2009, (http://files.ots.treas.gov/131020.pdf).
---------------------------------------------------------------------------
The argument about regulator shopping, or arbitrage, seems to stem
from the conversion of Countrywide, which left the supervision of the
OCC and the Board of Governors of the Federal Reserve System (FRB) in
March 2007--after the height of the housing and mortgage boom--and came
under OTS regulation, Countrywide made most of its high-risk loans
through its holding company affiliates before it received a thrift
charter.
An often-overlooked fact is that a few months earlier, in October
2006, Citibank converted two thrift charters from OTS supervision to
the OCC. Those two Citibank charters totaled more than $232 billion--
more than twice the asset size of Countrywide ($93 billion)--We
strongly believe that Citibank and Countrywide applied to change their
charters based on their respective business models and operating
strategies. Any suggestion that either company sought to find a more
lenient regulatory structure is without merit.
In the last 10 years (1999-2008), there were 45 more institutions
that converted away from the thrift charter (164) than converted to the
thrift charter (119). Of those that converted to the OTS, more than
half were State-chartered thrifts (64). In dollar amounts during the
same 10-year period, $223 billion in assets converted to the thrift
charter from other charter types and $419 billion in assets converted
from the thrift charter to other charter types.
We disagree with any suggestion that banks converted to the thrift
charter because OTS was a more lenient regulator. Institutions chose
the charter type that best fits their business model.
If regulatory arbitrage is indeed a major issue, it is an issue
between a Federal charter and the charters of the 50 States, as well as
among the States. Under the Administration's Proposal, the possibility
of such arbitrage would continue.
The OTS is also concerned that the NBS may tend, particularly in
times of stress, to focus most of its attention on the largest
institutions, leaving midsize and small institutions in the back seat.
It is critical that all regulatory agencies be structured and operated
in a manner that ensures the appropriate supervision and regulation of
all depository institutions, regardless of size.
IV. Administration Proposal To Eliminate the Thrift Charter
The OTS does not support the provision in the Administration's
Proposal to eliminate the Federal thrift charter and require all
Federal thrift institutions to change their charter to the National
Bank Charter or State bank. We believe the business models of Federal
banks and thrift institutions are fundamentally different enough to
warrant two distinct Federal banking charters.
It is important to note that elimination of the thrift charter
would not have prevented the current mortgage meltdown, nor would it
help solve current problems or prevent future crises. Savings
associations generally are smaller institutions that have strong ties
to their communities. Many thrifts never made subprime or Alt-A
mortgages; rather they adhered to traditional, solid underwriting
standards. Most thrifts did not participate in the private originate-
to-sell model; they prudently underwrote mortgages intending to hold
the loans in their own portfolios until the loans matured.
Forcing thrifts to convert from thrifts to banks or State chartered
savings associations would not only be costly, disruptive, and punitive
for thrifts, but could also deprive creditworthy U.S. consumers of the
credit they need to become homeowners and the extension of credit this
country needs to stimulate the economy.
We also strongly support retaining the mutual form of organization
for insured institutions. Generally, mutual institutions are weathering
the current financial crisis better than their stock competitors. The
distress in the housing markets has had a much greater impact on the
earnings of stock thrifts than on mutual thrifts over the past year.
For the first quarter 2009, mutual thrills reported a return on average
assets (ROA) on 0.42 percent, while stock thrifts reported an ROA of
0.04 percent. We see every reason to preserve the mutual institution
charter and no compelling rationale to eliminate it.
OTS also supports retention of the dual banking system with both
Federal and State charters for banks and thrifts. This system has
served the financial markets in the United States well. The States have
provided a charter option for banks and thrifts that have not wanted to
have a Federal charter. Banks and thrifts should be able to choose
whether to operate with a Federal charter or a State charter.
V. Administration Proposal To Eliminate the Exceptions in the Bank
Holding Company Act for Thrifts and Special Purpose Banks
A. Elimination of the Exception in the Bank Holding Company Act for
Thrifts
Because a thrill is not considered a ``bank'' under the Bank
Holding Company Act of 1956 (BHCA), \2\ the FRB does not regulate
entities that own or control only savings associations. However, the
OTS supervises and regulates such entities pursuant to the Home Owners
Loan Act (HOLA).
---------------------------------------------------------------------------
\2\ 12 U.S.C. 1841(c)(2)(B) and (j).
---------------------------------------------------------------------------
As part of the recommendation to eliminate the Federal thrift
charter, the Administration Proposal would also eliminate the savings
and loan holding company (SLHC). The Administration's draft legislation
repeals section 10 of the HOLA, concerning the regulation of SLHCs and
also eliminates the thrift exemption from the definition of ``bank''
under the BHCA. A SLHC would become a bank holding company (BHC) by
operation of law and would be required to register with the FRB as a
BHC within 90 days of enactment of the act.
Notably, these provisions also apply to the unitary SLHCs that were
explicitly permitted to continue engaging in commercial activities
under the Gramm-Leach-Bliley Act of 1999. \3\ Such an entity would
either have to divest itself of the thrift or divest itself of other
subsidiaries or affiliates to ensure that its activities are
``financial in nature.'' \4\
---------------------------------------------------------------------------
\3\ 12 U.S.C. 1467a(c)(9)(C).
\4\ 12 U.S.C. 1843(k).
---------------------------------------------------------------------------
The Administration justifies the elimination of SLHCs, by arguing
that the separate regulation and supervision of bank and savings and
loan holding companies has created ``arbitrage opportunities.'' The
Administration contends that the intensity of supervision has been
greater for BHCs than SLHCs.
Our view on this matter is guided by our key principles, one of
which is to ensure that changes to the financial regulatory system
address real problems. We oppose this provision because it does not
address a real problem. As is the case with the regulation of thrift
institutions, OTS does not believe that entities became SLHCs because
OTS was perceived to be a more lenient regulator. Instead, these
choices were guided by the business model of the entity.
The suggestion that the OTS does not impose capital requirements on
SLHCs is not correct. Although the capital requirements for SLHCs are
not contained in OTS regulations, savings and loan holding company
capital adequacy is determined on a case-by-case basis for each holding
company based on the overall risk profile of the organization. In its
review of a SLHCs capital adequacy, the OTS considers the risk inherent
in an enterprise's activities and the ability of capital to absorb
unanticipated losses, support the level and composition of the parent
company's and subsidiaries' debt, and support business plans and
strategies.
On average SLHCs hold more capital than BHCs. The OTS conducted an
internal study comparing SLHC capital levels to BHC capital levels. In
this study. OTS staff developed a Tier 1 leverage proxy and conducted
an extensive review of industry capital levels to assess the overall
condition of holding companies in the thrift industry. We measured
capital by both the Equity/Assets ratio and a Tier 1 Leverage proxy
ratio. Based on peer group averages, capital levels (as measured by
both the Equity/Assets ratio and a Tier 1 Leverage proxy ratio) at
SLHCs were higher than BHCs, prior to the infusion of Troubled Asset
Relief Program funds, in every peer group category. The consistency in
results between both ratios lends credence to the overall conclusion,
despite any differences that might result from use of a proxy formula.
As this study shows, the facts do not support the claim that the
OTS docs not impose adequate capital requirements on SLHCs. The
proposal to eliminate the SLHC exception from the BHCA is based on this
and other misperceptions. Moreover, in our view the measure penalizes
the SLHCs and thrifts that maintained solid underwriting standards and
were not responsible for the current financial crisis. The measure is
especially punitive to the unitary SLHCs that will be forced to divest
themselves of their thrift or other subsidiaries.
We believe SLHCs should be maintained and that the OTS should
continue to regulate SLHCs, except in the case of a SLHC that would be
deemed to be a Tier 1 Financial Holding Company. These entities should
be regulated by the systemic risk regulator.
B. Elimination of the Exception in the Bank Holding Company Act for
Special Purpose Banks
The Administration Proposal would also eliminate the BHCA
exceptions for a number of special purpose banks, such as industrial
loan companies, credit card banks, [rust companies, and the so-called
``nonbank banks'' grandfathered under the Competitive Equality Banking
Act of 1987. Neither the FRB nor OTS regulates the entities that own or
control these special purpose banks, unless they also own or control a
bank or thrill. As is the case with unitary SLHCs, the Administration
Proposal would force these entities to divest themselves of either
their special purpose bank or other entities. The Administration's
rationale for the provision is to close all the so-called ``loopholes''
under the BHCA and to treat all entities that own or control any type
of a bank equally.
Once again our opinion on this aspect of the Administration
Proposal is guided by the key principle of ensuring that changes to the
financial regulatory system address real problems that caused the
crisis. There are many causes of the financial crisis, but the
inability of the FRB to regulate these entities is not one of them.
Accordingly, we do not support this provision.
Forcing companies that own special purpose banks to divest one or
more of their subsidiaries is unnecessary and punitive. Moreover, it
does not address a problem that caused the crisis or weakens the
financial system.
VI. Prudential Supervision of Holding Companies
A. In General
The Administration's Proposal would provide for the consolidated
supervision and regulation of any systemically important financial firm
(Tier 1 FHC) regardless of whether the firm owns an insured depository
institution. The authority to supervise and regulate Tier 1 FHCs would
be vested in the FRB. The FRB would be authorized to designate Tier 1
FHCs if it determines that material financial distress at the company
could pose a threat, globally or in the United States, to financial
stability or the economy during times of economic stress. \5\ The FRB,
in consultation with Treasury, would issue rules to guide the
identification Tier 1 FHCs. Tier 1 FHCs would be subjected to stricter
and more conservative prudential standards than those that apply to
other BHCs, including higher standards on capital, liquidity, and risk
management. Tier 1 FHCs would also be subject to Prompt Corrective
Action.
---------------------------------------------------------------------------
\5\ The FRB would be required to base its determination on the
following criteria:
(i) the amount and nature of the company's financial assets;
(ii) the amount and types of the company's liabilities, including
the degree of reliance on short-term funding;
(iii) the extent of the company's off-balance sheet exposures;
(iv) the extent of the company's transactions and relationships
with other major financial companies:
(v) the company's importance as a source of credit for
households, businesses, and State and local governments and as a source
of liquidity for the financial system;
(vi) the recommendation, if any, of the Financial Services
Oversight Council; and
(vii) any other factors that the Board deems appropriate.
Title II, Section 204. Administration Draft Legislation.
http://www.financialstability.gov/docs/regulatoryreform/07222009/
titleII.pdf.
---------------------------------------------------------------------------
The Proposal also calls for the creation of a Financial Services
Oversight Council (Council) made up of the Secretary of the Treasury
and all of the Federal financial regulators. Among other
responsibilities, the Council would make recommendations to the FRB
concerning institutions that should be designated as Tier 1 FHCs. Also,
the FRB would consult the Council in setting material prudential
standards for Tier 1 FHCs and in setting risk management standards for
systemically important systems and activities regarding payment,
clearing and settlement.
The Administration's Proposal provides a regime to resolve Tier 1
FHCs when the stability of the financial system is threatened. The
resolution authority would supplement and be modeled on the existing
resolution regime for insured depository institutions under the Federal
Deposit Insurance Act. The Secretary of the Treasury could invoke the
resolution authority only after consulting with the President and upon
the written recommendation of two-thirds of the members of the FRB, and
the FDIC or SEC as appropriate. The Secretary would have the ability to
appoint a receiver or conservator for the tailing firm. In general,
that role would be filled by the FDIC, though the SEC could be
appointed in certain cases. In order to fund this resolution regime,
the FDIC would be authorized to impose risk-based assessments on Tier 1
FHCs.
OTS's views on these aspects of the Administration Proposal is
guided by our key principle that any financial reform package should
create the ability to supervise and resolve all systemically important
financial firms. The U.S. economy operates on the principle of healthy
competition. Enterprises that are strong, industrious, well-managed and
efficient succeed and prosper. Those that fall short of the mark
struggle or fail and other, stronger enterprises take their places.
Enterprises that become ``too big to fail'' subvert the system when the
Government is forced to prop up failing, systemically important
companies in essence, supporting poor performance and creating a
``moral hazard.''
The OTS supports this aspect of the Proposal and agrees that there
is a pressing need for a systemic risk regulator with broad authority
to monitor and exercise supervision over any company whose actions or
failure could pose unacceptable risk to financial stability. The
systemic risk regulator should have the ability and the responsibility
for monitoring all data about markets and companies, including, but not
limited to, companies involved in banking, securities, and insurance.
We also support the establishment of a strong and effective
Council. Each of the financial regulators would provide valuable
insight and experience to the systemic risk regulator.
We also strongly support the provision providing a resolution
regime for all Tier 1 FHCs. Given the events of recent years, it is
essential that the Federal Government have the authority and the
resources to act as a conservator or receiver and to provide an orderly
resolution of systemically important institutions, whether banks,
thrifts, bank holding companies or other financial companies. The
authority to resolve a distressed Tier 1 FHC in an orderly manner would
ensure that no bank or financial firm is ``too big to fail.'' A lesson
learned from recent events is that the failure or unwinding of
systemically important companies has a far reaching impact on the
economy, not just on financial services.
The continued ability of banks, thrifts, and other entities in the
United States to compete in today's global financial services
marketplace is critical. The systemic risk regulator should be charged
with coordinating the supervision of conglomerates that have
international operations. Safety and soundness standards, including
capital adequacy and other factors, should be as comparable as possible
for entities that have multinational businesses,
B. Role of the Prudential Supervisor in Relation to the Systemic Risk
Regulator
You have asked for our views on what we consider to be the
appropriate role of the prudential supervisor in relation to the
systemic risk regulator. In other words, what is the proper delineation
of responsibilities between the agencies?
Generally, we believe that for systemically important institutions,
the systemic risk regulator should supplement, not supplant, the
primary Federal bank supervisor. In most cases the work of the systemic
regulator and the prudential regulator will complement one another,
with the prudential regulator focused on the safety and soundness of
the depository institution and the systemic regulator focused more
broadly on financial stability globally or in the United States.
One provision in the Proposal provides the systemic risk regulator
with authority to establish, examine, and enforce more stringent
standards for subsidiaries of Tier 1 FHCs--including depository
institution subsidiaries--to mitigate systemic risk posed by those
subsidiaries. If the systemic risk regulator issues a regulation, it
must consult with the prudential regulator. In the case of an order,
the systemic regulator must: (1) have reasonable cause to believe that
the functionally regulated subsidiary is engaged in conduct,
activities, transactions, or arrangements that could pose a threat to
financial stability or the economy globally or in the United States;
(2) notify the prudential regulator of its belief, in writing, with
supporting documentation included and with a recommendation that the
prudential regulator take supervisory action against the subsidiary;
and (3) not been notified in writing by the prudential regulator of the
commencement of a supervisory action, as recommended, within 30 days of
the notification by the systemic regulator.
We have some concerns with this provision in that it supplants the
prudential regulator's authority over depository institution
subsidiaries of systemically significant companies. On balance,
however, we believe such a provision is necessary to ensure financial
stability. We recommend that the provision include a requirement that
before making any determination, the systemic regulator consider the
effects of any contemplated action on the Deposit Insurance Fund and
the United States taxpayers.
C. Regulation of Thrifts and Holding Companies on a Consolidated Basis
You have asked for OTS's views on whether a holding company
regulator should be distinct from the prudential regulator or whether a
consolidated prudential bank supervisor could also regulate holding
companies. \6\
---------------------------------------------------------------------------
\6\ With respect to this question we express our opinion only
concerning thrifts and their holding companies. We express no opinion
as to banks and BHCs.
---------------------------------------------------------------------------
The OTS supervises both thrifts and their holding companies on a
consolidated basis. Indeed, SLHC supervision is an integral part of OTS
oversight of the thrift industry. OTS conducts holding company
examinations concurrently with the examination of the thrift
subsidiary, supplemented by offsite monitoring. For the most complex
holding companies, OTS utilizes a continuous supervision approach. We
believe the regulation of the thrift and holding company has enabled us
to effectively assess the risks of the consolidated entity, while
retaining a strong focus on protecting the Deposit Insurance Fund.
The OTS has a wealth of expertise regulating thrifts and holding
companies. We have a keen understanding of small, medium-sized and
mutual thrifts and their holding companies. We are concerned that if
the FRB became the regulator of these holding companies, it would focus
most of its attention on the largest holding companies to the detriment
of small and mutual SLHCs.
With regard to holding company regulation, OTS believes thrifts
that have nonsystemic holding companies should have strong, consistent
supervision by a single regulator. Conversely, a SLHC that would be
deemed to be a Tier 1 FHC should be regulated by the systemic
regulator. This is consistent with our key principle that any financial
reform package should create the ability to supervise and resolve all
systemically important financial firms.
VII. Consumer Protection
The Committee did not specifically request input regarding consumer
protection issues and the Administration's Proposal to create a
Consumer Financial Protection Agency (CFPA); however, we would like to
express our views because adequate protection of consumers is one of
the key principles that must be addressed by effective reform. Consumer
protection performed consistently and judiciously fosters a thriving
banking system to meet the financial services needs of the Nation.
The OTS supports the creation of a CFPA that would consolidate
rulemaking authority over all consumer protection regulations in one
regulator. The CFPA should be responsible for promulgating all consumer
protection regulations that would apply uniformly to all entities that
offer financial products, whether a federally insured depository
institution, a State bank, or a State-licensed mortgage broker or
mortgage company. Making all entities subject to the same rules and
regulations for consumer protection could go a long way towards
accomplishing OTS's often stated goal of plugging the gaps in
regulatory oversight that led to a shadow banking system that was a
significant cause of the current crisis.
Although we support the concept of a single agency to write all
consumer rules, we strongly believe that consumer protection-related
examinations, supervision authority and enforcement powers for insured
depository institutions should be retained by the FBAs and the National
Credit Union Administration (NCUA). In addition to rulemaking
authority, the CFPA should have regulation, examination and enforcement
power over entities engaged in consumer lending that are not insured
depository institutions. Regardless of whether a new consumer
protection agency is created, it is critical that, for all federally
insured depository institutions, the primary Federal safety and
soundness regulator retain authority for regulation, examination, and
enforcement of consumer protection regulations.
VIII. Conclusion
In conclusion, we support the goals of the Administration and this
Committee to create a reformed system of financial regulation that
fills regulatory gaps and prevents the type of financial crisis that we
have just endured.
Thank you again, Mr. Chairman, Ranking Member Shelby, and Members
of the Committee for the opportunity to testify on behalf of the OTS.
We look forward to working with the Members of this Committee and
others to create a system of financial services regulation that
promotes greater economic stability for providers of financial services
and the Nation.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM SHEILA C. BAIR
Q.1. What is the best way to decrease concentration in the
banking industry? Is it size limitations, rolling back State
preemption, higher capital requirements, or something else?
A.1. We must find ways to impose greater market discipline on
systemically important institutions. We believe there are
several ways to decrease concentration levels in the banking
industry without the Federal Government setting size limits on
banks. For example, certain requirements, such as higher
capital and liquidity levels, could be established to mirror
the heightened risk they pose to the financial system.
Assessments also could be used as incentives to contain growth
and complexity, as well as to limit concentrations of risk and
risk taking.
However, one of the lessons of the past few years is that
regulation alone is not enough to control imprudent risk taking
within our dynamic and complex financial system. You need
robust and credible mechanisms to ensure that market players
will actively monitor and keep a handle on risk taking. In
short, we need to enforce market discipline for systemically
important institutions. To end ``too big to fail,'' we need an
orderly and highly credible mechanism that is similar to the
process we use to resolve FDIC-insured banks. In such a
process, losses would be borne by the stockholders and
bondholders of a holding company, and senior managers would be
replaced. There would be an orderly resolution of the
institution, but no bail-out. Open bank assistance should not
be used to prop up any individual firm.
Q.2. Treasury has proposed making the new banking regulator a
bureau of the Treasury Department. Putting aside whether we
should merge the current regulators, does placing the new
regulator in Treasury rather than as a separate agency provide
enough independence from political influence?
A.2. We believe independence is an essential element of a sound
supervisory program. Supervisors must have the authority and
resources to gather and evaluate sufficient information to make
sound supervisory decisions without undue pressures from
outside influences. The FDIC and State banking supervisors, who
often provide a different and unique perspective on the
operations of community banks, have worked cooperatively to
make sound supervisory decisions without compromising their
independence.
As currently structured, two of the Federal banking
agencies, the Office of the Comptroller of the Currency (OCC)
and the Office of Thrift Supervision (OTS) are bureaus within
the U.S. Department of the Treasury. Although subject to
general Treasury oversight, the OCC and OTS have a considerable
amount of autonomy within the Treasury with regard to
examination and enforcement matters. Unlike Treasury, the
bureaus within the U.S. Department of OCC and OTS are funded by
examination and other fees assessed on regulated entities, and
they have independent litigating authority. The other three
Federal banking agencies--Governors of the Federal Deposit
Insurance Corporation, the Board of Governors of the Federal
Reserve, and the National Credit Union Association, are fully
independent agencies, self-funded though assessments or other
fees, and have independent litigating authority. To the extent
the OTS and OCC would be merged into a single regulator under
Treasury, continued independence could be maintained through
nonappropriated funding sources, independent litigating
authority, and independent decision-making authority, such as
currently afforded to the OCC and OTS.
Q.3. Given the damage caused by widespread use of subprime and
nontraditional mortgages--particularly low documentation
mortgages--it seems that products that are harmful to the
consumer are also harmful to the banks that sell them. If bank
regulators do their job and stop banks from selling products
that are dangerous to the banks themselves, other than to set
standards for currently unregulated firms, why do we need a
separate consumer protection agency?
A.3. As currently proposed, the new Consumer Financial
Protection Agency (CFPA) would be given sole rulemaking
authority for consumer financial protection statutes over all
providers of consumer credit, including those outside the
banking industry. The CFPA would set a floor on consumer
regulation and guarantee the States' ability to adopt and
enforce stricter (more protective) laws for institutions of all
types, regardless of charter. It also is proposed that the CFPA
would have consumer protection examination and enforcement
authority over all providers of consumer credit and other
consumer products and services--banks and nonbanks.
Giving the CFPA the regulatory and supervisory authority
over nonbanks would fill in the existing regulatory and
supervisory gaps between nonbanks and insured depository
institutions and is key to addressing most of the abusive
lending practices that occurred institutions and is key to
addressing most of during the current crisis. In addition, the
provision to give the CFPA sole rulewriting authority over
consumer financial products and services would establish
strong, consistent consumer protection standards among all
providers of financial products and services and eliminate
potential regulatory arbitrage that exists because of Federal
preemption of certain State laws.
However, the Treasury proposal could be made even more
effective with a few targeted changes. As recent experience has
shown, consumer protection issues and the safety and soundness
of insured institutions go hand-in-hand and require a
comprehensive, coordinated approach for effective examination
and supervision. Separating Federal banking agency examination
and supervision (including enforcement) from consumer
protection examination and supervision could undermine the
effectiveness of each with the unintended consequence of
weakening bank oversight.
As a Federal banking supervisor and the ultimate insurer of
$6 trillion in deposits, the FDIC has the responsibility and
the need to ensure consumer protection and safety and soundness
are properly integrated. The FDIC and other Federal banking
agencies should retain their authority to examine and supervise
insured depository institutions for consumer protection
standards established by the CFPA. The CFPA should focus its
examination and enforcement resources on nonbank providers of
products and services that have not been previously subject to
Federal examinations and standards. The CFPA also should have
back-up examination and enforcement authority to address
situations where it determines the Federal banking agency
supervision is deficient.
Q.4. Since the two most recent banking meltdowns were caused by
mortgage lending, do you think it is wise to have a charter
focused on mortgage lending? In other words, why should we have
a thrift charter?
A.4. Over several decades, financial institutions with thrift
charters have provided financing for home loans for many
Americans. In recent years, Federal and State banking charters
have expanded into more diversified, full service banking
operations that include commercial and residential mortgage
lending. However, it is understandable that the lack of
diversification and exposure to the housing market could raise
concerns about the thrift charter. Market forces have reduced
the demand for thrift charters. Given the dwindling size of the
Federal thrift industry, it makes sense to consider merging the
Federal thrift charter into a single Federal depository
institution charter.
Q.5. Should banking regulators continue to be funded by fees on
the regulated firms, or is there a better way?
A.5. We believe the banking industry should pay for its
supervision, but the Federal bank supervision funding process
should not disadvantage State-chartered depository institutions
and the dual banking system. State-chartered banks pay
examination fees to State banking agencies. The Federal banking
agencies are self-funded through assessments, exam fees, and
other sources. This arrangement helps them remain independent
of the political process and separates them from the Federal
budget appropriations.
Q.6. Why should we have a different regulator for holding
companies than for the banks themselves?
A.6. We do not believe it is always necessary to have a
different regulator for the holding company and the bank.
Numerous one-bank holding companies exist where the bank is
essentially the only asset owned by the holding company. In
these cases, there is no reason why bank regulators could not
also serve as holding company regulators as it is generally
more efficient and prudent for one regulator to evaluate both
entities.
In the case of more complex multibank holding companies,
one can argue it is more effective for the primary Federal
regulators to examine the insured depository institutions while
the Federal Reserve evaluates the parent (as a source of
strength) and the financial condition of the nonbank
subsidiaries. Yet even for a separate holding company
regulator, the prudential standards it applies should be at
least as strong as the standards applied to insured banks.
Q.7. Assuming we keep thrifts and thrift holding companies,
should thrift holding companies be regulated by the same
regulator as bank holding companies?
A.7. Similar to the answer to Question 6, it may not be
necessary for small thrifts that are owned by what are
essentially shell holding companies to have a separate holding
company regulator. While one can argue that more complex
organizations merit a separate holding company regulator, even
in this structure we believe prudential standards applied to a
holding company should be at least as strong as those applied
to an insured entity.
Q.8. The proposed risk council is separate from the normal
safety and soundness regulator of banks and other firms. The
idea is that the council will set rules that the other
regulators will enforce. That sounds a lot like the current
system we have today, where different regulators read and
enforce the same rules different ways. Under such a council,
how would you make sure the rules were being enforced the same
across the board?
A.8. The proposed risk council would oversee systemic risk
issues, develop needed prudential policies, and mitigate
developing systemic risks. A primary responsibility of the
council should be to harmonize prudential regulatory standards
for financial institutions, products, and practices to assure
market participants cannot arbitrage regulatory standards in
ways that pose systemic risk. The council should evaluate
different capital standards that apply to commercial banks,
investment banks, investment funds, and others to determine the
extent to which these standards circumvent regulatory efforts
to contain excess leverage in the system. The council should
ensure that prompt corrective action and capital standards are
harmonized across firms. For example, large financial holding
companies should be subject to tougher prompt corrective action
standards under U.S. law and be subject to holding company
capital requirements that are no less stringent than those for
insured banks. The council also should undertake the
harmonization of capital and margin requirements applicable to
all OTC derivatives activities and facilitate interagency
efforts to encourage greater standardization and transparency
of derivatives activities and the migration of these activities
onto exchanges or central counterparties. To be successful, the
council must have sufficient authority to require some
uniformity and standardization in those areas where
appropriate.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM JOHN C. DUGAN
Q.1. What is the best way to decrease concentration in the
banking industry? Is it size limitations, rolling back State
preemption, higher capital requirements, or something else?
A.1. The financial crisis has highlighted the importance of
inter-linkages between the performance of systemically
important banks, financial stability, and the real economy. It
has also highlighted the risks of firms that are deemed ``too
big to fail.'' There are a range of policy options that are
under active consideration by U.S. and global supervisors to
address these issues. Given the multifaceted nature of this
problem, we believe that a combination of policy responses may
be most appropriate.
A crucial first step, we believe, is strengthening and
raising the current capital standards for large banking
organizations to ensure that these organizations maintain
sufficient capital for the risks they take and pose to the
financial system. Part of this effort is well underway through
initiatives being taken by the Basel Committee on Bank
Supervision (the ``Committee''). As announced in July, the
Committee has adopted a final package of measures that will
strengthen and increase the capital required for trading book
and certain securitization structures. The results of a recent
quantitative analysis conducted by the Committee to assess the
impact of the trading book rule changes suggest that these
changes will increase average trading book capital requirements
by two to three times their current levels, although the
Committee noted significant dispersion around this average.
The Committee has underway several other key initiatives
that we believe are also critical to reduce the risks posed by
large, internationally active banks. These include:
Strengthening the quality, international
consistency, and transparency of a bank's capital base;
Developing a uniform Pillar -1 based leverage
ratio, which, among other requirements, would apply a
100 percent credit conversion factor to certain off-
balance sheet credit exposures;
Introducing a minimum global standard for funding
liquidity that includes a stressed liquidity coverage
ratio requirement, underpinned by a longer-term
structural liquidity ratio; and
Developing a framework for countercyclical capital
buffers above the minimum requirement. The framework
will include capital conservation measures such as
constraints on capital distributions. The Basel
Committee will review an appropriate set of indicators,
such as earnings and credit-based variables, as a way
to condition the build up and release of capital
buffers. In addition, the Committee will promote more
forward-looking provisions based on expected losses.
The OCC has been actively involved in, and strongly supports,
these initiatives. In addition to these actions, there are
other policy initiatives under consideration, including the
development of incremental capital surcharges that would
increase with the size and/or risk of the institution, and
measures to reduce the systemic impact of failure, such as
reduced interconnectedness and resolution planning.
As noted in my testimony, the OCC also endorses domestic
proposals to establish a Financial Stability Oversight Council
that would identify and monitor systemic risk, gather and share
systemically significant information, and make recommendations
to individual regulators. This council would consist of the
Secretary of the Treasury and all of the Federal financial
regulators, and would be supported by a permanent staff. We
also endorse enhanced authority to resolve systemically
significant financial firms.
We believe that a multipronged approach, as outlined above;
is far more appropriate than relying on a single measure, such
as asset size, to address the risks posed by large
institutions. We also believe that to ensure the
competitiveness of U.S. financial institutions in today's
global economy, many of these policy initiatives need to be
coordinated with, and implemented by, supervisors across the
globe.
Finally, we strongly disagree with any suggestion that
Federal preemption was a root cause of the financial crisis or
that rolling back preemption would be a solution. In this
regard, we would highlight that the systemic risk posed by
companies such as AIG, Lehman Brothers, and Bear Stearns were
outside of the OCC's regulatory authority and thus not affected
by the OCC's application of Federal preemption decisions.
Q.2. Treasury has proposed making the new banking regulator a
bureau of the Treasury Department. Putting aside whether we
should merge the current regulators, does placing the new
regulator in Treasury rather than as a separate agency provide
enough independence from political influence?
A.2. It is critical that the new agency be independent from the
Treasury Department and the Administration to the same extent
that the OCC and OTS are currently independent. For example,
current law provides the OCC with important independence from
political interference in decision making in matters before the
Comptroller, including enforcement proceedings; provides for
funding independent of political control; enables the OCC to
propose and promulgate regulations without approval by the
Treasury; and permits the agency to testify before Congress
without the need for the Administration's clearance of the
agency's statements. It is crucial that these firewalls be
maintained in a form that is at least as robust as current law
provides with respect to the OCC and the OTS, to enable the new
regulator to maintain comparable independence from political
influence. In addition, consideration should be given to
providing the new regulator the same independence from OMB
review and clearance of its regulations as is currently
provided for the FDIC and the Federal Reserve Board. This would
further protect the new agency's rulemaking process from
political interference.
Q.3. Given the damage caused by widespread use of subprime and
nontraditional mortgages--particularly low documentation
mortgages--it seems that products that are harmful to the
consumer are also harmful to the banks that sell them. If bank
regulators do their job and stop banks from selling products
that are dangerous to the banks themselves, other than to set
standards for currently unregulated firms, why do we need a
separate consumer protection agency?
A.3. In the ongoing debate about reforming the structure of
financial services regulation to address the problems
highlighted by the financial crisis, relatively little
attention has been paid to the initial problem that sparked the
crisis: the exceptionally weak, and ultimately disastrous,
mortgage underwriting practices accepted by lenders and
investors. The worst of these practices included:
The failure to verify borrower representations
about income and financial assets (the low
documentation loans mentioned in this question);
The failure to require meaningful borrower equity
in the form of real down payments;
The acceptance of very high debt-to-income ratios;
The qualification of borrowers based on their
ability to afford artificially low initial monthly
payments rather than the much higher monthly payments
that would come later; and
The reliance on future house price appreciation as
the primary source of repayment, either through
refinancing or sale.
The consequences of these practices were disastrous not just
for borrowers and financial institutions in the United States,
but also for investors all over the world due to the
transmission mechanism of securitization. To prevent this from
happening again, while still providing adequate mortgage credit
to borrowers, regulators need to establish, with additional
legislative authorization as necessary, at least three minimum
underwriting standards for all home mortgages:
First, underwriters should verify income and
assets.
Second, borrowers should be required to make
meaningful down payments.
Third, a borrower should not be eligible for a
mortgage where monthly payments increase over time
unless the borrower can afford the later, high
payments.
It is critical that these requirements, and any new mortgage
regulation that is adopted, apply to all credit providers to
prevent the kind of competitive inequity and pressure on
regulated lenders that eroded safe and sound lending practices
in the past. Prudential bank supervisors, including the OCC,
are best positioned to develop such new underwriting standards
and would enforce them vigorously with respect to the banks
they supervise. A separate regulatory mechanism would be
required to ensure that such standards are implemented by
nonbanks. While the proposed new Consumer Financial Protection
Agency would have consumer protection regulatory authority with
respect to nonbanks, they would not have--and they should not
have--safety and soundness regulatory authority over
underwriting standards.
Q.4. Since the two most recent banking meltdowns were caused by
mortgage lending, do you think it is wise to have a charter
focused on mortgage lending? In other words, why should we have
a thrift charter?
A.4. When there are systemwide problems with residential
mortgages, institutions that concentrate their activities in
those instruments will sustain more losses and pose more risk
to the deposit insurance fund than more diversified
institutions. On the other hand, there are many thrifts that
maintained conservative underwriting standards and have
weathered the current crisis. The Treasury proposal would
eliminate the Federal thrift charter--but not the State thrift
charter--with all Federal thrifts required to convert to a
national bank, State bank, or State thrift, over the course of
a reasonable transition period. (State thrifts would then be
treated as State ``banks'' under Federal law.) An alternative
approach would be to preserve the Federal thrift charter, with
Federal thrift regulation being conducted by a division of the
merged agency. With the same deposit insurance fund, same
prudential regulator, same holding company regulator, and a
narrower charter (a national bank has all the powers of a
Federal thrift plus many others), it is unclear whether
institutions will choose to retain their thrift charters over
the long term.
Q.5. Should banking regulators continue to be funded by fees on
the regulated firms, or is there a better way?
A.5. Funding bank regulation and supervision through fees
imposed on the regulated firms is preferable to the alternative
of providing funding through the appropriations process because
it ensures the independence from political control that is
essential to bank supervision.
For this reason, fee-based funding is the norm in banking
regulation. In the case of the OCC and OTS, Congress has
determined that assessments and fees on national banks and
thrifts, respectively, will fund supervisory activities, rather
than appropriations from the United States Treasury. Since
enactment of the National Bank Act in 1864, the OCC has been
funded by various types of fees imposed on national banks, and
over the more than 145 years that the OCC has regulated
national banks, this funding mechanism has never caused the OCC
to weaken or change its regulation or supervision of national
banks, including with respect to national banks' compliance
with consumer protection laws. Neither the Federal Reserve
Board nor the FDIC receives appropriations. State banking
regulators typically also are funded by assessments on the
entities they charter and supervise.
Q.6. Why should we have a different regulator for holding
companies than for the banks themselves?
A.6. Combining the responsibilities for prudential bank
supervision and holding company supervision in the same
regulator would be a workable approach in the case of those
holding companies whose business is comprised solely or
overwhelmingly of one or more subsidiary banks. Elimination of
a separate holding company regulator in these situations would
remove duplication, promote simplicity and accountability, and
reduce unnecessary compliance burden for institutions as well.
Such a consolidated approach would be more challenging
where the holding company has substantial nonbanking activities
in other subsidiaries, such as complex capital markets
activities, securities, and insurance. The focus of a
dedicated, strong prudential banking supervisor could be
significantly diluted by extending its focus to substantial
nonbanking activities. The Federal Reserve has unique resources
and expertise to bring to bear on supervision of these sorts of
activities conducted by bank affiliates in a large, complex
holding company. Therefore, a preferable approach would be to
preserve such a role for the Federal Reserve Board, but to
clearly delineate the respective roles of the Board and the
prudential bank supervisors with respect to the holding
company's activities.
Q.7. Assuming we keep thrifts and thrift holding companies,
should thrift holding companies be regulated by the same
regulator as bank holding companies?
A.7. Yes. Thrift holding companies, unlike bank holding
companies, currently are not subject to consolidated
regulation; for example, no consolidated capital requirements
apply at the holding company level. This difference between
bank and thrift holding company regulation created arbitrage
opportunities for companies that were able to take on greater
risk under a less rigorous regulatory regime. Yet, as we have
seen--AIG is the obvious example--large nonbank firms can
present similar risks to the system as large banks. This
regulatory gap should be closed, and these firms should be
subject to the same type of oversight as bank holding
companies. The Treasury Proposal would make these types of
firms subject to the Bank Holding Company Act and supervision
by the Federal Reserve Board. We support this approach,
including a reasonable approach to grandfathering the
activities of some thrift holding companies that may not
conform to the activities limitations of the Bank Holding
Company Act.
Q.8. The proposed risk council is separate from the normal
safety and soundness regulator of banks and other firms. The
idea is that the council will set the rules that the other
regulators will enforce. That sounds a lot like the current
system we have today, where different regulators read and
enforce the same rules different ways. Under such a council,
how would you make sure the rules were being enforced the same
across the board?
A.8. The Treasury proposal establishes the Financial Services
Oversight Council to identify potential threats to the
stability of the U.S. financial system; to make recommendations
to enhance the stability of the U.S. financial markets; and to
provide a forum for discussion and analysis of emerging issues.
Based on its monitoring of the U.S. financial services
marketplace, the Council would also play an advisory role,
making recommendations to, and consulting with, the Board of
Governors of the Federal Reserve System. As I understand the
Treasury proposal, however, the Council's role is only
advisory; it will not be setting any rules. Therefore, we do
not anticipate any conflicting enforcement issues to arise from
the Council's role.
Q.9. Mr. Dugan, in Mr. Bowman's statement he says Countrywide
converted to a thrift from a national bank after it had written
most of the worst loans during the housing bubble. That means
Countrywide's problems were created under your watch, not his.
How do you defend that charge and why should we believe your
agency will be able to spot bad lending practices in the
future?
A.9. In evaluating the Countrywide situation, it is important
to know all the facts. Both Countrywide Bank, N.A., and its
finance company affiliate, Countrywide Home Loans, engaged in
mortgage lending activities. While the national bank was
subject to the supervision of the OCC, Countrywide Home Loans,
as a bank holding company subsidiary, was subject to regulation
by the Federal Reserve and the States in which it did business.
Mortgage banking loan production occurred predominately at
Countrywide Home Loans, \1\ the holding company's finance
subsidiary, which was not subject to OCC oversight. Indeed, all
subprime lending, as defined by the borrower's FICO score, was
conducted at Countrywide Home Loans and not subject to OCC
oversight. The OCC simply did not allow Countrywide Bank, N.A.,
to engage in such subprime lending.
---------------------------------------------------------------------------
\1\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).
---------------------------------------------------------------------------
When Countrywide Financial Corporation, the holding
company, began to transition more of the mortgage lending
business from Countrywide Home Loans to the national bank, the
OCC started to raise a variety of supervisory concerns about
the bank's lending risk and control practices. Shortly
thereafter, on December 6, 2006, Countrywide Bank applied to
convert to a Federal savings bank charter.
Countrywide Bank became a Federal savings bank on March 12,
2007. Going forward, Countrywide Bank, FSB, was regulated by
OTS, and Countrywide Home Loans was regulated by the OTS and
the States in which it did business. Countrywide Financial
Corporation continued to transition its mortgage loan
production to the Countrywide Bank, FSB. By the end of the
first quarter of 2008, over 96 percent of mortgage loan
production of Countrywide Financial Corporation occurred at
Countrywide Bank, FSB. \2\
---------------------------------------------------------------------------
\2\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).
---------------------------------------------------------------------------
Bank of America completed its acquisition of Countrywide
Financial Corporation on June 30, 2008.
Countrywide Bank, N.A., was not the source of toxic
subprime loans. The OCC raised concerns when Countrywide began
transitioning more of its mortgage lending operations to its
national bank charter. It was at that point that Countrywide
flipped its national bank charter to a Federal thrift charter.
The facts do not imply lax supervision by the OCC, but rather
quite the opposite.
The OCC continues to identify and warn about potentially
risky lending practices. On other occasions, the OCC has taken
enforcement actions and issued guidance to curtail abuses with
subprime credit cards and payday loans. Likewise, the Federal
banking agencies issued guidance to address emerging compliance
risks with nontraditional mortgages, such as payment option
ARMs, and the OCC took strong measures to ensure that that
guidance was effectively implemented by national banks
throughout the country.
Q.10. All of the largest financial institutions have
international ties, and money can flow across borders easily.
AIG is probably the best known example of how problems can
cross borders. How do we deal with the risks created in our
country by actions somewhere else, as well as the impact of
actions in the U.S. on foreign firms?
A.10. As noted in our response to Question 1, the global nature
of today's financial institutions increasingly requires that
supervisory policies and actions be coordinated and implemented
on a global basis. The OCC is an active participant in various
international supervisory groups whose goal is to coordinate
supervisory policy responses, to share information, and to
coordinate supervisory activities at individual institutions
whose activities span national borders. These groups include
the Basel Committee on Bank Supervision (BCBS), the Joint
Forum, the Senior Supervisors Group (SSG), and the Financial
Stability Board. In addition to coordinating capital and other
supervisory standards, these groups promote information sharing
across regulators.
For example, the SSG recently released a report that
evaluates how weaknesses in risk management and internal
controls contributed to industry distress during the financial
crisis. The observations and conclusions in the report reflect
the results of two initiatives undertaken by the SSG. These
initiatives involved a series of interviews with firms about
funding and liquidity challenges and a self-assessment exercise
in which firms were asked to benchmark their risk management
practices against recommendations and observations taken from
industry and supervisory studies published in 2008.
One of the challenges that arise in resolving a cross-
border bank crisis is that crisis resolution frameworks are
largely designed to deal with domestic failures and to minimize
the losses incurred by domestic stakeholders. As such, the
current frameworks are not well suited to dealing with serious
cross-border problems. In addition to the fact that legal
systems and the fiscal responsibility are national matters, a
basic reason for the predominance of the territorial approach
in resolving banking crises and insolvencies is the absence of
a multinational framework for sharing the fiscal burdens for
such crises or insolvencies.
To help address these issues, the BCBS has established a
Cross-border Bank Resolution Group to compare the national
policies, legal frameworks and the allocation of
responsibilities for the resolution of banks with significant
cross-border operations. On September 17, 2009, the BCBS issued
for comment a report prepared by this work group that sets out
10 recommendations that reflect the lessons from the recent
financial crisis and are designed to improve the resolution of
a failing financial institution that has cross-border
activities. The report's recommendations fall into three
categories including:
The strengthening of national resolution powers and
their cross-border implementation;
Ex ante action and institution-specific contingency
planning, which involves the institutions themselves as
well as critical home and host jurisdictions; and,
Reducing contagion and limiting the impact on the
market of the failure of a financial firm by actions
such as further strengthening of netting arrangements.
We believe adoption of these recommendations will enhance
supervisors' ability to deal with many of the issues posed by
resolving a cross-border bank.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM DANIEL K. TARULLO
Q.1. What is the best way to decrease concentration in the
banking industry? Is it size limitations, rolling back State
preemption, higher capital requirements, or something else?
A.1. Answer not received by time of publication.
Q.2. Treasury has proposed making the new banking regulator a
bureau of the Treasury Department. Putting aside whether we
should merge the current regulators, does placing the new
regulator in Treasury rather than as a separate agency provide
enough independence from political influence?
A.2. Answer not received by time of publication.
Q.3. Given the damage caused by widespread use of subprime and
nontraditional mortgages--particularly low documentation
mortgages--it seems that products that are harmful to the
consumer are also harmful to the banks that sell them. If bank
regulators do their job and stop banks from selling products
that are dangerous to the banks themselves, other than to set
standards for currently unregulated firms, why do we need a
separate consumer protection agency?
A.3. Answer not received by time of publication.
Q.4. Since the two most recent banking meltdowns were caused by
mortgage lending, do you think it is wise to have a charter
focused on mortgage lending? In other words, why should we have
a thrift charter?
A.4. Answer not received by time of publication.
Q.5. Should banking regulators continue to be funded by fees on
the regulated firms, or is there a better way?
A.5. Answer not received by time of publication.
Q.6. Why should we have a different regulator for holding
companies than for the banks themselves?
A.6. Answer not received by time of publication.
Q.7. Assuming we keep thrifts and thrift holding companies,
should thrift holding companies be regulated by the same
regulator as bank holding companies?
A.7. Answer not received by time of publication.
Q.8. The proposed risk council is separate from the normal
safety and soundness regulator of banks and other firms. The
idea is that the council will set rules that the other
regulators will enforce. That sounds a lot like the current
system we have today, where different regulators read and
enforce the same rules different ways. Under such a council,
how would you make sure the rules were being enforced the same
across the board?
A.8. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM JOHN E. BOWMAN
Q.1. What is the best way to decrease concentration in the
banking industry? Is it size limitations, rolling back State
preemption, higher capital requirements, or something else?
A.1. There are several ways to decrease the concentration in
the banking industry, including:
1. Restricting further increases in concentrations. The
largest banks in the U.S. have principally achieved
their concentration dominance by mergers and
acquisitions. Hence, slight changes to the current
rules regarding the regulatory review and approval of
mergers/acquisitions could play a large part in
restricting further concentration. There could be
modest changes made to the Herfindahl Hirschman Index
(HHI) analysis when reviewing merger/acquisition
applications of very large banks to restrict increases
in concentrations.
2. Reduce current concentrations. Options could range from
severe, such as forced break-ups, to less severe such
as requiring largest banks to increase their regulatory
capital and/or tangible capital levels.
3. Reduce the advantages of ``Too Big To Fail'' (TBTF).
Having the U.S. Government as an implicit backstop for
liquidity and capital reserves allowed the largest
banks to raise capital at less expensive rates than
could smaller, community banks. Large banks were able
to use that capital to fund the acquisition of other
banks. Removing the U.S. Government as a backstop by
implementing explicit take over authority and
procedures for TBTF institutions would help eliminate
this moral hazard.
4. Improve the outlook for community banks and thrifts.
Efforts to make it easier to organize new or de novo
banks and thrifts, as well as for smaller institutions
to increase capital levels, would help level the
playing field between community institutions and large
banks.
Q.2. Treasury has proposed making the new banking regulator a
bureau of the Treasury Department. Putting aside whether we
should merge the current regulators, does placing the new
regulator in Treasury rather than as a separate agency provide
enough independence from political influence?
A.2. OTS has stated publicly that it does not support the
elimination of the thrift charter or the Administration's
Proposal to establish a new agency, the National Bank
Supervisor (NBS), by eliminating the Office of the Comptroller
of the Currency, which charters and regulates national banks,
and the OTS, which charters Federal thrifts and regulates
thrifts and their holding companies. However, if a new NBS is
established to be the Federal chartering and supervisory
authority for Federal depository institutions, such new agency
should be independent from the Department of Treasury rather
than bureau of the Department.
Among the Federal banking agencies, the Board of Governors
of the Federal Reserve System and the Federal Deposit Insurance
Corporation each are independent from Treasury for all
purposes. A similar separation for any new banking regulator
would assure that the agency would be free from any possible
constraints on rulemaking, enforcement, or litigation matters.
An example of recently established agency that is independent
of the Department of Treasury or any other Department is the
Federal Housing Finance Agency, which was created by the
Housing and Economic Recovery Act in July 2008.
To the extent that it is determined that the new NBS should
be part of the Department of Treasury, if it is granted
explicit independence in a number of areas, it would be
insulated from political influence to the same degree that the
OTS currently is. Examples of the type of activities of the new
supervisor that must remain independent include the ability of
the agency to testify and to make legislative recommendations.
Another important area of independence is the agency's
authority to litigate. The current OTS authority provides that
Secretary of Treasury may not intervene in any matter or
proceeding before OTS, including enforcement matters, and not
prevent the issuance of any rule or regulation by the agency.
Any new agency should have the same authority that OTS
currently does. The operations of the NBS should be funded by
assessments and not through the appropriations process.
Q.3. Given the damage caused by widespread use of subprime and
nontraditional mortgages particularly low documentation
mortgages--it seems that products that are harmful to the
consumer are also harmful to the banks that sell them. If bank
regulators do their job and stop banks from selling products
that are dangerous to the banks themselves, other than to set
standards for currently unregulated firms, why we need a
separate consumer protection agency?
A.3. The OTS examines institutions to ensure that they are
operating in a safe and sound manner. OTS does not believe that
Federal regulators should dictate the types of products that
lenders must offer. Although we believe strongly that
Government regulators should prohibit products or practices
that are unfair to consumers, the Government should not be
overly prescriptive in defining lenders' business plans or
mandating that certain products be offered to consumers.
Defining standards for financial products would put a
Government seal of approval on certain favored products and
would effectively steer lenders toward products. It could have
the unintended consequence of fewer choices for consumers by
stifling innovation and inhibiting the creation of products
that could benefit consumers and financial institutions. We are
concerned about the consumer protection agency defining
standards for financial products and services that would
require institutions to offer certain products (e.g., 30-year
fixed rate mortgages). The imposition of such a requirement
could result in safety and soundness concerns and stifle credit
availability and innovation.
The OTS supports consolidating rulemaking authority over
all consumer protection regulation in one Federal regulator
such as the proposed consumer protection agency. This regulator
should be responsible for promulgating all consumer protection
regulations that would apply uniformly to all entities that
offer financial products, whether an insured depository
institution, State-licensed mortgage broker or mortgage
company. Any new framework should be to ensure that similar
bank or bank-like products, services, and activities are
treated in the same way in a regulation, whether they are
offered by a chartered depository institution, or an
unregulated financial services provider. The product should
receive the same review, oversight, and scrutiny regardless of
the entity offering the product.
To balance the safety and soundness requirements of
depository institutions with these important functions of the
consumer protection agency, the OTS recommends retaining
primary consumer-protection-related examination and supervision
authority for insured depository institutions with the FBAs and
the NCUA. The OTS believes that the CFPA should have primary
examination and enforcement power over entities engaged in
consumer lending that are not under the jurisdiction of the
FBAs.
Safety and soundness and consumer protection examination
and enforcement powers should not be separated for insured
depository institutions because safety-and-soundness
examinations complement and strengthen consumer protection. By
separating safety-and-soundness functions from consumer
protection, the CFPA and an FBA could each have gaps in their
information concerning an institution.
Q.4. Since the two most recent banking meltdowns were caused by
mortgage lending, do you think it is wise to have a charter
focused on mortgage lending? In other words, why should we have
a thrift charter?
A.4. Beginning with the enactment of the Home Owners Loan Act.
Congress has several times acted to reinforce a national
housing policy. Over the years, Congress has taken steps to
ensure that a specialized housing lender is retained among the
charter options available tor insured institutions. The causes
of any banking crisis are difficult to identify because of the
interconnected nature of financial services. The crisis that we
currently are working through is different in several important
ways from the banking crisis of the 1980s and early 1990s. In
the early months of the current crisis, there appeared to be
similarities in its origins to the crisis of the 1980s and
appeared to have been caused by mortgage lending. Even if the
early obvious causes of the current crisis are found in the
mortgage market, the industry has evolved and changed since the
earlier crisis. The elimination of a dedicated mortgage lending
charter would not have eliminated the current crisis.
In the 1980s, the thrift industry was more limited in the
activities in which it could engage and in the loan products
institutions could offer to consumers. In a period of rapidly
rising interest rates, many thrift institutions held long term
fixed rate mortgages on their books while at the same time
paying high rates on deposits to meet competition. The mortgage
banking industry was not mature and the use of the secondary
mortgage market was not widespread, therefore the long term
fixed rate assets originated by thrifts created an interest
rate mismatch on the books of the institutions. As a result of
the earlier crisis, the OTS developed a proprietary interest
rate risk model and expertise in supervision of institutions
likely to have interest rate risk concerns. Throughout varied
interest rate environments, the industry has not experienced
the problems of the 1980s.
However, interest rate risk was not a primary cause of the
current crisis and the mortgage related causes of the current
crisis are already the subject of revised guidance at the OTS
and the other Federal banking agencies. Unlike the problems of
the 1980s, there are a number of causes of the mortgage related
problems that surfaced in the current crisis.
First, during the recent housing boom, credit was extended
to too many borrowers who lacked the ability to repay their
loans when interest rates rose on the adjustable rate loans.
For home mortgages, some consumers received loans based on
their ability to pay introductory teaser rates, an unfounded
expectation that home prices would continue to rise, inflated
income figures, or other underwriting practices that were not
as prudent as they should have been.
In addition, mortgage related problems are in part the
result of inadequate supervision of State entities that had no
Federal oversight. Another factor was the growth of the
secondary market and the ability of lenders of any charter type
or organizational form to fund lending activities with sales of
originated loans. Whether it was the entities that originated
the loans or the numerous entities that packaged the loans and
sold them as part of securities, the entities involved were not
always supervised by Federal banking regulators and that lack
of supervision is a more direct contributor to the crisis than
the existence of a charter that focuses on mortgage lending.
There are many lessons learned from the current crisis, but
one of them is not that Congress should eliminate the thrift
charter or a charter that focuses on housing finance.
Homeownership continues to be an important policy objective for
Congress. Consumers deserve to have the option of obtaining a
loan from a dedicated home and consumer lender that is able to
offer products that meet that consumer's needs.
Q.5. Should banking regulators continue to be funded by fees on
the regulated firms, or is there a better way?
A.5. As a general matter, we believe that bank regulatory
agencies (agencies) be funded by the institutions that they
regulate. The alternative, funding the agencies with tax payer
dollars through the appropriations process, is inherently
problematic. Funding the agencies in this manner creates a
taxpayer subsidy for the institutions. Moreover, subjecting the
agencies to the appropriations process will make the agencies
more vulnerable to political influence.
Now more than ever it is critical that the agencies be
independent and free of political influence. However, funding
the agencies through appropriations will do just the opposite.
The Office of Federal Housing Enterprise Oversight (OFHEO) was
subject to the appropriations process and as such was very
vulnerable to political influence. For example, in 2004 OFHEO
investigated accounting improprieties at Fannie Mae and that
entity used the appropriations process to hinder the agency,
portraying it as over its head on complex financial matters.
This resulted in the Senate Appropriations Committee voting to
hold back $10 million of a proposed funding increase until
OFHEO got a new director. (S. Rep. No. 108-353, at 71.)
It is critical that the agencies have the resources
necessary to effectively regulate institutions. As was the case
with OFHEO, Congress can withhold or threaten to withhold such
funds. Even in the absence of such actions, Continuing
Resolutions (CR) and other appropriations law requirements may
hinder the agencies in achieving their mission. Beginning in
October of every year and until a yearly appropriations bill is
passed, agencies under the appropriations process are typically
under a hiring freeze and are severely restricted in their
expenditures under a CR. On January 21, 2004, Annando Falcon,
then Director of OFHEO testified that Congress' protracted FY04
appropriations process placed ``severe constraints'' on OFHEO's
capacity to implement reforms at Freddie Mac and carry out
other oversight responsibilities. Director Falcon told the
House Financial Services Capital Markets Subcommittee that
``[t]he short-term continuing resolutions we are operating
under prevent us from hiring the additional examiners,
accountants and analysts we need to strengthen our oversight.
In addition, we are unable to hire the help we need to conduct
our review of Fannie Mae. If the long term [continuing
resolution] is enacted which freezes our budget at 2003 levels,
we will need to scale back oversight at a time when greater
oversight has never been more urgent.'' (Special Examination of
Freddie Mac: Hearing Before the Subcommittee on Capital
Markets, Insurance and Government Sponsored Enterprises of the
H. Comm. on Financial Services, 108th Cong. 8-9 (January 21,
2004) (statement of Armando Falcon, Director of Office of
Federal Housing Enterprise Oversight.))
Some believe that a banking agency may supervise an
institution less vigorously if it fears that the institution
will switch charters and the agency will lose a funding source.
However, there is no evidence that this is the case and we
strongly disagree with this suggestion.
Q.6. Why should we have a different regulator for holding
companies than for the banks themselves?
A.6. Since the establishment of the savings and loan holding
company, the OTS and its predecessor have regulated savings
associations and their holding companies. Regulators have
greater oversight into an institution and the holding company
if they have the same supervisor. OTS disagrees that the
institution and the holding company should have a different
regulator. An exception to this general statement is if the
holding company is so large or interconnected with other
financial services companies that a systemic regulator also
will provide oversight.
OTS has long had authority to charter and regulate thrift
institutions and the companies that own or control them. The
agency has a comprehensive program for assessing and rating the
overall enterprise as well as the adequacy of capital, the
effectiveness of the organizational structure, the
effectiveness of the risk management framework for the firm and
the strength and sustainability of earnings. OTS performs
capital adequacy assessments on an individualized basis for the
firms under our purview with requirements as necessary,
depending on the company's risk profile, its unique
circumstances and its financial condition.
The net effect of this approach has been a strong capital
cushion for the holding companies OTS supervises and the
ability for the firms under our purview to support the insured
depositories within their corporate structures. It is because
the agency supervises the institution and the holding company
that the impact of the holding company activities on the
institution can be assessed on a regular basis.
Q.7. Assuming we keep thrifts and thrift holding companies,
should thrift holding companies be regulated by the same
regulator as bank holding companies?
A.7. As explained more fully in the answer above, thrifts and
thrift holding companies should continue to have the same
supervisor. The regulatory framework that has been developed
for the institution and its holding company provides a seamless
supervisory process for savings associations and their holding
companies. The benefits of having the same regulator for the
institution and the holding company include the supervisor's
ability to view the institution and the holding company as a
whole and judgments based on all of the information.
Q.8. The proposed risk council is separate from the normal
safety and soundness regulator of banks and other firms. The
idea is that the council will set rules that the other
regulators will enforce. That sounds a lot like the current
system we have today, where different regulators read and
enforce the same rules different ways. Under such a council,
how would you make sure the rules were being enforced the same
across the board?
A.8. The Administration has proposed the creation of the
Financial Services Oversight Council (Council) to be chaired by
the Secretary of the Treasury and to include the heads of the
Federal banking agencies and other agencies involved in the
regulation of financial services. The Council will make
recommendations to the Board of Governors of the Federal
Reserve System (FRB) concerning entities that should be
designated as systemically significant (Tier 1 FHCs). The FRB
will consult the Council in setting material prudential
standards for Tier 1 FHCs and in setting risk management
standards for systemically important payment, clearing, and
settlement systems and activities. The Council will also
facilitate information sharing, provide a forum for discussion
of cross-cutting issues and prepare an annual report to
Congress on market developments and emerging risks. Under the
Administration's proposal, the Council would not be authorized
to promulgate rules.
Q.9. Mr. Bowman, in your statement you defend your agency's
regulation of thrifts and thrift holding companies, however you
never mention AIG. How do you defend your agency's performance
with that company?
A.9. Commencing in 2005, OTS actions demonstrated a progressive
level of supervisory criticism of AIG's corporate governance
culminating in a communication to the company in 2008 which
discussed the supervisory rating downgrade and a requirement to
provide OTS with a remediation plan to address the risk
management failures. OTS criticisms addressed AIG's risk
management, corporate oversight, and financial reporting.
It is critically important to note that AIG's crisis was
caused by liquidity problems, not capital inadequacy. AIG's
liquidity was impaired as a result of two of AIG's business
lines: (1) AIGFP's ``super senior'' credit default swaps (CDS)
associated with collateralized debt obligations (CDO), backed
primarily by U.S. subprime mortgage securities and (2) AIG's
securities lending commitments. While much of AIG's liquidity
problems were the result of the collateral call requirements on
the CDS transactions, the cash requirements of the company's
securities lending program also were a significant factor.
AIG's securities lending activities began prior to 2000.
Its securities lending portfolio is owned pro rata by its
participating, regulated insurance companies. At its highest
point, the portfolio's $90 billion in assets comprised
approximately 9 percent of the group's total assets. AIG
Securities Lending Corp, a registered broker-dealer in the
U.S., managed a much larger, domestic securities lending
program as agent for the insurance companies in accordance with
investment agreements approved by the insurance companies and
their functional regulators.
The securities lending program was designed to provide the
opportunity to earn an incremental yield on the securities
housed in the investment portfolios of AIG's insurance
entities. These entities loaned their securities to various
third parties, in return for cash collateral, most of which AIG
was obligated to repay or roll over every 2 weeks, on average.
While a typical securities lending program reinvests its cash
in short duration investments, such as treasuries and
commercial paper, AIG's insurance entities invested much of
their cash collateral in AAA-rated residential mortgage-backed
securities with longer durations.
Similar to the declines in market value of AIGFP's credit
default swaps, AIG's residential mortgage investments declined
sharply with the turmoil in the housing and mortgage markets.
Eventually, this created a tremendous shortfall in the
program's assets relative to its liabilities. Requirements by
the securities lending program's counterparties to meet margin
requirements and return the cash AIG had received as collateral
then placed tremendous stress on AIG's liquidity.
Q.10. I asked Chairman Bair this question a few weeks ago, so
this is for the rest of you. All of the largest financial
institutions have international ties, and money can flow across
borders easily. AIG is probably the best known example of how
problems can cross borders. How do we deal with the risks
created in our country by actions somewhere else, as well as
the impact of actions in the U.S. on foreign firms?
A.10. OTS exercises its supervisory responsibilities with
respect to complex holding companies by communicating with
other functional regulators and supervisors who share
jurisdiction over portions of these entities and through our
own set of specialized procedures. With respect to
communication, OTS is committed to the framework of functional
supervision Congress established in Gramm-Leach-Bliley. Under
Gramm-Leach-Bliley, the consolidated supervisors are required
to consult on an ongoing basis with other functional regulators
to ensure those findings and competencies are appropriately
integrated into the assessment of the consolidated enterprise
and, by extension, the insured depository institution.
As a consolidated supervisor, OTS relies on effective
communication and strong cooperative relationships with the
relevant primary supervisors and functional regulators.
Exchanging information is one of the primary regulatory tools
to analyze a holding company and to ensure that global
activities are supervised on a consolidated basis.
Approximately 85 percent of AIG, as measured by allocated
capital, is contained within entities regulated or licensed by
other supervisors. AIG had a multitude of regulators in over
100 countries involved in supervising pieces of the AIG
corporate family. OTS established relationships with these
regulators, executed information sharing agreements where
appropriate, and obtained these regulators' assessments and
concerns for the segment of the organization regulated.
As part of our supervisory program for AIG, OTS began in
2005 to convene annual supervisory college meetings. Key
foreign supervisory agencies, as well as U.S. State insurance
regulators, participated in these conferences. Part of the
meetings was devoted to presentations from the company. In this
portion, supervisors had an opportunity to question the company
about any supervisory or risk issues. Another part of the
meeting included a ``supervisors-only'' session, which provides
a venue for participants to ask questions of each other and to
discuss issues of common concern regarding AIG. OTS also used
the occasion of the college meetings to arrange one-on-one side
meetings with foreign regulators to discuss in more depth
significant risk in their home jurisdictions.
This notion of consolidated supervision in a cross-border
context is a widely accepted global standard implemented by
most prudential supervisors. The key concepts of cross-border
consolidated supervision have been supported by the Basel
Committee on Banking and reflected in numerous publications.
This framework has been embraced by the International Monetary
Fund and World Bank and utilized in connection with their
Financial Sector Assessment Program (FSAP) which is an
assessment of countries' financial supervisory regimes.
STRENGTHENING AND STREAMLINING PRUDENTIAL BANK SUPERVISION
----------
TUESDAY, SEPTEMBER 29, 2009
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 2 p.m. in room SD-538, Dirksen Senate
Office Building, Senator Christopher J. Dodd (Chairman of the
Committee) presiding.
OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
Chairman Dodd. The Committee will come to order.
Let me inform my colleagues here, my good friend, Richard
Shelby, is stuck in an airport in Birmingham trying to get
back, and so I left a message for him that when he arrives
about 10 or 11 this evening, that Senator Corker will call him
and read him the entire testimony today. He would like that. He
would appreciate that.
[Laughter.]
Chairman Dodd. So what we will do here is I will make a few
opening comments and I will ask if either of my colleagues
would like to be heard at all and we will get right to our
witnesses. We thank them for joining us here today in this
hearing on ``Prudential Bank Regulation: Should There Be
Further Consolidation?''
I know we have had a lot of informal conversations with
each other over many, many months on this subject and many
others related to the reform of the financial regulatory
structure. As I have said over and over again, while I think
some of us are getting closer to firmer ideas, I believe most
of us here are still very anxious to hear from people who bring
a particular knowledge and expertise, as our witnesses do here
today, on this subject matter. So we are interested in your
thoughts.
We all understand here how important this subject matter
is. We also understand how important it is that we do it right
and that we realize we are doing things here that have not been
done in years, and so as we chart forward, we want to make sure
that we are doing so carefully and thoughtfully. So while I
know there are those who are impatient, that while we haven't
answered all the questions, even though the problems that
emerged a year ago have not been entirely solved, I think it is
important that we do it carefully and right, and that is our
determination on this Committee.
This afternoon, we will have a chance to hear from four
very knowledgeable witnesses on the subject matter. I have read
all of your testimony. I think it has been tremendously
helpful. I think you go beyond, in some cases, talking about
the single prudential regulator or the consolidation of
regulation to other areas, as well, so while we are talking
about that subject matter, certainly my colleagues don't need
any advice from me on the subject matter, but clearly, the
expertise is at this table. We would invite questions regarding
a wide subject matter, in addition to the one that is the title
of the hearing today.
So with that, this afternoon we examine how best to ensure
the strength and security of our banking system. I would like
to thank our witnesses again for returning to share your
expertise after the last hearing was postponed.
Today, we have a convoluted system of bank regulators
created by an almost historical accident. I think most experts
would agree that no one would have designed a system that
worked like this. For over 60 years, Administrations of both
political parties, Members of Congress across the political
spectrum, commissions, and scholars have proposed streamlining
this irrational system.
Last week, I suggested further consolidation of bank
regulators would make a lot of sense. We could combine the
Office of the Comptroller of the Currency and the Office of
Thrift Supervision while transferring bank supervision
authorities from the Federal Deposit Insurance Corporation and
the Federal Reserve and leaving them to focus on their core
functions.
Since that time, I have heard from many who have argued
that I should not push for a single bank regulator. The most
common argument is not that it is a bad idea, but rather,
consolidation is too politically difficult to achieve. That
argument doesn't work terribly well with me, nor, I suspect,
with many, if not most, of my colleagues.
Just look what the status quo has given us. In the last
year, some of our largest banks needed billions of dollars of
taxpayer money to prop them up and dozens of smaller banks have
failed outright. It is clear that we need to end charter
shopping, where institutions look around for the regulator that
will go easiest on them. It is clear that we must eliminate the
overlaps, redundancies, and additional red tape created by the
current alphabet soup of regulators. We don't need a super-
regulator with many missions, but a single Federal bank
regulator whose sole focus is the safe and sound operation of
our Nation's banks. A single operator would ensure
accountability and end, I think, the frustrating ``pass the
bucket'' excuses that we have been faced with over these many,
many months.
We need to preserve our dual banking system, and I feel
just as strongly about that point as I do the earlier point.
State banks have been a source of innovation and a source of
strength, tremendous strength, in our communities. A single
bank regulator can work, I think, with the 50 State bank
regulators. Any plan to consolidate bank regulations would have
to ensure community banks are created appropriately. Community
banks did not cause the crisis and they should not have to bear
the cost or burden of increased regulation necessitated by
others. Regulation should be based on risk. Community banks do
not present the same type of supervisory challenges that large
counterparts do.
But we need to get this right, as I said a moment ago,
which is why you are all here today. I am working again with
Senator Shelby and other Members of the Committee and
colleagues here to find a consensus that we can craft on this
incredibly important bill.
So with that, unless one of my other colleagues wants to be
heard for a few minutes on opening up, I will turn to our
witnesses.
Our first witness--and I will introduce all of them briefly
here--Eugene Ludwig, is the Chief Executive Officer of the
Promontory Financial Group. Before assuming that
responsibility, Gene served as the Vice Chairman and Senior
Control Officer of Bankers Trust Corporation, which he joined
in 1998. He served as the Comptroller of the Currency from 1993
to 1998, and prior to joining the OCC, was a partner in the law
firm of Covington and Burling.
Martin Baily is a Senior Fellow for Economics at the
Brookings Institution. Dr. Baily also serves as the Cochair of
the Pew Task Force on Financial Sector Reform and is a senior
advisor to McKinsey and Company. He served as Chairman of the
Council of Economic Advisors under the Clinton administration
from 1999 to 2001, and prior to that was a member of the same
Council from 1994 to 1996.
Richard Carnell is an Associate Professor at the Fordham
University School of Law. He previously served as the Assistant
Secretary for Financial Institutions at the Treasury from 1993
to 1999. And prior to that, Mr. Carnell was also a Senior
Counsel to this very Committee, from 1989 to 1993.
Richard Hillman is the Managing Director of the Financial
Markets and Community Investment Team of the U.S. Government
Accountability Office. He has been with GAO for 31 years and
his team looks at the effectiveness of regulatory oversight in
the financial and housing markets and the management of
community development programs.
We are honored that all four of you are with us today. We
thank you for your service, your past service, and your
willingness to participate in today's conversation.
All of you have been before this Committee many times in
the past and I will not limit you in a strict fashion to the
time, but if you would try to keep it in that 5 to 7 minutes--
and I know your testimony goes on longer than that, and the
testimony, the full testimony and comments and supporting data,
we will include as part of the record, as well.
Gene, we welcome you back to this Committee.
STATEMENT OF EUGENE A. LUDWIG, CHIEF EXECUTIVE OFFICER,
PROMONTORY FINANCIAL GROUP, LLC
Mr. Ludwig. Chairman Dodd, and to Ranking Member Shelby,
who is not here, and other distinguished Members of this
Committee, I am honored to be here today and I want to commend
you and the staff for the thoughtful way in which you have
examined the causes of the financial crisis and the need for
reform in this area. Under your leadership, Chairman Dodd and
Ranking Member Shelby, the bipartisan and productive traditions
of the Senate Banking Committee have continued.
In this regard, it should be noted that the need for an
end-to-end independent consolidated banking regulator, the
subject you have asked me to address today, has been championed
over the years by Members of the Senate Banking Committee,
including its Chairman, as well as Treasury Secretaries from
both sides of the aisle.
Consistent with this tradition, the Administration's white
paper is directionally helpful and commendable. While
refinements to the white paper are needed, this is an
inevitable part of the policymaking process.
I also want to commend the Treasury Department of former
Secretary Henry Paulson for having developed its so-called
``Blueprint,'' which also has added important and positive
developments to the debate in this area.
Lamentably, the financial regulatory problem we face is not
just the current crisis. Over the past 20-plus years, we have
witnessed the failure of hundreds of U.S. banks and bank
holding companies, supervised by every one of our regulatory
agencies. By the end of this year alone, well over 100 U.S.
banks will have failed, costing the Deposit Insurance Fund tens
of billions of dollars. Before this crisis is over, we will
witness the failure of hundreds more.
In the face of this irrefutable evidence, it is impossible
to say there is not a very serious problem with our regulation
of financial services organizations. There are three things,
however, this problem is not. It is not about the lack of
talented people in our regulatory agencies. It is not about
weak regulation or weaker bankers. The problem is in large
part--the problem stems from a dysfunctional regulatory
structure, a structure that exists nowhere else in the world
and no one wants to copy, a structure that reflects history,
not deliberation.
The recent financial crisis has accentuated many of the
shortcomings of the current regulatory system. Needless burdens
that weaken safety and soundness focus, lack of scale needed to
address problems in technical areas, regulatory arbitrage where
the ability to select or threaten to select a weaker supervisor
tears at the fabric of solid regulation, delayed rulemaking,
regulatory gaps, limitations on investigations, where one
agency cannot seamlessly examine and resolve a problem from a
bank to its nonbank affiliate, and diminished international
leadership. What is needed and what would resolve these
problems is an end-to-end independent consolidated banking
supervisor.
Now, there have been a number of misconceptions about what
a consolidated end-to-end institutional bank regulator is and
what it is not. First, an end-to-end supervisor is not a super-
regulator along the lines of Britain's FSA. The end-to-end
consolidated institutional supervisor would not regulate
financial markets like the FSA, would not establish consumer
protection rules like the FSA, would not have resolution
authority, would not have deposit insurance authority or any
central banking functions.
The consolidated end-to-end institutional regulator would
focus only on the prudential issues applicable to financial
institutions, and this model has been quite successful
elsewhere in the world. I think this is really quite important.
For example, the Office of the Superintendent of Financial
Institutions, OSFI, in Canada, and the Australian Prudential
Regulatory Authority, called APRA, in Australia have been quite
successful consolidated supervisors even in the current crisis,
where Canadian and Australian banks have fared much better than
our own.
There has been a second misconception that a consolidated
regulator that regulates enterprises chartered at the national
level cannot fairly supervise smaller community organizations
and that it would do violence to our dual banking system. I
might say as an aside, I, like the Chairman, believe the dual
banking system is alive and well and an important fabric of our
banking system and this would not do violence to it.
In fact, interesting enough, even today, the OCC supervises
well over a thousand community banking organizations whose
businesses are local in character. That is, the national
supervisor supervises over a thousand small banks. In fact, it
is the majority of the banks it supervises, the vast majority,
and they choose that as a matter of their own predilection, not
by rule. Indeed, today, all our Federal regulators regulate
large institutions and smaller institutions. A new consolidated
supervisor at the Federal level would merely pick up the FDIC
and Federal Reserve examination and supervisory authorities.
To emphasize, all the consolidated supervisor would do is
take the Federal component and move it to another Federal box.
It would not change the regulation or the fabric of that
supervision.
Third, some have claimed that a consolidated institutional
supervisor would not have the benefit of other regulatory
voices. This would clearly not be the case, as a consolidated
institutional supervisor would fulfill only one piece of the
regulatory landscape. The Federal Reserve, Treasury, SEC, FDIC,
CFTC, FINRA, FINCEN, OFAC, and the FHFA would continue to have
important responsibilities with respect to the financial
sector.
In addition, proposals are being made to add additional
elements to the U.S. financial regulatory landscape, the
Systemic Risk Council and a new financial consumer agency. This
would leave multiple financial regulators at the Federal level
and 50 bank regulators, 50 insurance regulators, and 50
securities regulators at the State level. It seems to me that
is a lot of voices.
Fourth, some have also claimed that the primary work of the
Federal Reserve--monetary policy, payment system, and acting as
the bank of last resort--and the FDIC--deposit insurance--would
be seriously hampered if they did not have supervisory
responsibility. The evidence does not support these claims.
One, a review of FOMC minutes does not suggest much, if
any, use is made of supervisory data in monetary policy
activities. In the case of the FDIC, it has long relied on a
combination of publicly available data and examination data
from the other agencies.
Two, there are not now, to my knowledge, any limitations on
the ability of the Federal Reserve or the FDIC to collect any
bank supervisory data. Indeed, if need be, the Federal Reserve
or the FDIC can accompany another agency's examination team to
obtain relevant data or review relevant practices.
Three, if the FDIC or the Federal Reserve does not have
adequate cooperation on gathering information, Congress can
make clear by statute that this must be the case.
And four, even if the FDIC were not the supervisor of State
chartered banking entities, the FDIC would continue to have
back-up supervisory authority and be able to be resident--
resident--in any bank it chose.
Finally, I would note that it is important that the new
consolidated supervisor be an independent agency for at least
three reasons. First, banking supervision should not be subject
to political influence.
Second, the agency and the agency head needs the stature of
the Federal Reserve, SEC, or FDIC to attract talented people
and to be taken seriously by the other agencies.
Third, and this, I think, is critically important,
Congress, in fulfilling its oversight function--its critical
oversight function--must hear the unfettered truth about the
banking system from the head of its supervisory agency, not
views filtered through another department or agency. And
indeed, I would go further. I think it is incredibly difficult
for you to fulfill your oversight responsibilities with an
alphabet soup of regulators. Indeed, having regulators that
have clear missions, it seems to me, makes it possible for you
to exercise your critical function in a more effective way. If
one pushed these together even more, as has been suggested by
some, I think it becomes almost unmanageable for Congress.
In sum, our country greatly needs a consolidated
independent end-to-end institutional regulator. Without one, we
will not have financial stability, in my view, and we will
continue to be victimized by periods of bank failures and
follow-on credit crunches that deteriorate our economy.
Thank you very much.
Chairman Dodd. Thank you very much, Gene Ludwig. We
appreciate it very much.
Dr. Baily, we thank you, as well, for being with us.
STATEMENT OF MARTIN N. BAILY, SENIOR FELLOW, ECONOMIC STUDIES,
THE BROOKINGS INSTITUTION
Mr. Baily. Well, thank you, Chairman Dodd and Members of
the Committee, to give me a chance to talk about this issue.
The summary of my testimony is, number one, I think that
the best guide to financial reform is the objectives approach,
which divides up regulation into microprudential,
macroprudential, and conduct of business regulation. So we have
to make sure that all parts of the financial sector are
adequately supervised, we don't have gaps in regulation. We
also want to make sure we don't have duplicative agencies.
After all, there were plenty of regulators. There were rooms
full of regulators. They didn't prevent this crisis.
My second point is that the quality of regulation must be
improved regardless of where it is done, and I don't want to
denigrate anybody in the regulatory agencies, but I do think
there is a problem that they may not always be well enough
paid, have enough experience, or have the kind of stature that
they need to deal with our very complex financial sector,
particularly the large global banks. I don't think we want a
situation where people are in Government jobs for a while and
then they move over to the financial sector, viewing that as
sort of where they are going to make their money. I think we
want the regulatory jobs to be desirable and stable jobs and
get the best people we can.
I agree with the Chairman and very much with Gene Ludwig
that we need a single Federal microprudential regulator,
combining the supervisory functions currently carried out at
the Fed, the OCC, the OTS, the SEC, and the FDIC. I think this
regulator should partner closely with State regulators. You
mentioned the importance of the community banks, and I agree
with you on that. I would say, however, that some of the State
chartered nonfinancial institutions were a source of a lot of
the bad mortgages that were made, so I think having the right
partnership between the Federal regulator and the State
chartered enterprises is important. I think there should be a
sharing of information there and perhaps of standards and
appropriate methods and data.
I do think, and this is going a little beyond the immediate
discussion of this hearing, but I do think the U.S. does need
an effective conduct of business regulator. That is an
important part. As Gene said, that has been combined in the
U.K., where the FSA was both the prudential regulator and the
conduct of business regulator, and cobbling it all, the whole
lot that was done there, I think that is a mistake. I think
having a separate conduct of business regulator is a good idea.
My own view is it would be nice to have that in a single
agency, and I think the SEC is probably the place to put it,
although the SEC, I must say, did not do a very good job in
this crisis. But I think potentially the SEC should be the
place that looks after small shareholders and also looks after
consumers, so it would have a CFPA division within the SEC.
Now, I know there is a case for having a separate consumer
agency and I am not diametrically opposed to that. I think
there are some advantages to the consolidation of having
conduct of business regulation in one place, but a good CFPA on
its own would be fine.
Now, this structure that we are describing takes away from
the Fed an important part of its existing power, which is what
has been to supervise the bank holding companies, most of the
large banks and a number of the smaller banks. I think that is
the right thing to do. I agree with Gene. I don't think this is
something that the Fed has done particularly well. They are
obviously paying a lot more attention to it now than they used
to, but historically, I don't think that is something that they
have done very well.
I share that view with my colleague, Alice Rivlin, who I
think has testified to this Committee, and she was there and
saw the point that Gene Ludwig made, which is that the
prudential people haven't typically had a lot of say on Open
Market Committee meetings. That hasn't been a main thing.
I do think it is very important that the Fed, as the lender
of last resort to the financial sector, does have to have
information about what is going on in the banks. I think that
was a significant failure in the U.K., where the FSA and the
Bank of England were so separate and were not talking to each
other, and I think Mervyn King, the head of the Bank of
England, thought it was inappropriate for him to talk too much
to the FSA. He wanted the independence of the Bank of England
when they were making monetary policy. You know, I see his
argument, but I think that was a big mistake and one of the
things that got them into trouble.
So I think we should have a lot of lines of communication
shared between the regulators and the Federal Reserve so that
they can set monetary policy with the adequate amount of
information and that they are aware of what is going on in the
banks, and if they need to be a lender of last resort, that is
not suddenly sprung on them. But I think they don't have to be
the people that are doing the day-to-day supervision.
Another point I would like to make in this regard is that
the big bank holding companies, or the big banks, as we know,
both investment banks or the traditional commercial banks, are
run as single entities. So the idea that you had a bank holding
company which was sort of a separate entity from the bank
itself really is not the way things operate. These were run
from the top and these banks would sort of come up with a new
line of business, something that was going to be profitable,
and they would discuss it, and then as someone was walking
about the door, they would sort of say, well, which legal
entity shall we put this in, and the answer to that was
typically, well, where would they get the most favorable tax
treatment? Where would they get the most favorable regulatory
treatment? It is not as if these things were really different
entities.
So I think another advantage of having a single prudential
regulator is that they would regulate these businesses top to
bottom as single companies, which is what they are.
I have used up my time. The last thing I want to say is to
reinforce the point that Gene made. I think we both had the
same reaction when we attended the hearing in August. You know,
it is natural for regulators to say, well, don't close my
agency. Mine is all right. When you came back and some of the
other Members of the Committee came back and said, well,
shouldn't we consolidate, shouldn't we make this a more
rationally organized regulatory structure, the answer came
back, well, the U.K. had trouble and they had this single
regulator, so we don't see why that should do any good.
That prompted, I think, both of us to go take a look--Gene
probably knew already, but I actually went to take a look at
regulation around the world, not covering every country, but
trying to cover several countries, and particularly the
English-speaking countries which tend to have some similarity
of their institutions, and you are right.
Canada, I think, did a much better job. They do actually
have quite a few different agencies, so they weren't my ideal.
I think Australia, which actually the Paulson Blueprint pointed
to, is to be commended. They took quite a while. They decided,
what is the best way to regulate. They took their time in doing
it. They consolidated in an appropriate way.
What happened in the U.K.--and I grew up in the U.K., I am
fond of the U.K., but they didn't do this very well--Gordon
Brown came in as Chancellor of the Exchequer and he said, it is
crazy to have all these agencies. I think he was right about
that. That the functions that these different companies are
performing are crossing boundaries and we want to have a single
agency. But they hadn't made any preparation. They hadn't
really laid the groundwork for doing it. They hadn't figured
out how to do it well. And, in fact, the FSA remained really
quite divided. There were a lot of different subagencies within
that, so they weren't communicating well, and as I said
earlier, they weren't communicating with the Bank of England.
So I think the examples that were given last time to say,
oh, other countries--a single agency doesn't work in other
countries, I think that is wrong. I think if you look in the
right place, you will find that having a single prudential
regulator is pretty much what is the right choice to make,
based on international experience.
Let me stop there. Thank you.
Chairman Dodd. Thank you very much, Dr. Baily.
Dr. Carnell? Thank you very much, Doctor, for being with
us.
STATEMENT OF RICHARD S. CARNELL, ASSOCIATE PROFESSOR, FORDHAM
UNIVERSITY SCHOOL OF LAW
Mr. Carnell. Mr. Chairman and Members of the Committee, our
current bank regulatory structure is and remains a source of
serious problems. Its defects are significant and longstanding.
The system is needlessly complex, needlessly expensive, and
imposes needless compliance burdens on banks. It impedes--it
blunts regulators' accountability with a tangled web of
overlapping jurisdictions and responsibilities, and it gives
credence to the old saying, when everyone is responsible, no
one is responsible.
The system wastes time, wastes energy. It hinders timely
action by regulators. It brings policy down to the lowest
common denominator that four agencies can agree on. And it
takes a particular toll on far-sighted action, action aimed at
preventing future problems. That is because so often in
policymaking, there is someone who says, if it ain't broke,
don't fix it. So it is a lot easier to get agreement when you
wait until you are confronted with a problem than when you are
trying to look ahead and head off problems to begin with.
Now, there is a straightforward solution to the problems we
see from our fragmented regulatory system, and that solution is
to unify the supervision of FDIC-insured depository
institutions, banks and thrifts, in a single agency. Treasury
Department Lloyd Bentsen offered that solution here in this
room 15 years ago and it made sense at the time. I worked with
him in preparing that proposal, and I think the events of the
last 15 years bear out the wisdom of that approach.
This new agency would take on the existing bank regulatory
responsibilities of the OCC, OTS, Federal Reserve, and FDIC.
The Federal Reserve would retain all its existing central
banking functions, including monetary policy, the discount
window, and the payment system. The FDIC would retain all its
deposit insurance powers and responsibilities, including back-
up examination and enforcement authority.
On top of that, under the approach I propose, the Fed and
the FDIC would be on the board of the new agency, let us say a
five- or seven-member board with those two agencies
represented. The Fed and FDIC could have their examiners
participate in examinations conducted by the new agency, and
they would have full access to supervisory information. So the
Fed and FDIC would get all the information they get now and
their examiners could be part of teams in all FDIC-insured
banks, which is more access than they customarily enjoy now.
This straightforward structure would be a major improvement
over the current fragmented structure. It would promote
clarity, efficiency, accountability, and timely action. Equally
important, it would give the bank regulator greater
independence from special interest pressure. That is, this new
agency would regulate the full spectrum of FDIC-insured
institutions. There wouldn't be the sort of subspecialization
category like we see with thrift institutions.
Now, if you look at the thrift debacle, for example, you
see that thrift regulation was better when it was done by
agencies that had a broad jurisdiction than when it was done by
specialized thrift-only regulators. So, for example, at the
Federal level, we had thrifts regulated by both the FDIC, which
regulated the traditional savings banks, and we had thrifts
regulated by the specialized Federal Home Loan Bank Board.
FDIC-regulated thrifts were much less likely to fail and, if
they did fail, caused smaller losses than the Home Loan Bank
Board-regulate thrifts, and we see the same thing at the State
level.
At the State level, in about two-thirds, three-quarters of
the States, the State Banking Commissioners supervise thrifts,
and in those States, the losses to the insurance fund were much
lower than we saw in States with specialized thrift regulators,
and that is basically because the thrift regulators had no
reason for being if there wasn't a thrift industry, and so they
looked for every way to keep thrift institutions going, even
when, in fact, it was unrealistic at that point. The result was
a failure to deal effectively with troubled thrifts, much
larger losses to the Deposit Insurance Fund.
A unified structure would have another major advantage. It
would recognize the reality of how banking organizations
actually operate, and Dr. Baily already touched on this, as
well. Under the existing system, each agency looks at only part
of the organization. But in these organizations, you may, in
fact, have the various parts doing business with each other
extensively, and to evaluate risk, you need to look at the
whole, think about the whole, and it sure helps in doing that
to be responsible for the whole.
So the fragmented system hinders the agency from getting
the full picture. Here is how Secretary Bentsen described the
problem. Under our current system, any one regulator may see
only a limited piece of a dynamic, integrated banking
organization when a larger perspective is crucial, both for
effective supervision of the particular organization and for an
understanding of broader industry conditions and interests.
Mr. Chairman, if I could, I wanted to speak a bit to the
question of holding company regulation, which came up earlier.
First, I want to note something that may not be widely
appreciated, and that is that holding companies as a major
subject of regulation, that thing is unique to the United
States. In other countries, the regulation focuses on the bank.
Regulators look out, reach out, but it is not like we have got
people devoting their careers to the Bank Holding Company Act.
And here is what two of the leading experts, Pauline Heller
and Melanie Fein, say. Bank holding companies have no inherent
necessity in a banking system. They developed in the United
States only because of our unique banking laws which
historically limited geographic location and activities of
banks. Their only material purpose has been to serve as
vehicles for getting into things banks couldn't get into
directly.
So this puts it into perspective. There is nothing magical.
There is nothing high priestly about bank holding company
regulation. There is no need for a separate holding company
regulator. A bank regulator can fully handle all the functions
of a holding company regulator, policing the banks'
transactions with the banks and looking at overall risk.
In conclusion, Secretary Bentsen, speaking from this table
in 1994, underscored the risk of continuing to rely on what he
called ``a dilapidated regulatory system that is ill-defined to
prevent future banking crises and ill-equipped to cope with
crises when they occur.'' He observed in words eerily
applicable to the present that our country had just emerged
from its worst financial crisis since the Great Depression, a
crisis that our bank regulatory system did not adequately
anticipate or resolve.
And he issued this warning, which we would yet do well to
heed. If we fail to fix the system now, the next financial
crisis we face will again reveal its flaws, and who suffers
then? Our banking industry, our economy, and potentially the
taxpayers. You have the chance to help prevent that result.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much for your testimony. I
was very fond of Lloyd Bentsen, served with him here. He was a
wonderful Member of the Senate and a very good Secretary of the
Treasury as well. So thank you for being with us.
Welcome, Mr. Hillman. Nice to see you, and thank you for
being here. Thank you for your service to the GAO, 31 years.
Congratulations on that contribution.
STATEMENT OF RICHARD J. HILLMAN, MANAGING DIRECTOR, FINANCIAL
MARKETS AND COMMUNITY INVESTMENT TEAM, GOVERNMENT
ACCOUNTABILITY OFFICE
Mr. Hillman. Thank you very much. Mr. Chairman and Members
of the Committee, I am pleased to be here today to discuss
issues relating to efforts to reform the regulatory structure
of our Nation's financial system.
In January 2009, we reported on gaps and limitations in our
current structure, and we presented a framework for evaluating
proposals to modernize the U.S. financial regulatory system.
Given the importance of the U.S. financial sector to the
domestic and international economies, we also added
modernization of the outdated regulatory structure as a new
area to our high-risk list because the fragmented and outdated
regulatory structure was ill-suited to meeting the challenges
of the 21st century.
My statement today, which is based on prior reports that we
have completed, focuses on how regulation has evolved and
recent work that further illustrates the significant
limitations and gaps in the existing regulatory structure, the
experiences of countries with other types of varying regulatory
structures and how they fared during the financial crisis, and
our reviews on certain aspects and proposals to reform the
regulatory system.
I would like to make the following points:
First, the current U.S. financial regulatory system is a
fragmented and complex arrangement of Federal and State
regulation that has been put into place over the past 150 years
but has not kept pace with major developments in financial
markets and products in recent decades. My prepared statement
details numerous examples from our prior work identifying major
limitations of the Nation's fragmented banking regulatory
structure. For example, in July, we reported that less
comprehensive oversight by various regulators responsible for
overseeing fair lending laws intended to prevent lending
discrimination may allow many violations by independent
mortgage lenders to go undetected. That same month, we also
reported that regulatory capital measures did not always fully
capture certain risks and that none of the multiple regulators
responsible for individual markets or institutions had clear
responsibility to assess the potential effects or the build-up
of systemwide leverage.
Recent proposals to reform the U.S. financial regulatory
system include some elements that would likely improve
oversight of the financial markets and make the system more
sound, stable, and safer for consumers and investors. For
example, under proposals under the Administration and others,
new regulatory bodies would be created that would be
responsible for assessing threats that could pose systemic
risks. Our past work has clearly identified the need for a
greater focus on systemwide risks in the regulatory system.
In addition, the Administration and others are proposing to
create a new entity that would be responsible for ensuring that
consumers of financial services are adequately protected. Our
past work has found that consumers often struggled to
understand complex financial products, and the various
regulators responsible for protecting them have not always
performed effectively. As a result, the creation of a separate
consumer protection regulator is one sound way for ensuring
that consumers are better protected from unscrupulous sales
practices and inappropriate financial products.
However, our analysis indicates that additional
opportunities for further consolidating the number of Federal
regulators exist that would decrease fragmentation, reduce the
potential for differing regulatory treatment, and improve
regulatory independence. For example, the Administration's
proposal would only combine the current regulators for national
banks and thrifts into one agency while leaving the three other
depository institution regulators--the Federal Reserve, FDIC,
and the regulator for credit unions, NCUA--intact. Our work has
revealed that multiple regulators who perform similar functions
can be problematic. When multiple regulators exist, variations
in their resources and expertise can limit their effectiveness.
The need to coordinate their actions can hamper their
ability to quickly respond to market events, and institutions
engaging in regulatory arbitrage by changing regulators through
reduced scrutiny or their activities or to threaten to change
regulators in order to weaken regulatory actions against them.
Having various regulators that are funded by assessments
from the institutions they regulate can also in such regulators
become overly dependent on individual large institutions for
funding, which could compromise their independence in
overseeing such firms. As a result, we would urge the Congress
to consider additional opportunities to consolidate regulators
as it deliberates reform of our regulatory system.
Finally, regardless of any regulatory reforms that are
adopted, we urge the Congress to continue to actively monitor
the progress of such implementation and be prepared to make
legislative adjustments to ensure that any changes in the U.S.
financial regulatory system are as effective as possible. In
addition, we believe that it is important that Congress provide
for appropriate GAO oversight of any regulatory reforms to
ensure accountability and transparency in any new regulatory
system, and GAO stands ready to assist the Congress in its
oversight capacity and evaluate the progress agencies are
making implementing any changes.
Mr. Chairman and Members of the Committee, I appreciate the
opportunity to discuss these critical issues and would be happy
to respond to any questions at the appropriate time.
Chairman Dodd. Thank you very, very much. Let me thank all
of you on behalf of the Committee for your testimony and your
observations. They have been very, very helpful this afternoon.
Let me pick up on the issue of the community banks and the
issue of a single regulator, because I think this is where
maybe the most contentious political problems arise. I want to
underscore the point--I think, Gene, you made it, others may
have made it as well--that we have a lot of community banks
that are operating under Federal charters and, in fact, are
regulated at the Federal level. I think you mentioned 1,000 or
a number like that. And at a time, obviously, when they could
have easily, under the present system, decided to migrate from
that to a State charter--they may have had their own reasons
for not doing so, but the fact that so many have stayed with a
Federal regulator indicates a relatively high degree of
satisfaction in terms of how they were being handled, in the
midst of that same institution handling the Chases, the
JPMorgans, and Bank of America and other large institutions. So
you have the largest number of community banks in many ways
maintaining a regulatory structure where there is duality. But
it is of concern, and I think we need to address it in ways
that are practical.
There have been some suggestions, something along this
line, and I would like to maybe get a little more in the weeds
on this. How do you envision, if we had a single regulator, a
division within that regulator to be able to handle the
concerns of the community banks, particularly ones that would
be State chartered, how they would handle that in a way that
would give them some degree of satisfaction that they are not
going to be lumped together in a way that would diminish their
capacity to be able to function and get lost in the shuffle?
How do you do that?
I would ask all of you, and if you have got any ideas on
that, I would be interested in your thoughts.
Mr. Ludwig. Well, Mr. Chairman, I think that it is
important for the new regulatory agency to have departments
that are specialized in dealing with institutions of a
particular size. The Comptroller's office currently has three
segments: one deals with small banks, one midsized, one large.
I think that there are specialized techniques, ability to
simplify supervision for community banks, and I think it is
important.
In that regard, I think the same kind of sensitivity to
small bank supervision can be found both at the Federal Reserve
and the FDIC. Remember, the only thing that one would do in
terms of this new agency would be to move the Federal component
of the supervisory authority to the new agency. It would not
change the component. But I think one can have a separate
division that focuses on simplifying it. I think that Congress,
in writing these rules itself, ought to mandate that simplified
treatment--that one of the responsibilities of the new agency
is to reduce burden wherever possible, particularly in terms of
community and regional financial institutions.
Chairman Dodd. Dr. Baily.
Mr. Baily. Yes, I agree very much with what Gene said. I
think that can be handled within a single regulator. The
Federal Reserve currently supervises the bank holding
companies, and you think of them as the big ones. But,
actually, some of them are pretty small. They have got quite a
range. So they have been supervising both big and small banks.
So I think it is certainly possible to have a separate
division within the prudential regulator that looks to the
needs of community banks, and I think it is very important that
small banks not be overburdened with regulation. One wants
different requirements, perhaps, different capital requirements
for a bank that has large overseas operations, subsidiaries.
That has become--it seems too big to fail, although I hope we
can overcome that problem. The needs there are very different
than the community banks, and I think that should be part of
the legislation taking account of that.
Chairman Dodd. I should have asked this of Gene as well. In
your examination of global examples, you mentioned Australia
and Canada, and I do not know this, so I apologize for my
ignorance on this. I do not know what the Australian banking
system looks like. Is there duality there at all? Or is this
all one system? Is there any place you looked at that has a
comparable duality of systems that would----
Mr. Baily. Well, there certainly are countries that have
small banks. Germany has a lot of small banks, actually many of
them State-owned banks that ended up buying quite a bit of CDOs
as a matter of fact. So they did not always make good
decisions.
Typically, in Canada, you have some small banks, but really
the market is dominated by about five or half a dozen very
large banks. So I do not think they are quite comparable to the
U.S., which, as you say, or somebody said earlier, grew up
because of geographical limitations.
I do not know whether you want to add to it.
Chairman Dodd. Do you have anything on that, Gene?
Mr. Ludwig. First, Canada does have a Federal system, and
there are some smaller institutions. But there is no place on
Earth that really quite has the number of commercial banking
institutions that we do.
Having said that, the point is well taken that Germany does
have a good many landesbanks, and I think a survey of the world
would reveal other consolidated supervisory mechanisms that
deal with small banks and large banks and do it effectively.
And I think Canada is probably a pretty good example, actually,
though they are not as numerous.
Chairman Dodd. Well, Germany is sort of the antithesis of
ours. That is a highly decentralized system in many ways in
Germany.
Dr. Carnell.
Mr. Carnell. Yes, three things. First, Secretary Bentsen's
legislative proposal included a statutory requirement
establishing a community banking division within the agency
seeking to institutionalize a sensitivity to the ways community
banks are different and the ways they should not be treated
just the same as larger institutions.
And I think--and this is my second point--that something
like that, even though in a sense it is just an outline of an
idea, it sends a signal that Congress cares about it, that it
is something that needs to be done. I think that is a signal
that the agency will clearly hear.
And then, third, in any event the new agency would have
every incentive to foster a healthy community banking system.
The agency has no reason to favor large over small, and there
are advantages to the agency when bankers come in, for example,
to talk to Members of Congress, that people are having a
positive experience with the new agency.
So there is absolutely no reason for the regulator to hold
back from doing the best job it can. There is no reason why a
unified regulator would do any less of a good job than what we
see now where an agency like the OCC regulates from the largest
banks down to some of the smallest.
Finally, you mentioned duality, and in case you were asking
about a dual banking system, that is not something that you see
abroad. That is, to my knowledge, a quirk of U.S. regulation
having to do basically with some developments in the 1860s and
1870s.
Chairman Dodd. Thank you very much.
Mr. Hillman.
Mr. Hillman. There clearly are ways to provide a voice for
State banks or community banks and still achieve great
consolidation of the banking regulatory structure. I agree with
Rick that one of the ways in which you could achieve that would
be to establish a division within that prudential regulator to
serve the needs of community and State member institutions.
Another way of achieving that goal would also be, like the
FDIC currently has with its board structure, to ensure that
membership of that board might include members that have a
background or might have been a prior community banker in the
past. That would give that regulator the opportunity to have
that voice heard at the highest levels of the institution.
Chairman Dodd. Good idea. Good suggestion.
Senator Corker.
Senator Corker. Thank you, Mr. Chairman, and I thank each
of you for your testimony. I know Gene and Marty we have talked
with--a great deal about this and certainly appreciate the two
of you coming in.
I am going to ask some questions that do not necessarily
reflect my point of view but just to probe. I am open on all of
these issues and am still, like many Members on this Committee,
trying to figure out what is the best route or have you all
propose something, and maybe a hybrid of that is best, who
knows? But hopefully we will get to that--I know we will--
before we regulate.
You mentioned the issue of having an alphabet soup of
people coming to talk to us, and it is not unlike having
witnesses come before our Committee with differing points of
views in many ways. I have to tell you, I have enjoyed that.
Each of the regulators, sometimes gleefully, sometimes not,
points out the deficiencies of the other regulator. And I have
to tell you, there is some merit in that. Just for what it is
worth, you know, to have a captive regulator, much like we have
with the GSEs, which would be the case with all banks, to me,
could be very problematic. I think having feet on the ground
sometimes gives you a sense--I know in my business it was very
important to be in various States where we were building. As
Senators, we go back home to our States to not be
Washingtonized, and there is just some benefit of having feet
on the ground, as the FDIC has argued and as the Fed has
argued.
And then the OCC to me is the most procyclical--which what
we are talking about is a super OCC. Let us face it. They are
the most procyclical organization that we have. They move
quickly in a direction that creates bubbles, and now they are
out throughout the country. Anybody that has got a commercial
real estate loan or anything like it is being criticized, and
so they are creating, I think strongly creating a self-
fulfilling prophecy.
So I would love to hear your comments about the RUBs being
helpful in some cases and the competition being helpful, but
also what would be in this to keep the OCC--super OCC, if you
will--from being so procyclical as they are now.
Mr. Ludwig. Well, Senator, a couple of comments. I agree
with your comment that if one were to homogenize the entire
regulatory system down to one, there would be something that
would be lost. But we are not homogenizing it down to one.
First, the FDIC itself has back-up supervisory authority,
which means the FDIC would have on-site continued
responsibilities.
Second, as I mentioned, both the FDIC and the Fed would
have serious information gathering and review authorities.
Senator Corker. But that does not happen now. I mean, they
do not share information now. I know you said we could put that
in law, but that is problematic.
Mr. Ludwig. Well, I am not honestly sure that is the case.
There are certainly claims that that is the case. If it is the
case, it is heart-stopping because in the midst of this crisis,
one would assume that the information the Fed and the FDIC and
other agencies need to do the job would be forthcoming or they
would be squawking, I mean big time, to you and others.
In addition, we are talking about a systemic regulator.
There is the SEC, the CFTC, FINRA. There are all these other
agencies, and in terms of giving you the kind of diversity you
need to hear other points of view, you will still have the 50
State bank supervisors that can be called up. So you get quite
a--even with a simplified Federal regulatory mechanism, you get
quite a cacophony of other voices that I think is available.
As to your comment on procyclicality, I think that there is
the nature of all regulators, and I think that actually if you
looked at all the agencies, both at the Federal and State
level, you would find that in times of stress they become
tougher. You see the calls at the G-20 and others for more
capital right now, sort of in a crisis.
Senator Corker. Which creates a bigger crisis.
Mr. Ludwig. Which has a tendency to be procyclical, which
is not desirable. The Spanish had it right in terms of their--
through their cycle provisioning and through their cycle
capital rules, which I am very hopeful that will be adopted in
this country.
But I do not think that is limited just to the OCC. It is
something, I agree with you, that deserves criticism because an
evenhanded effort and a push to an evenhanded effort is highly
desirable.
Senator Corker. And let me just--I know my time is about
up. The clock must have been on 2 minutes today.
Chairman Dodd. Your questions are so eloquent.
Senator Corker. OK. There you go.
If you would--and I know Marty is getting--and this is my
last, just to advance this a little bit, the procyclical piece
to me is a huge problem that you do not necessarily create by
your formula, but it is something that has not served us well.
The same thing happens in 1990 and 1991, and we just do a
really poor job of it.
There is nothing in your proposal that, for instance,
changes--I mean, much of this is about rearranging the deck
chairs and just getting different people--it is almost a family
squabble. We sometimes refer to the insurance industry's issue
the same way. But what they do is also very important, and, you
know, the--for instance, the counterparty risk, I mean, is
this--is there anything about any of this that changes their
ability to really look to those deficiencies that really are
the heart of the problem here, that really are causing us right
now to be doing what we are doing? And, Marty, you may answer
that, and I will stop.
Mr. Baily. Well, I agree with you very much, Senator, that
simply creating a single prudential regulator is not going to
solve all our problems. The deficiencies of our system are
greater than that, and there were a lot of private failures. We
need to try to improve private incentives so that people do not
get to play with other people's money and they take on the risk
if the risk is there.
So I agree with you completely. This is not by any means
going to solve all our problems. I think it does help, though,
because it allows for the kind of consolidated regulation that
can, if necessary, stand up to the big banks and make sure that
they are following the right rules. It can respond, it has got
the resources and the stature to respond to innovation because
one of the problems with regulation is you are always sort of
one step behind what the private market is trying to do. And we
want to encourage that innovation, but at the same time, we do
not want it to be in the direction of making things less safe.
So on the procyclicality side, we need to get rid of that.
First of all, I think we need higher capital requirements so
that in good times there is plenty of capital, and in bad times
we can sort of cushion that shock. So that needs to be part of
the reform, too, is how we deal with cyclicality, and there are
some proposals there for so-called ``contingent capital'' or
``convertible capital'' that allow you to do that. So I think
that should be an important part of the regulatory changes.
I just think also on the diversity of views, the way I
would put it is that we need to make sure that our prudential
regulator is accountable. I mean, there are a lot of people--
again, I do not want to impugn anybody in particular, but some
regulators made some very bad decisions in this process. And,
you know, do they still have jobs? Maybe they should not.
We need to set up this structure in a way that preserves
accountability whether it is a single prudential regulator or
more than one.
Mr. Carnell. Mr. Chairman, could I just add two quick
points here?
Chairman Dodd. Yes, certainly.
Mr. Carnell. First, that the agency, Senator Corker, would
incorporate a diversity of views because under what I am
proposing it would have the Fed and the FDIC on its board. They
would share in making policy. But even so, they are likely to
have some disagreement with what comes out, and they will let
you know about the disagreement. You would have more diversity
within such a board than you would at most any independent
agency and the rest of the Government.
Second, it is key in preventing crisis to look ahead and
fix the roof while the sky is still blue, not to wait until the
thunderstorm is brewing up.
Now, as for being procyclical--and I am building on that
point--the Federal Reserve has actually tried to get rid of one
of the existing two capital standards: the leverage limit. It
has tried at least twice in the past 15 years. The existing
capital standards were set in 1986 and 1992. We had years of
enormous, unprecedented prosperity, record profits, and nothing
was done to raise capital standards that had been set as the
second best during a crisis.
So I think the existing system, including the Fed's role in
it, does not look good at all there.
Senator Corker. Chairman Dodd, Senator Warner and I had a
summit last night down at Johnny's Half Shell, and----
Chairman Dodd. Why weren't we invited?
Senator Corker. This whole issue, I think, of leverage is
one that certainly we need to look at. You know, we actually
urge people in this country to use leverage, but we penalize
equity. And I hope that as we move through this, that is
something that we will look at more closely.
I am sorry to take so much time.
Chairman Dodd. Not at all.
Senator Reed.
Senator Reed. Thank you, Mr. Chairman. Thank you,
gentlemen, very much for your testimony.
It seems that you are coalescing around the advice of the
single consolidated regulator, and I just want to understand
what the landscape will look like afterwards in simple terms.
There will be essentially two banking regulators--the FDIC
and the Federal regulator. Is that your approach, Mr. Ludwig,
focused on----
Mr. Ludwig. Well, first there would be an----
Senator Reed. No, I know the SEC is there and other things.
Mr. Ludwig. But in terms of bank lending, you would have a
highly professionalized institutional regulator, and to Senator
Corker's concerns about procyclicality and also--I do not think
it would be a super OCC.
One of the problems with the current alphabet soup is
nobody is large enough, professional enough that there is
really the kind of study, focus, or stature for these
supervisors to be able to go head to head adequately on things
like derivatives, emerging new capital structures, et cetera.
So I think that you would have two that would be at the
Federal level close to supervision, but the Federal Reserve by
nature, with its information gathering, study, and concern
would be actively involved in thinking about these issues and
prescribing solutions. And the new systemic council or systemic
enterprise would also be very much a backstop to the banking
supervision, as it would be a backstop to other regulatory
issues throughout the Federal and State systems.
Senator Reed. Well, let me just take a step further and
focus on the point that Professor Baily made about the top-to-
bottom bank holding company regulation. Would that be the
Federal Reserve, or would that be the new----
Mr. Ludwig. Oh, no, that absolutely has to be the new
institutional supervisor. The notion, the stopping at the
border, I think Mr. Baily said it really quite eloquently.
Stopping at the border is absolutely pernicious, because if you
have an examination issue and you really want to follow that
through, you cannot basically have a situation where it
migrates to another enterprise and the investigator cannot get
to it, cannot see it, cannot enforce it. It must be holistic.
Senator Reed. No, I accept that, but typically bank holding
companies today are deposit-taking institutions, investment
banks, proprietary traders, wealth management, et cetera. SEC
has a responsibility, the CFTC. So just give me an idea of how
this new Federal regulator who has got top-to-bottom
responsibilities interacts with SEC, CFTC, and everybody else.
That would have to be done, correct?
Mr. Ludwig. Yes, it would, and to the point that there
would not only be one. It would have the ability to investigate
in detail and would have the responsibility to be an expert in
all the financial issues that are important to the institution.
But it would have, if you will, a colook, a coexamination,
coconcerns from these other agencies.
Senator Reed. You know, it goes to the point that was made,
which is that when everyone is in charge, who is in charge? And
we saw that so many times.
Mr. Ludwig. But it would be primarily in charge, Senator.
Senator Reed. So it would be very clear that this regulator
would be the primary regulator of all these functions, even if
they feel under the range of CFTC or SEC.
Mr. Ludwig. In my view, yes.
Senator Reed. OK.
Mr. Baily. Yes, in my view, also.
Now, I do think the systemic regulator, whether it is a
council or whether it is the Federal Reserve--I think myself I
would prefer it to be the Federal Reserve, but whichever--does
have, I think, the need to look across our whole financial
sector because the prudential regulator is basically saying, Is
this institution safe and sound? And we then have a consumer
protection agency that is saying, ``Is it behaving itself with
respect to the consumer?'' But we need to have a systemic
regulator that says, ``Do we have within our financial system a
buildup of risky assets? Are we seeing a huge rise in risks
being taken?''
Paul Volcker remarked that one of the clearest signs that a
financial institution was going to get into trouble was that it
was building a fancy new headquarters.
So I think, you know, if you see somebody making lots of
money doing something that--that may be because they are very
good, or it may be because they are taking a lot of risk.
Senator Reed. Just a quick question. The FDIC is supported
by its own fundraising activities, to put it mildly. One of our
problems, frankly, is that we have underresourced at critical
moments our bank regulators, our SEC. It goes to the point that
you have all made. Where is the expertise? Where are the
computer systems? How can you keep up with five Ph.D.s when you
are, you know, a recent law school graduate?
So should we have this agency dedicated funding, not
through the appropriations process?
Mr. Ludwig. It should be dedicated funding by the industry.
I do not think it needs to cost the taxpayer a nickel, and it
ought to have, as is true today with the Federal Reserve,
plenty of deep pockets to be able to do its job correctly.
Senator Reed. If I may, one final question. We have talked
about one Federal regulator for Federal institutions. Should
there be one Federal charter? Should we eliminate the Federal
thrift charter, the Federal savings bank charter, et cetera?
Mr. Ludwig. I do not think you need to do that. I think the
issue of the Federal thrift charter is an issue that is
fundamentally steeped in the housing policy of the United
States. That is, do we want to foster housing as a special
goal. That decision need not be made if you have a single
consolidated institutional supervisor.
Senator Reed. Thank you, gentlemen.
Mr. Baily. My inclination might be to create a single
charter for these Federal institutions. I do not think I will
fall on my sword on that one, but that would be my inclination.
And to go back to Senator Corker's point, we do have a lot
of provisions in our tax law and our laws to promote
homeownership, and I think that is a good idea. I think
homeownership is a good thing. But as part of that, we also
promote borrowing. I mean, we really do, and maybe we have gone
too far in that direction.
Senator Reed. Just one final point. Professor Baily, you
made, I think, a very cute observation. Most of the decisions
where to stick these functions were a function of regulatory
preference and tax law. And as we sort of look at reforming our
regulatory system, I do not think we can be sort of oblivious
to tax provisions that----
Mr. Baily. Absolutely.
Senator Reed. ----can form behavior more than our
regulators. And as we go forward systematically, I think we
really have to look at the Tax Code as well as the Federal
regulations and Federal banking law.
Mr. Baily. Absolutely.
Chairman Dodd. That is very good. And good suggestions, by
the way.
Senator Warner.
Senator Warner. Thank you, Mr. Chairman. I appreciate the
panel. It is a little challenging. You have raised a lot of the
issues I was hoping to. I guess that is the challenge of being
far down the table here. But I will try to re-ask the same
questions perhaps.
As somebody who has been an advocate, as I think some of
the panel knows, of a single end-to-end regulator, you know, I
want to go back to what the Chairman raised around some of the,
I think, legitimate concerns that the community banks and
smaller banks have offered, and I would be happy to have any
member of the panel comment on this.
I do think there is--the notion of a separate division
makes some sense, but in any large organization is not the bias
going to be toward the larger institutions? Is the best
personnel going to want to seek out serving the larger
institutions? And could you--what other protections could we
ensure to make sure that the smaller banks do not get the short
end of the stick? And I believe a couple of you mentioned--
Martin, you mentioned as well that you could have different
regulatory standards. And I guess I would like you to touch a
little bit on that. How do we make sure that if we were to go
with the single end-to-end regulator you would not be imposing
the same overly burdensome set of regulations on a very small
community-based bank that you might be on a major bank holding
company?
Mr. Ludwig. First, I would say----
Mr. Baily. Go ahead.
Mr. Ludwig. Oh, I am sorry, Martin.
Mr. Baily. No, no. Go ahead. No, please, you start, and it
gives me more time to think.
Mr. Ludwig. First, I would say, Senator, that I do think
that it makes sense to enact protections so that community
banks--one, it is a comfort that they are protected in terms of
having a simplified, specialized regulatory approach that best
suits their needs.
Having said that, my own experience at the OCC, where there
are--in my day, I think over 2,000 community banks. It may be
actually true today. I used the word a thousand--is that you do
have the quality people at the agency devoting their attention
to the community banking sector. Indeed, one of the advantages
of having a consolidated regulator is, as people come up, you
have similar talent available for both sides of the aisle, and
you find--today, for example, the gentleman in charge of small
bank supervision at the OCC was a large bank supervisor during
his time, and he is one of the most talented people there. I
think you will find that interplay.
The danger, I think, works the other way, that if you
separate the two, you will only have second-class supervisors
at the smaller institutions as opposed to having the cross-
fertilization you do with the larger institutions.
The other thing I think worth pointing out is just because
you are smaller or larger does not necessarily mean you are
more complex or less complex. Some of the smaller institutions
by choice get involved in fairly complex issues, and there is
going to be a tendency as we go into the future, because of the
Internet, because of technology, because of the structured
products available, that smaller institutions will indeed get
involved with these more complex activities, and the supervisor
not only needs to supervise that adequately, A, but it also
needs to have the sophistication to help the small bank with
these products. I think it is perfect doable, and I think you
will just have a higher-quality supervision generally.
One cannot also overstate in this whole discussion the
pernicious nature of regulatory arbitrage. I know that is not
your question. But both having----
Senator Warner. That was my next question.
Mr. Ludwig. As a supervisor, whether it is your examiners
that get threatened by the offhand, intended remark of some bad
actor banks saying, look, we do not have to put up with this,
we can move to another regulator, and how that--even if you are
being tough at headquarters to do the right thing, how that can
degrade the quality of supervision generally. That is not just
theoretical, but if you have to do it every day, it is real.
Senator Warner. Before Marty answers, I do think that is a
valid point, that we sometimes look at the arbitrage in terms
of banks that have actually switched charters and some of those
that were very much engaged in the crisis, but I think that is
a very important point you raised, that if simply the implied
threat of switching may end up utilizing that regulatory
arbitrage and consequently not having the----
Mr. Ludwig. When I was Comptroller, Senator, I had bankers
in my office when they were unhappy threaten me, and my
examiners, I know, had to live it in the field during their
time, and I think most folks who have experienced that would
have that, and that is really--it degrades the quality of
supervision.
Mr. Baily. I would like to reinforce that view, and I think
it is why--you know, in general, I am a big fan of competition
as a means of making things more efficient and creating
diversity, but competition among regulators can have this
downside of regulatory arbitrage.
Let me comment on the point about maybe different
requirements. You know, Senator Dodd mentioned that it may be
difficult politically. That shouldn't govern what decision is
made. It may be difficult politically to do consolidation, so I
think one thing that needs to be sure to be in the legislation
is that we satisfy the community banks that we are looking
after them, because otherwise, there is going to be a lot of
resistance to this legislation.
And obviously, as individuals, we all like the devil we
know, so to speak, and people want to hold on to the regulator
they have, and that is another reason they are resistant to
this consolidation. So I think it is very important that we
carve out for the community banks a sense that they will be
looked after, they won't be subject to burdensome regulations.
On the other end of the scale, for the----
Senator Warner. Can you speak to that for a moment?
Mr. Baily. Yes----
Senator Warner. I know my time is running out, but just how
could we put in place, or what kind of guidelines so that you
wouldn't perhaps have the same level of burdensome regulation
for a small community bank versus a major bank holding company?
Mr. Baily. Well, I think I would defer to my colleagues on
the details. The part of it that I think I would like to
comment on is the capital requirements. I actually don't like
the idea of designating Tier 1 institutions. I don't like the
idea of trying to cap the size of institutions. But clearly, we
need to do something so that we don't end up bailing out these
great big institutions.
So having a sort of sliding scale, that the bigger you are
or the more interconnected you are or depending on the kind of
activity you do, that the capital requirements and potentially
the extent of supervision--how often, the nature, the
information you have to report, how frequently you have to
report it--those kinds of things could increase as an
institution becomes larger or more important to the system, and
I think that is also a way of taking some of the burden off of
the community banks.
Mr. Ludwig. If I might, Senator, I would reserve the right
to come back to the Committee with a list of suggestions,
because I come from a small town myself, and I am a huge
believer in community banks. I think it is one of the great
benefits here in the United States, one of the great forces for
good and innovation, and I think the consolidated supervisor at
the end of the day will do more to support community banking
than the current system.
Senator Warner. And it may even get down to not simply
capital requirements, but literally forms and volume of forms
they have to----
Mr. Ludwig. Right. Right.
Senator Warner. I know my time is expiring. One final
point, Mr. Chairman. I won't ask the question, but I just want
to follow up on Senator Reed's comments, and again, it is part
of what the panel has made mention of. When we have seen these
kind of closed doors take place that you have had before this
panel, clearly the most visible example of that with the
enormous scandal of Mr. Madoff and the fact that regulators
were not able to go beyond their prescribed jurisdiction, and
that clearly--thank goodness we have not had that same kind of
travesty take place in the banking system, but this fact that
we have got one focus looking at the bank holding company
level, another looking at the bank depository piece, could
create that same kind of--and as Senator Reed mentioned, the
securities piece--failing to have that single end-to-end
regulator that can look at the whole bank holding company and
all of its operations would prevent that.
Chairman Dodd. Let me just, before I turn to Senator
Merkley, it is a related question. Maybe Mark asked this in a
way. Maybe he addressed it when I stepped out for a second, and
that is on the issue of assessments, for instance. I don't know
if you raised that or not, but do you see some? Because,
clearly, if I am sitting back as a community banker, I am
going, well, wait, yes, it is nice to have the division in all
of this, but am I going to be assessed? I presume you wouldn't
be, but I wonder if you would address that question, because
clearly it is one of the concerns I would have. Could you
address the issue of assessments?
Mr. Baily. I think you must have a system that is
countercyclical, while our current system is procyclical, and
one that doesn't penalize the best community banks, which the
current system does, and pay for the sins of the bad ones. So
the system of assessments that funds this agency has to be one
that takes into account not increasing the assessment for
community banks and certainly not increasing the assessment for
any banks in the storm, and I think that is achievable in terms
of the way the institution is funded.
Chairman Dodd. Legislatively, in some way, though, right?
Mr. Baily. Yes, sir. So, for example, the reserves on
deposit at the Fed are currently used to fund the Federal
Reserve's regulatory activities, I believe. One could use the
reserves similarly to fund the regulatory activities of the new
consolidated supervisor, if that was Congress's predilection,
or part of it could be used to make sure that the community
banks had a particularly fair opportunity to pay what was
appropriate for them. I think there is a lot of plasticity in
the way one could construct this to be fair and countercyclical
in terms of the funding mechanism.
Chairman Dodd. Thank you very much.
Senator Merkley.
Senator Merkley. Thank you very much, Mr. Chair, and thank
you all for your testimony.
When Mr. Bernanke was before us, he made an argument that
the Fed should be the principal entity both for monetary
policy, prudential policy, consumer policy, and systemic risk--
everything----
[Laughter.]
Senator Merkley. and I raised my concern that some of these
would be in conflict with each other and he made the best case
he could that they fit very well together.
I think the article that was in the Washington Post on
Sunday that pointed out some of the failure to address consumer
issues over a significant period of time in many ways goes to
my concerns. I believe that what I am hearing from you all is
summed up in part by what is in the GAO report, that the twin
peaks model is viewed as advantageous by some because the two
principle objectives of financial regulation, systemic
protection and consumer protection, are fundamentally in
conflict, and putting these objectives in different agencies
institutionalizes the distinction and ensures that each agency
focuses on a particular objective. It goes on. But does that
fundamentally underlie the perspective that all four of you are
bringing to the table?
Mr. Baily. Well, I think--I am an admirer of Ben Bernanke.
I am not a close friend of his, but I have known him for a long
time and I admire the way he handled this crisis. As I said in
my testimony, I don't think the Fed--I am also an admirer of
Alan Greenspan, who is a friend of mine, and I don't think--
leading up to this crisis, I think they made some very
substantial mistakes when they didn't give enough consumer
protection and they didn't react to some of the bad lending
that was going on. So I think there were certainly a lot of
mistakes that were made prior to this crisis that would have
mitigated it.
So, you know, I understand why, obviously, the Fed wants to
hold on to the authorities it has, but I think what we are
suggesting is that you take away the prudential regulation
part, because that may be in conflict. You make sure that it
still has access to the information it needs, but it is no
longer the prudential regulator.
I think the thing that the Federal Reserve has done well is
monetary policy, not that they haven't made any mistakes, but
if you look over the last, oh, 20, 30 years, I think they have
done a good job, and typically when you pick people to serve on
the Fed, you tend to pick economists or people with expertise
in monetary policy, and that is the thing they should do, and I
think they should also, since monetary policy is key to the
stability of the economy, I think they should also be concerned
with systemic stability.
But I don't see why--they certainly haven't done a great
job on prudential regulation and I don't see--what is the point
of the Chairman of the Federal Reserve sitting around worrying
about details of credit card regulation? That is what he is
doing right now, and I think that is a mistake and not a good
use of his time.
Senator Merkley. Does anyone else want to comment?
Mr. Carnell. Yes. A couple of things, Senator Merkley, if I
could. First, the Federal Reserve argument that it needs to be
a primary Federal bank regulator to do its monetary policy
responsibilities are just not credible, based on facts at
several levels. First, right now, the Federal Reserve only has
supervisory responsibility for 13 percent of FDIC-insured
assets and 10 percent of FDIC-insured institutions, so it is
not a significant proportion at all.
And then on top of that, our whole commercial banking
system only accounts for 18 percent of credit market assets.
Gone are the days when banks held 50 percent of those assets,
as would have been true when I was born. There is just a big
change in the growth of other financial markets and it is just
out of touch with reality for someone to suggest that that Fed
connection to being a primary Federal bank regulator is
essential.
Senator Merkley. I want to get into some other questions
before I run out of time here, but Mr. Carnell, to follow up,
you made a comment in regard to bank holding companies, that
they exist to allow banks to get into businesses that are, and
I am not sure if I caught this quite right, but incompatible
with banking or very distinct from banking. Should we be
eliminating bank holding companies? I mean, do they serve a--
what purpose do they serve----
Mr. Carnell. Well, just so----
Senator Merkley. ----more risk than value?
Mr. Carnell. I don't think we need to eliminate them, but I
do think our system has put much too much emphasis on them. I
think our focus in banking policy should be on what can banks
do and how should they go about doing it.
I wouldn't want to leave the impression that bank holding
companies had this role as letting do something nefarious. I
mean, we are talking about things like opening an office in the
next county, opening a bank in the next State. These were
things that restrictive laws of 50 years ago didn't allow. And
then getting into nonbanking activities, many of which are not
allowed in the bank or Congress has passed a law saying they
could be in the same corporate family.
So it is not that the activities were inherently
problematic, but it is that we have this enormous growth of
holding company regulation that is really unrelated to any real
need other than the fact that we sort of built it up in these
loophole-based ways.
Mr. Ludwig. If I might, Senator, go a little farther, I
would say that the comment--I forget whether it was Senator
Corker or someone made, that, in fact, what happens when you
have to make a decision at the corporate level, you ultimately
decide what box to put it in for capital reasons or tax
reasons, et cetera, and what happens then at the supervisory
level--so I find something wrong in the bank. I can't go to
that other entity. That other entity is not being supervised,
and in fact, if you look at this current debacle, a great deal
of the problem in the larger financial institutions was not in
the technical bank. The bank was infected by it. It was
actually in the nonbank affiliates that were hard to get to and
it was hard to look at the animal as a whole. And if you are
really going to be an effective supervisor--after all,
everybody has the same interest, a healthier institution--you
have got to do the whole piece.
Senator Merkley. Thank you all. I am over my time. I will
just close by echoing concerns about the community banks and
also about our credit union system, where they have rules that
have constrained their risk, not using prepayment penalties,
having interest rate caps, and so forth. They are a little
nervous about being rolled into a system with an unfamiliar
regulator and perhaps paying fees disproportionate to the risk
they impose on the system, and so our community banks and our
credit unions may--are a little disturbed that they might not
have been so much of the problem but may get rolled into a
disadvantageous set of rules, and so of great interest. Thank
you.
Chairman Dodd. One of these things that is going to be
important for us, this is not being punitive. I think that is
one of the things we are getting into, this notion that because
some have been good actors and bad actors, I think we have some
history of that. So I think it is really important as we look
at all of this, this is not to punish some or discipline some,
but rather to try to think in 21st century architectural terms.
How do we create an architecture and a structure that makes
sense in all of this?
And the only thing I was getting at on the assessment
issue, because I think putting aside the question of who was
responsible for what, just given the magnitude and size and
complexity of institutions, I mean, the idea that you would
level sort of the same assessments across the board because you
have one regulator, to me would be offensive. I mean, you have
got to clearly make some distinguishing features. But I hope we
can stay away from the punitive quality here as we look at all
of this.
We can go back and examine, how did we get here and what we
are trying to do, and I think all of us agree that, in part, it
was this patchwork out there that contributed, certainly, among
other things. It is not the only thing. I think somebody made
that point, that there are a lot of issues we need to look at.
This is one of one.
And it isn't going to solve everything, either. I think Bob
Corker made the point, and I agree with him on this, is the
assumption that if you solve this, you would solve the problem,
I think would be false.
But clearly I want to get away--because I think you can see
that developing, that argument that somehow we are laying--we
are blaming institutions by putting them in this. That is not
the argument at all. The question is whether or not this makes
sense.
Let me raise one other question I have for you, and then I
will see if anyone has interest in a second round. I wonder if
you agree with the Administration's proposal regarding the
systemically important financial companies that have a parent
or significant affiliate engaged in commercial activities,
whether they should be regulated as a bank holding company and
forced to divest commercial activities. This is a big issue
that is going to be before us. It sort of follows on with
Jeff's question, I think, that he raised. Does anyone want to
jump into this one? Professor, you sound like you have got some
strong views on this, so----
Mr. Carnell. I do. I think this is a very troublesome
aspect of the Administration's proposal. I should emphasize
that I am troubled mainly on its use of political capital. I
don't know that--I don't think the substantive stakes are very
large here. I will make that more clear in a moment.
Go back to the point I made earlier about how bank holding
company regulation as a really big deal is unique to the United
States. It is a historical quirk of our system. It is something
the Federal Reserve got hold of in a context where the
Congressional objectives were completely different from what we
have now and the Fed was able to expand its authority and make
it into a very big deal.
Let me actually just make that a bit more clear. The bank
holding--there is something in my written statement about this,
but the Bank Holding Company Act was passed in 1956 in a
populist effort to limit bigness and also to split up some
affiliations, like Bank of America and TransAmerica were
affiliated at the time. But basically we had--Chairman Wright
Patman of the House Banking Committee believed that everything
was too big, including $100 million banks, and so he responded
with the Bank Holding Company Act. He got trade association
support for people who were concerned about banks getting into
their business.
We are not talking about something that was a safety and
soundness statute in its origin. It was a kind of populist
antimonopoly statute in its origin. We see safety and soundness
come in as a criterion in 1970 as a basis for exceptions on
some things. But this was not originally a safety and soundness
statute. It was not a statute relating to bank policy. And yet
it becomes what my old boss, Jerry Hawk, Under Secretary of the
Treasury, said, a matter of theology, where there are people
invested in a certain kind of outcome here.
And so what they are wanting to do, then, is to conform the
existing nonfinancial owners of financial institutions to sort
of a very pure version of how they would like things to come
out. Now, in fact, nonfinancial institution ownership has saved
the taxpayers money. Ford Motor Company put about $1 billion,
as I recall, into a thrift institution that had acquired
trouble. So there has been positive results. I don't think
there have been significant negative results. And this
ownership, like General Electric and so forth, was not a source
of the current crisis.
So the idea of making a big deal out of this is sort of
like, as we have seen from some quarters, is sort of like
trying to protect us from the Mexican mafia by building a wall
on the Canadian border. It is just not related to the major
problems.
Chairman Dodd. Well, thank you for that observation. I want
to make the point, I just mentioned to Senator Merkley as he
was walking out, I heard him say credit unions. Credit unions
are not part of this consideration at all. We are talking about
banks. And before we start getting inundated with e-mails and
messages from across the country, credit unions, you are OK on
this.
[Laughter.]
Chairman Dodd. Let the word go forth from all of this.
Senator Corker, any----
Senator Corker. No. I think you have just given evidence as
to where the real political clout is.
[Laughter.]
Senator Corker. I referred earlier to sot of a super-OCC,
and I realize it is sort of that, what you are proposing. As we
have looked at the resolution mechanisms that need to be in
place so that we don't have the same kind of problem, I think
we all understand part of the reason we had the problems we had
was there was no resolution mechanism for highly complex bank
holding entities and one of the only solutions was to prop them
up artificially.
So the OCC has argued strongly to keep in place the ability
to use taxpayer monies to prop up institutions that fail. The
FDIC, on the other hand, has argued strongly against that. I
happen to have fallen on their side of the equation and think
that having any institution that is too big to fail creates
tremendous problems, and I really appreciate what Paul Volcker
has said about that recently.
But hand-in-hand with this is the notion of how we
resolve--in other words, we have the regulator--how we resolve
that. You all have already made a great case for this type of
arrangement that you want to have. I don't think there is any
point in going down that path anymore. I understand what it is
you would like to see happen. But what should we do as a it
relates to a resolution mechanism and how should that be set
up?
Mr. Ludwig. Well, Senator Corker, I couldn't agree with you
more that resolving the largest institutions is a critical
issue and I am not in favor of propping them up. That is, if we
don't resolve them, we basically create two problems. One is we
have public utilities if we don't have an ability to resolve
them. And we also disadvantage the community and regional
institutions.
Rather, this whole structure ought to be one that creates
sufficient stability and focuses in a professional way on
proper supervision so as to minimize burden and increase the
ability of all these institutions to support the economy of the
United States. And where one of these institutions is not doing
its job correctly and it gets into problems, we have to have a
private sector component here--this is really a private sector
activity--where it fails, and we have to have the ability to
fail it without creating a systemic crisis. If we don't have
that, I think we also have the danger that these largest
institutions end up controlling the economy and the
Governmental mechanism, not vice-versa.
Mr. Baily. Can I throw in a comment? I think Gene is
absolutely right and you are right. We don't want to have
institutions that are too big to fail. We want to be able to
have a mechanism by which they can go bankrupt when they make
bad decisions. Otherwise, this is not a good system at all. But
realistically, I mean, if an airline goes into bankruptcy, you
can still have the planes fly, or if a railroad goes into
bankruptcy, you can still have the trains go on the tracks. The
trouble with a financial institution is that it may get to a
certain point where it really can't function without some kind
of funding or some kind of support to keep it going.
Now, to some extent, that was the justification for giving
money to General Motors. You needed money for the suppliers,
and I don't want to get into that case which I don't know the
ins and outs of.
But clearly, we need a mechanism, whether it is a
bankruptcy or a resolution mechanism, that has a certain amount
of money available to make sure that you don't just close the
doors and people can't get at their money. Now, what is in the
Treasury proposal is a sort of open-ended checkbook that
somebody can write a check for any amount to prop up an
institution. So I think that is--I don't agree with that. I
think that Treasury proposal is too open-ended, and I think the
House and the Senate need to make sure taxpayers are protected
and that they have a control over the purse.
But I don't think we can, at the same time, just say, no,
we are never going to put taxpayer money in again, because the
fact of the matter is we will come into another financial
crisis and we will end up putting in a lot of money, and it is
better to have a resolution mechanism or a special bankruptcy
court that has the resources to let this thing down gently,
although letting it down.
Mr. Carnell. Senator, be wary of anyone who puts a lot of
stress on the notion that we need a new resolution mechanism.
By and large, we had the resolution mechanisms that we needed.
I could be a little more specific about that, but just to put
it in the perspective.
There certainly are some things that could be helpful here,
but basically, we had the mechanisms. There were two problems.
First, the system had been allowed to go in the direction of
internal weakness to such a degree that problems piled up and
happened quickly. But mainly----
Senator Corker. And how did that happen, by the way?
Mr. Carnell. Well, I mean, we are talking about a decade in
which--or more specifically, from about 2002 to 2007 in which
market participants became increasingly complacent about credit
risk and where regulators were not taking the opportunity to
strengthen things like capital standards while the sky was blue
and the sun was shining, take advantage of that time to build
bank capital up. Those would be some examples of things that
could have been done in the context.
But the key thing is that most of the laws we needed were
already in place, and in the case of something that is a bank
or thrift, the Federal Deposit Insurance Act is the model for
the world in terms of doing resolution, and----
Senator Corker. And we used it, but what about in the other
examples of how they kind of--I won't name the entities, but
our largest entities in the country, what about in those cases?
Mr. Carnell. Well, if you----
Senator Corker. What type of mechanisms existed that we
didn't use?
Mr. Carnell. Well, I should emphasize that many of the
largest entities in the country are bank holding companies
where the biggest part of the firm is the bank. So the law was
there available for that. Now, with a bank holding company----
Senator Corker. Or the FDIC to come into the bank component
itself.
Mr. Carnell. That is correct, and let me just emphasize
that this does not require--it certainly doesn't require a pot
of taxpayer money and it doesn't necessarily--FDIC money is not
the only thing that is available, because you can--the FDIC
needs to satisfy insured deposits. But other creditors can have
a haircut applied to their claims and you close the bank one
day and it opens the next business day with a new charter, but
the same tellers and so forth there.
Now, as for the nonbank part of organizations, we do have
the bankruptcy courts. There are some changes that would make
sense for bankruptcy courts dealing with nonbank financial
institutions, for example, to make sure that you can't shop for
the court that you think is best, say shop between New York and
Delaware or something like that, to make sure that these cases
go to judges who have some expertise and some other things to
expedite that. But basically, the law is there.
Senator Corker. I would like for you, if you would, to
schedule some time to come in and talk about some of the tweaks
on the bankruptcy side. And again, I just want to point out
that in many ways on this regulatory piece, we are looking at
sort of rearranging the deck chairs, and I think the
suggestions that each of you have made have been very helpful,
but even after you make those changes, it is that lack of--it
is that procyclical thinking that drove us to where we were.
The sun was shining and so we were continuing to do more and
more instead of reserving up more. And I still haven't heard of
a way--it seems like to me that what we are going to do is
create sort of a super-regulatory entity, but we still haven't
yet figured out a way to cause them to actually not be
procyclical. So again----
Mr. Carnell. If I could come back to you on that one,
Senator, it is a very difficult challenge, and I do not mean to
suggest that there is any simple solution to the problem that
you--the challenge you pose there.
I do emphasize in my testimony the importance of looking at
the incentives that regulators have, because the fact is: bank
regulators had the tools that they needed, but they did not
take action that they could have here. Part of it is a
foresight problem, but part of it is also an incentive problem.
That is, if you look at it from the standpoint of the
particular people making the decisions, what makes sense from
their standpoint?
Now, in a four-regulator system where there is squabbling
over turf, where there is competition for regulatory clientele,
it is tougher to look ahead--if you are the person who is
looking ahead and said--to take the example--let us go for
higher capital standards now, let us raise the standard in
terms of your exposure to systemic risk from other
institutions. If you look ahead and you are doing the thing
that is not considered obvious at the time, you are more open
to criticism. And in a multiregulator system, the friction
among regulators provides something of a disincentive there. On
top of that, where you need to do joint rulemaking with
regulators--and that is a requirement under various laws--you
know, you run into other ones who say, ``If it ain't broke,
don't fix it.''
Mr. Baily. Since you want people to be wary of folks like
me that think----
Mr. Carnell. I do not mean you.
Mr. Baily. Well, you should, because I think you need to
have a certain amount of money available. However good a system
you set up, a big financial institution is going to get into
trouble at some point in the future. That has always been true,
and I suspect it is going to be true again. We can improve
regulation as much as we like, but somewhere somebody is going
to get into trouble again. And I think we need to make sure
that we have a mechanism, whether it is--I think it should be a
special bankruptcy court. I do not think you can just pick any
judge. I mean, this has to be a judge with special expertise.
Or you have a resolution mechanism, and there has to be a way--
you know, this is not just FDIC, because this is not just
banks. It is financial institutions more generally. And we have
to have a way in which we can keep them operating and that they
do not bring the rest of the system down while we are doing it.
And if we do not set up that now, then you are going to end
up--taxpayers are going to cost a lot of money down the road.
Mr. Ludwig. Two points, Senator. One is that these systemic
problems are really, by and large, governmental problems. They
are not institutional problems. So when you say who is going to
be looking out, one of the reasons you want to have somebody
with a systemic responsibility for looking for systemic
problems--i.e., bubbles--that is independent is because if you
look historically, it has really been governmental problems
into which institutions are dragged, by and large.
The second thing is the point you made and the point that
Rick made about a single consolidated regulator being less
given to arbitrage and, therefore, more likely to be
conservative. To some degree, the proof of the pudding is in
Canada and Australia. In both those systems, they are both
English-speaking countries with consolidated prudential
supervisors, and that is all they did. And in both systems,
they were quite conservative as regulators in terms of their
institutions.
Now, I just came back from Canada. I was up a couple weeks
ago and spent some time with their finance minister and their
head of the central bank and their bankers. And they will all
say that their supervisor was a restraining force on them
getting into a lot of the problems that our institutions got
into.
Senator Reed [presiding]. Senator Warner.
Senator Warner. Mr. Chairman, I will not ask a question. I
would just like to make a request to the panel, because it is
clear that the panel has got a lot of ideas here.
As I think I said earlier, I would love to see more
specificity about how we can ensure community banks, smaller
banks, are inside a single end-to-end regulator, from
assessments to less regulatory, less paperwork. What are the
protections we could give beyond division, number one?
Number two, Senator Corker and I believe that there needs
to be expanded resolution authority at least to bank holding
companies, with the FDIC, and the FDIC has raised--and I know
you have addressed today, but has raised the concern that if
they were--if we took away their prudential supervision, would
back-up supervision be enough to have them have their pulse on
the status of all of the institutions that they might cover in
this expanded jurisdiction. So I would love to have some
specific suggestions on how we could address that concern.
And then, third, obviously, you know, the Federal Reserve
will make the point that, as lender of last resort, they still
need to keep their hands in this pie in terms of at least with
these larger institutions on the bank holding companies. And I
think you have made some very--the whole panel has made a
number of valid points about the bank holding companies, but I
would love--and, again, Martin, you made the comment about the
fact that FDIC and the Fed would be on the board. But what are
other ways that we could ensure that the Fed, as lender of last
resort, would not lose the expertise that they have?
Thank you, Mr. Chairman.
Senator Reed. Thank you very much, gentlemen. I just have
one or two quick questions since I have got the opportunity
with this panel, which is rare.
Going back to the landscape after we adopt a single
regulator, at least hypothetically, should the Federal Reserve
continue to have any regulatory authority with respect to State
member banks if that is all they are doing in the regulatory
sphere? Mr. Ludwig.
Mr. Ludwig. I would not think so, Senator. I think there is
huge advantage to having, just like companies, entities that do
things that they do well and focus on them. I think it is
better for oversight for the Congress. I think it is better for
the agencies themselves. And I think to Martin Baily's
excellent point, monetary policy is so essential in central
banking functions. Do we really want our Chairman of the
Federal Reserve sitting around thinking about either consumer
rules or bank supervision rules? Which are not unimportant, but
how much can you do in a day?
I think one of the problems we have with CEOs generally is
how much can you actually accomplish in a day, and I think that
is an enterprise that they should give up.
Senator Reed. Another general question is that this is an
opportunity, obviously, and a necessity to look across the
board in terms of the Federal regulatory structure, and I think
not just in concept of how you regulate banks, but the
structure itself of the Federal Reserve. As we cut back,
presumably, some of their responsibilities, does their present
structure still need to remain the same with regional banks
located sort of because the way America was in 1930, not 2010?
Does anyone have any comments?
Mr. Carnell. I would not try to defend the location of
Federal Reserve banks, including, you know, the old thing about
why are there two in Missouri. But I do think the Federal
Reserve banks play a valuable role in Federal Reserve
policymaking. That is, they are not just regional offices that
receive top-down directives from Washington. And I think in
monetary policy and in a great many other things, they provide
a diversity of perspective that is desirable.
I would note, by the way, that where a significant
proportion of supervisory personnel are currently located in
Reserve banks, that same space could be used, if desired, by
employees of the new agency, and you would still have, you
know, interaction of proximity there. So I would keep the
Reserve banks. I would encourage cross-fertilization like that.
I do not think----
Mr. Ludwig. I think that is an excellent--I mean, a
consolidated supervisor does not mean that everything should be
in Washington. And, indeed, with the majority of the banks
being located everywhere, you would assume there would be
substantial regional offices and duty stations really all over
the place. But the advantage of being able to filter it back
and have cross-fertilization I think is huge.
Mr. Baily. I agree.
Senator Reed. Let me ask you if there is a final comment by
any of the panelists that you would like to make before I thank
you very much and--yes?
Mr. Carnell. Actually, I would like to say, if I could,
some words in favor of a consumer financial protection agency.
I support creating a new independent agency. As I would
propose, it would have full responsibility for writing rules
implementing consumer protection legislation, financial
consumer legislation. And I would also agree with the
Administration that it should have primary enforcement
authority over nonbank lenders.
Now, I differ with the Administration on a couple of
points. I think it should have only back-up enforcement
authority over FDIC-insured banks and their affiliates. I think
that is enough. I think that will do the job. And I also do not
support slashing the preemptive effect of the National Bank
Act. The State regulators had primary responsibility for
dealing with nonbank lenders that were the epicenter of
predatory lending. They did a poor job, and yet what they talk
about is national bank preemption, which was not the practical
problem there.
On top of that, I point out that the Supreme Court issued a
major decision earlier this year, Cuomo v. Clearing House, that
cut back on some of the preemptive claims made for the National
Bank Act. So I do not think there is a need for action in the
preemption area, certainly not what the Administration has
proposed. But the agency is a good idea.
Senator Reed. Thank you, gentlemen, very much for this
excellent testimony, and thank you very much.
Mr. Baily. Thank you for having us.
[Whereupon, at 3:55 p.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
This afternoon, we will examine how best to ensure the strength and
security of our banking system. I would like to thank our witnesses for
returning to share your expertise after the last hearing was postponed.
Today, we have a convoluted system of bank regulators created by
historical accident. Experts agree that nobody would have designed a
system that worked like this. For over 60 years, Administrations of
both parties, members of Congress, commissions, and scholars have
proposed streamlining this irrational system.
Last week I suggested further consolidation of bank regulators
would make a lot of sense. We could combine the Office of the
Comptroller of the Currency and the Office of Thrift Supervision while
transferring bank supervision authorities from the Federal Deposit
Insurance Corporation and the Federal Reserve, leaving them to focus on
their core functions.
Since that time, I have heard from many who have argued that I
should not push for a single bank regulator. The most common argument
is not that it's a bad idea--it's that consolidation is too politically
difficult. That argument doesn't work for me.
Just look what the status quo has given us. In the last year some
of our biggest banks needed billions of dollars of taxpayer money to
prop them up, and dozens of smaller banks have failed outright.
It's clear that we need to end charter shopping, where institutions
look around for the regulator that will go easiest on them.
It's clear that we must eliminate the overlaps, redundancies, and
additional red tape created by the current alphabet soup of regulators.
We don't need a super-regulator with many missions, but a single
Federal bank regulator whose sole focus is the safe and sound operation
of the Nation's banks. A single operator would ensure accountability
and end the frustrating pass the buck excuses we've been faced with.
We need to preserve our dual banking system. State banks have been
a source of innovation and a source of strength in their communities. A
single Federal bank regulator can work with the 50 State bank
regulators.
Any plan to consolidate bank regulators would have to ensure
community banks are treated appropriately. Community banks did not
cause this crisis and they should not have to bear the cost or burden
of increased regulation necessitated by others.
Regulation should be based on risk--community banks do not present
the same type of supervisory challenges their large counterparts do.
But we need to get this right, which is why you are all here today.
I am working with Senator Shelby and my colleagues on the Committee to
find consensus as we craft this incredibly important bill.
______
PREPARED STATEMENT OF EUGENE A. LUDWIG
Chief Executive Officer, Promontory Financial Group, LLC
September 29, 2009
Introduction
Chairman Dodd, Ranking Member Shelby, and other distinguished
Members of the Senate Banking Committee; I am honored to be here today
to address the important subject of financial services regulatory
reform. I want to commend you and the other Members of the Committee
and staff for the serious, thoughtful, and productive way in which you
have examined the causes of the financial crisis and the need for
reform in this area.
Today, there are few subjects more important than reform of the
financial services regulatory mechanism. Notwithstanding the fine men
and women who work tirelessly at our financial regulatory agencies, the
current outdated structure of the system has failed America. At this
time last year, we were living through a near meltdown of the world's
financial system, triggered by weaknesses generated here in the United
States. Two of our largest investment banks and our largest insurance
company failed. Our two giant GSE's failed. Three of our largest
banking organizations were merged out of existence to prevent them from
failing.
But the problem is not just about an isolated incident of 1 year's
duration. Over the past 20-plus years we have witnessed the failure of
hundreds of U.S. banks and bank holding companies. The failures have
included national banks, State member banks, State nonmember banks and
savings banks, big banks and small banks, dozens if not hundreds of
banks supervised by every one of our regulatory agencies. By the end of
this year alone, I believe over 100 U.S. banks will have failed,
costing the deposit insurance fund tens of billions of dollars. And, I
judge that before this crisis is over we will witness the failures of
hundreds more. In the face of this irrefutable evidence, it is
impossible to say something is not seriously wrong.
Now is the time to act boldly and bring American leadership back to
this system. A failure to act boldly and wisely will condemn America
either to a loss of leadership in this critical area of our economy
and/or additional instances of the kinds of financial system failures
that we have been living through increasingly over the past several
decades, the most pronounced instance of which is currently upon us.
No one should underestimate the complexity of accomplishing the
needed reforms, though in truth the changes that are needed are
surprisingly straightforward from a conceptual perspective. The
Administration's financial services regulation White Paper is
commendable and directionally correct. It identifies the major issues
in this area and provides momentum for reform. In my view, certain
essential refinements to the plan laid out in the White Paper are
needed; the need for revisions and refinements is an inevitable part of
the policymaking process. I also want to commend the Treasury
Department of former Secretary Henry Paulson for having developed its
so-called ``blueprint,'' which also has added important and positive
elements to the debate in this area.
Financial services regulatory reform is not fundamentally a
partisan issue. It is fundamentally a professional issue. And, under
the leadership of you and your staffs Chairman Dodd and former Ranking
Member Shelby the traditions of the Senate Banking Committee, which for
decades has prided itself on a balanced bipartisan look at the facts
and the needs of the country has continued. In this regard, it should
be noted that many of the matters I cover below, including importantly
the need for an end-to-end consolidated banking regulator, have been
championed over the years by Members of the Senate Banking Committee,
including its Chairmen, from both sides of the aisle. Similarly, many
of these concepts, including the need for an end-to-end consolidated
institutional supervisor, have been championed by Treasury Secretaries
over the years from both political parties.
I have set out below the seven critical steps that are needed to
fix the American Financial Regulatory system and to refine the
approaches put forth by both the current and previous Treasury
Departments. Being so direct is no doubt somewhat presumptuous on my
part, but I have been fortunate in my career to have worked in multiple
capacities with the financial services industry and consumer
organizations in this country and abroad, including as a regulator,
money-center bank executive, board member, major investor in community
banks, and chairman and board member of community development and
consumer-related organizations.
So what has gone so wrong? Let me begin by saying what the problem
is not.
First, the problem is not the failure to have thousands of
talented people working in bank and bank holding company
supervision. I can testify from personal experience that we do
indeed have exceptionally fine and able men and women in all
our regulatory agencies.
Second, our banks and bank holding companies are not
subject to weak regulations. On the contrary, though not
without flaws, our codes of banking regulations are no less
stringent than those in countries that have weathered the
current and past crises well.
Third, it is not because America has weaker bankers than in
the countries that have been more successful at dealing with
the current crisis. On the contrary, we have a right to take
pride in America's banks and bankers many of whom work harder
than their peers abroad, have higher standards than their peers
abroad and contribute more to their communities in civic
projects than their peers abroad.
Of course, we have had isolated cases of regulators and bankers
that failed in their duties. However, 20-plus years with hundreds of
bank failures through multiple economic cycles is not the result of a
few misguided souls.
So what is the problem with financial institution safety and
soundness in the United States and how can we fix it? To my mind, the
answer is relatively straightforward, and I have outlined it in the
seven areas I cover below.
Needed Reforms
1. Streamline the current ``alphabet soup'' of regulators by creating a
single world class financial institution specific, end to end,
regulator at the Federal level while retaining the dual banking
system.
a. Introduction. We must dramatically streamline the current
alphabet soup of regulators. The regulatory sprawl that exists today
is, as this Committee well knows, a product of history, not
deliberation. The recent financial crisis has accentuated many of the
shortcomings of the current regulatory system.
Indeed, it is worth noting that our dysfunctional regulatory
structure exists virtually nowhere else. And, I am not aware of any
scholar or any country that believes it is the paradigm of financial
regulatory structuring; nor am I aware of one country anywhere that
wants to copy it.
b. How Our Regulatory Structure Fails: There are at least seven
ways in which our current regulatory structure fails:
Needless Burdens That Weaken Safety and Soundness Focus.
First, a profusion of regulators, such as we have in the United
States, adds too much needless burden to the financial services
system. Additional burdens where they do not add value are not
neutral. They actually diminish safety and soundness. Many
banking organizations today have several regulatory agencies to
contend with and dozens--in a few cases--hundreds of annual
regulatory examinations with which to cope. At the same time,
top management's time is not infinite. It is important to
streamline and target regulatory oversight, and accordingly top
management talent's focus to address those issues that most
threaten safety and soundness.
Lack of Scale Needed To Address Problems in Technical
Areas. Second, under our current regulatory structure, not one
of the institutional regulators is sufficiently large or
comprehensive enough in their supervisory coverage to
adequately ensure institutional safety and soundness.
Typically, no regulator today engages in end-to-end supervision
as different parts of the larger financial organizations are
supervised by different regulatory entities. And gaining scale
in regulatory specialties of importance, for example, risk
metrics, or capital markets activities, is severely hampered by
the too small and fractured nature of supervision today in
America.
Regulatory Arbitrage. Third, the existence of multiple
regulatory agencies is fertile ground for regulatory arbitrage,
thereby seriously undercutting strong prudential regulation and
supervision.
Delayed Rulemaking. Fourth, rulemaking while often
harmonized at least among the banking supervisors is slow to
advance because of squabbles among the financial services
regulators that can last for years at a time.
Regulatory Gaps. Fifth, because our regulatory structure is
a hodgepodge, for all its multiple regulators and
inefficiencies, it is not truly ``end-to-end'' and has been
prone to serious gaps between regulatory agency
responsibilities where there is little or no supervision. And
these gaps are often exploited by financial institutions,
overburdened by too much regulation in other areas--weeds take
root and flourish in the cracks of the sidewalk.
Limitations on Investigations. Sixth, where an experienced
and talented bank regulator believes he or she has found a
problem in the bank, that individual or his or her regulatory
agency cannot follow the danger beyond the legalistic confines
of the chartered bank itself. ``Hot pursuit'' is not allowed in
bank regulation today. We count on our bank examiners to
function as a police force of sorts. But even when our bank
detectives and cops sniff out trouble, they may have to quit
following the trail when they hit ``the county line'' where
another agency's jurisdiction begins. Like county sheriffs,
examiners sometimes can do little more than plead with the
examiners in the neighboring jurisdiction to follow up on the
matter.
Diminished International Leadership. Seventh, our hydra-
headed regulatory system, with periodic squabbles among its
various components, increasingly undercuts our moral force
around the world, leading to a more fractured and less
hospitable regulatory environment for U.S.-based financial
services providers.
Let me elaborate on two of these points--the counterproductive nature
of excess burdens and regulatory arbitrage:
Counterproductive Burdens. Today, a large financial
institution that has a bank in its chain is in almost all cases
subject to regulation by a bank regulator, the Federal bank
regulator, (the Federal component of which will be the Office
of the Comptroller of the Currency, the Federal Reserve Board,
the Federal Deposit Insurance Corporation, or the Office of
Thrift Supervision) and in many cases by a State bank
regulator. Many banking organizations have national banks,
State banks and savings banks in their chains, so they are
subject to all these bank supervisors.
In addition, every institution with a bank in its chain must have
either the Federal Reserve or the OTS as its bank holding
company and nonbank affiliate regulator.
In all cases, financial services companies with bank affiliates are
subject to the FDIC as an additional supervisor.
But the list does not stop there. Additional supervision may be
performed by the State Attorneys General, the Securities and
Exchange Commission, and the Financial Industry Regulatory
Authority. For Bank Secrecy Act, Foreign Corrupt Practices Act,
and anti-money-laundering matters there is a supervisory role
for the Financial Crimes Enforcement Network and Office of
Foreign Asset Control. Also, the insurance company subsidiaries
of bank holding companies may be subject to regulation by State
insurance regulators in each of the States. In addition, at
times, even the Federal Trade Commission serves as a
supervisor. And, the Justice Department sometimes becomes
involved in what historically might have been considered civil
infractions of various rules. Even the accounting standard
setting agencies directly or through the SEC, get into the act.
This alphabet soup of regulators results in multiple enforcement
actions, often for the same wrong, and dozens of examinations,
which as I have noted for our largest institutions may
literally total in the hundreds in a year. There are so many
needless burdens caused by this cacophony of regulators, rules,
examinations and enforcement activities that many financial
services companies shift their business outside the United
States whenever possible.
But the burden is not in and of itself what is most concerning. The
worst feature of our current system is that for all the
different regulators, the back-up supervision and the volumes
of regulation has not produced superior safety and soundness
results. On the contrary, based on the track record of at least
the last 20-plus years, it has produced less safety and
soundness than some simplified foreign systems. As the current
crisis and the past several debacles have shown, our current
expensive and burdensome system does not work.
Regulatory Arbitrage. Financial institutions that believe
their current regulator is too tough can change regulatory
regimes by simply flipping charters and thus avoid strong
medicine prescribed by the previous prudential supervisor.
Indeed, even where charter flipping does not actually occur,
the threat of it has pernicious implications. Sometimes stated
directly, sometimes indirectly, often by the least well-run
banking organization, the threat of charter flipping eats away
at the ability of examiners and ultimately the regulatory
agency to be the clear-eyed referee that the system needs them
to be.
And, regulatory arbitrage is greatly increased by the funding
disequilibrium in our system whereby the Comptroller's office
must charge its banks more since State-chartered banks are in
effect subsidized by the FDIC or the Fed. The practical
significance of this disequilibrium cannot be overstated.
c. Misconceptions. There have been a number of misconceptions about
what a consolidated end-to-end institutional supervisor is and what it
is not, as well as the history of this kind of prudential regulator.
Not a Super Regulator. First, an end-to-end consolidated
institutional supervisor is not a ``super regulator'' along the
lines of Britain's FSA. A consolidated institutional prudential
regulator does not regulate financial markets like the FSA. The
SEC and the CFTC do that. A consolidated institutional
regulator does not establish consumer protection rules like the
FSA. A new consumer agency or the Federal Reserve does that. A
consolidated institutional supervisor does not itself have
resolution authority or authority with respect to the financial
system as a whole. The FDIC does, and perhaps the Fed, the
Treasury and a new systemic council would also do that. The
consolidate institutional regulator would focus only on the
prudential issues applicable to financial institutions like The
Office of the Superintendent of Financial Institutions (OSFI)
in Canada and the Australian Prudential Regulatory Authority
(APRA), both of which have been successful regulators,
including during this time of crisis, something I discuss in
greater detail below.
An Agency That Charters and Supervises National Entities
Cannot Regulate Smaller Institutions. Second, there has been a
misconception that a consolidated regulator that regulates
enterprises chartered at the national level cannot fairly
supervise smaller community organizations. In fact, even today
the OCC currently supervises well over 1,000 community-banking
organizations whose businesses are local in character. And, it
is worth adding that these small, community organizations that
are supervised by the OCC, choose this supervision when they
clearly have the right to select a State charter with a
different supervisory mechanism. The OCC, it must also be
noted, supervises some of the largest banks in the United
States. If the OCC unfairly tilted supervision toward the
largest institutions or otherwise, it is hard to imagine that
it would have smaller institutions volunteer for its
supervision.
Entity That Regulates Larger Institutions Cannot Regulate
Smaller Institutions. Third, there is a misconception that a
consolidated regulator that regulates larger enterprises cannot
regulate smaller enterprises or will tilt the agency's focus in
favor of larger enterprises. In fact, whether consolidated or
not, all our current financial regulators regulate financial
institutions with huge size disparities. Today, all our Federal
regulators make meaningful accommodations so that they can
regulate large institutions and smaller institutions,
recognizing that often the business models are different. In
fact, as will be discussed in greater detail, it is important
to regulate across the size perspective for several reasons. It
means the little firms are not second-class citizens with
second-class regulation. It means that the agency has
regulators sufficiently sophisticated who can supervise complex
products that can exist in some smaller institutions as well as
larger institutions.
Checks and Balances. Fourth, some have worried that a
consolidated institutional supervisor would not have the
benefit of other regulatory voices. This would clearly not be
the case as a consolidate institutional supervisor would
fulfill only one piece of the regulatory landscape. The Federal
Reserve, Treasury, SEC, FDIC, CFTC, FINRA, FINCEN, OFAC, and
FHFA would continue to have important responsibilities with
respect to the financial sector. In addition, proposals are
being made to add additional elements to the U.S. financial
regulatory landscape, the Systemic Risk Council and a new
Financial Consumer agency. This would leave 8 financial
regulators at the Federal level and 50 bank regulators, 50
insurance regulators and 50 securities regulators at the State
level. I would think that this is a sufficient number of voices
to ensure that the consolidated institutional supervisor is not
a lone voice on regulatory matters.
Need To Supervise for Monetary Authority and Insurance
Obligations. Fifth, some have also claimed that the primary
work of the Federal Reserve (monetary policy, payments system
and acting as the bank of last resort) and the FDIC (insurance)
would be seriously hampered if they did not have supervisory
responsibilities. The evidence does not support these claims.
1. A review of FOMC minutes does not suggest much if any use is
made of supervisory data in monetary policy activities. In the
case of the FDIC, it has long relied on a combination of
publicly available data and examination data from other
agencies.
2. There are not now to my knowledge any limitations on the
ability of the Federal Reserve or the FDIC to collect any and
all information from the organizations they are now
supervising, whether or not they are supervising them.
3. And whether or not the Federal Reserve or the FDIC is
supervising an entity, it can accompany another agency's
examination team to obtain relevant data or review relevant
practices.
4. If the FDIC or the Federal Reserve does not have adequate
cooperation on gathering information, Congress can make clear
by statute that this must be the case.
5. The Federal Reserve's need for data goes well beyond the
entities it supervises and indeed where the majority of the
financial assets have been located. Hedge funds, private equity
funds, insurance companies, mortgage brokers, etc., etc., are
important areas of the financial economy where the Fed has not
gathered data to date and yet these were important areas of the
economy to understand in the just ended crisis. Should not
these be areas where Federal Reserve Data gathering power are
enhanced? Is this not the first order of business? Does the
Federal Reserve need to supervise all of these institutions to
gather data?
6. Even if the FDIC were not the supervisor of State chartered
banking entities, the FDIC would have backup supervisory
authority and be able to be resident in any bank it chose.
7. There is scant information that suggests the Federal Reserve or
FDIC's on-site activities, were instrumental in stemming the
current crises or bank failures. Again, it is important to
emphasize, this is not a reflection on these two exceptional
agencies or their extraordinarily able and dedicated
professionals. It is a reflection of our dysfunctional,
alphabet soup supervisory structure.
No Evidence That Consolidated Supervision Works. Sixth,
some have claimed that because the U.K.'s FSA has had bank
failures on its watch, a consolidated institutional regulator
does not work and would not work in the U.S. As noted above,
the U.K. FSA is a species of super-regulator with much broader
authorities than a mere consolidated regulator. It is also
worth noting that neither in the U.K. nor elsewhere is the
debate over supervision one that extols the U.S. model. Rather,
the debate tends to be simply over whether the consolidated
supervisor should be placed within the central bank or
elsewhere.
More importantly, it should be emphasized that there are regulatory
models around the world that have been extremely successful
using a consolidated institutional regulator model. Indeed, two
countries with the most successful track record through the
past crisis, Canada and Australia, have end-to-end, consolidate
regulators. In Canada the entity is OSFI and in Australia APRA.
Both entities perform essentially the same consolidated
institutional prudential supervisory function in their home
countries. In both cases they exist in governmental structures
where there are also strong central banks, deposit insurance,
consumer protections, separate securities regulators and strong
Treasury Departments. Canada and Australia's regulatory systems
work very well and indeed, that they have not just a successful
consolidated end-to-end supervisor but a periodic meeting of
governmental financial leaders that has many of the attributes
systemic risk council, discussed below.
Would It Do Damage To The Dual Banking System? Seventh,
there was considerable concern in the 1860s and 1870s that a
national charter and national supervision would do away with
the State banking system. It did not. Similar fears arose when
the Federal Reserve and FDIC became a Federal examination
supervisory component of State-chartered banking. These fears
were also unfounded. Both the Federal Reserve and the FDIC are
national instrumentalities that provide national examination
every other year and more frequently when an institution is
troubled. A new consolidated supervisor at the Federal level
would merely pick up the FDIC and Federal Reserve examination
and supervisory authorities.
d. Proposal. Accordingly, I strongly urge the Congress to create
one financial services institutional regulator. In urging the Congress
to take this step, I believe that several matters should be clarified:
Institutional Not Market Regulator. I am not suggesting
that we merge the market regulators--the Commodities Futures
Trading Commission, the SEC, and FINRA--into this new
institutional regulatory mechanism. The market regulators
should be allowed to continue to regulate markets--as a
distinct functional task with unique demands and delicate
consequences. Rather, I am suggesting that all examination,
regulation, and enforcement that focus on individual,
prudential financial regulation of financial institutions
should be part of one highly professionalized agency.
Issue Is Structure Not People. As a former U.S. Comptroller
of the Currency, who would see his former agency and position
disappear into a new consolidated agency, the creation of this
new regulator is not a proposition I offer lightly. I fully
understand the pride each of our Federal financial regulatory
agencies takes in its unique history and responsibility. As I
have said elsewhere in this testimony, I have nothing but the
highest regard for the professionalism and dedication the hard-
working men and women who make up these agencies bring to their
jobs every day. The issue is not about individuals, nor is it
about historic agency successes. Rather, it is all about a
system of regulation that has outlived the period where it can
be sufficiently effective. Indeed, perpetuating the current
antiquated system makes it harder for the fine men and women of
our regulatory agencies to fully demonstrate their talents and
to advance as far professionally as they are capable of
advancing.
Retention of Dual Banking System. In proposing a
consolidated regulatory agency, I am not suggesting that we
should do harm to our dual banking system as noted above.
Chartering authority is one thing; supervision and regulation
are quite another matter. The State charter can and should be
retained; the power of the States to confer charters is deeply
imbedded in our federalist system. There is nothing to prevent
States from examining the institutions subject to their
charters. On the contrary, one would expect the States to
perform the same regulatory and supervisory functions in which
they engage today. As noted, the new consolidated regulatory
agency would simply pick up the Federal component of the State
examination and regulation, currently performed by the Federal
Reserve and the FDIC.
Funding. This new consolidated financial institutional
regulatory agency should be funded by all firms that it
examines, eliminating arbitrage, which often masquerades as
attempts to save examination fees.
Importance of Independence. Importantly, this new
consolidated supervisory agency needs to be independent. It
needs to be a trusted, impartial, professional referee. This is
important for several reasons. It is absolutely essential for
the agency to be taken seriously that it be free from the
possible taint of the political process. It must not be
possible for politically elected leader to decide how banking
organizations are supervised because of political
considerations. Time and again, when the issue of bank
supervision and the political process has been considered by
Congress, Congress has opted to keep the regulatory mechanisms
independent.
Independence also bespeaks of attracting top talent to head the
agency, and this is of considerable importance. If the head of
the agency is not someone who is as distinguished and
experienced as the head of the SEC, Treasury Secretary or
Chairman of the Federal Reserve, if it is not someone with this
level of Government seniority and distinction, the agency will
not function at the level it needs to function to do the kind
of job we need in a complex world.
e. Architecture of Reform Proposals/Congressional Oversight.
Enterprises perform best where they have clear missions, and there are
not other missions to add confusion. The consolidated end-to-end
supervisor would have a clear mission and would fit nicely with the
proposals below where the roles and responsibilities of all parts of
our regulatory system would be simplified and targeted. The Federal
Reserve would be in charge of monetary policy, back-stop bank and
payments system activities. The FDIC would continue to be the deposit
insurer. The SEC and CFTC market regulators. The Systemic Council would
identify and seek to mitigate potential systemic events. And a consumer
organization would be responsible for consumer issue rule setting.
This allows for much more effective Congressional oversight.
Congress will be able to focus on each agency's responsibilities with
greater effectiveness when one agency engages in a disparate set of
activities.
2. Avoid a two-tier regulatory system that elevates the largest ``too-
big-to-fail'' institutions over smaller institutions.
Eliminating the alphabet soup of regulators should not give rise to
a two-class system where our largest banking organizations, deemed
``too big to fail,'' are regulated separately from the rest. To do that
has several deleterious outcomes:
a. Public Utilities or Favored Club. A two-class system means either
the largest institutions become, in essence, public utilities
subject to rules--such as higher capital charges, inflexible
product and service limitations, and compensation
straitjackets--or, they become a special favored club that
siphons off the blue chip credits, the best depositors, the
safest business, the best examiners and supervisory service
whereby the community banking sector has to settle for the
leftovers. Both outcomes are highly undesirable.
b. Smaller Institutions Should Not Be Second Class Citizens. I can
assure you that over time, condemning community banking to the
leftovers will make them less safe, less vibrant and less
innovative. Even today, tens, indeed hundreds of billions of
dollars have been used to save larger institutions, even
nonbanks, and yet we think nothing of failing dozens of
community banks. Over 90 banks have failed since the beginning
of 2009, and they were overwhelmingly community banks; the
number is likely to be in the hundreds before this crisis is
over.
c. Two-Tier Supervisory System Exacerbates ``Too-Big-To-Fail''
Problem. Creating a two tier supervisory system and designating
some institutions, as ``too big to fail'' is a capitulation to
the notion that some institutions should indeed be allowed to
function in that category. To me, this is a terrible mistake.
We are enshrining some institutions with such importance due to
their size and interconnected characteristics that we are
implicitly accepting the notion that our Nation's economic
well-being is in their hands, not in the hands of the people
and their elected officials.
d. Danger of Second Class Supervisory System for Smaller
Organizations. As a practical matter, a two-tier system makes
it less likely that top talent will be available to supervise
smaller institutions. At the end of the day, who wants to work
for the second regulator that has no ability to ever regulate
the institutions that are essentially defined as mattering most
to the Nation?
e. Size Is Not the Only Differentiating Characteristic. Finally,
just because we might have one prudentially oriented financial
services supervisor does not mean that we should not
differentiate supervision to fit the size and other
characteristics of the institutions being supervised. On the
contrary, we should tailor the supervision so that community
banks and other kinds of organizations--for example, trust
banks or credit card banks--are getting the kind of
professional supervision they need, no more and no less. But
such an avoidance of a one-size-fits-all supervisory model is
far from elevating a class of financial institution into the
``too-big-to-fail'' pantheon.
In sum, I urge the Congress not to create a ``too-big-to-fail''
category of financial institutions, directly or indirectly, either
through the regulatory mechanism or by rule. On the contrary, I urge
the Congress to take steps to avoid the perpetuation of such a bias in
our system.
3. It is essential to have a resolution mechanism that can resolve
entities, however large and interconnected.
Essential Nature of the Problem. It cannot be overstressed just how
important it is to develop a mechanism to safely resolve the largest
and most interconnected financial institutions. If we do not have such
a mechanism in place and functioning, we either condemn our largest
institutions to become a species of public utility, less innovative and
less competitive globally, or we have to create artificial measures to
limit size, diversity, and perhaps product offerings. If we choose the
first alternative and go the public utility route, we are in effect
admitting that some institutions are ``too big to fail,'' and thus
unbalancing the rest of our financial services sector. Moreover,
adopting either alternative would change not only the fabric of our
financial system, but the free-market nature of finance and the economy
in the United States.
Complexity of the Undertaking. An essential aspect to eliminating
the perception and reality of institutions that are ``too big to fail''
is to ensure that we have a resolution mechanism that can handle the
failure of very large and/or very connected institutions without taking
the chance of creating a systemic event. However, it is worth
emphasizing that creating such a resolution mechanism will require
careful legislative and regulatory efforts. Resolving institutions is
not easy.
To step back for a moment, it is quite striking that the seizure of
even a relatively small bank, (e.g., a bank with $60 million in assets)
is a very substantial undertaking. With the precision of a SWAT team,
dozens of bank examiners and resolutions experts descend on even a
small institution that is to be resolved, and they work nearly around
the clock for 48 hours, turning the bank inside out as they comb
through books and records and catalogue everything from cash to
customer files. Imagine magnifying that task to resolve a bank that is
10 times, 100 times, or 1,000 times larger than my community bank
example.
A Resolution Mechanism Can Be Created To Resolve the Problem. The
FDIC has capably discharged its duties as the receiver of even some
very large banks, but significantly revised processes and procedures
will have to be created to deal with the largest, most interconnected
and geographically diverse institutions with broad ranges of product
offerings. With that said, having worked both as a director of the FDIC
and in the private sector as a lawyer with some bankruptcy experience,
I am reasonably confident that we can create the necessary resolution
mechanism.
Several aspects to creating a resolution mechanism for the largest
banks that deserve particular attention are enumerated below:
a. Costs Should Not Be Borne By Smaller Institutions. We have to be
careful that the costs of resolution of such institutions are
not borne by smaller or healthier institutions, particularly at
the time of failure when markets generally may be disrupted.
This means all large institutions that might avail themselves
of such a mechanism should be paying some fees into a fund that
should be available when resolution is needed.
b. Treasury Backstop. Furthermore, such a fund should be backstopped
by the Treasury as is the FDIC Deposit Insurance Fund (DIF). We
should not be calling on healthy companies to fill up the fund
quickly, particularly during periods of financial turmoil. An
unintended consequence of current law is that we have been
requiring healthy community banks to replenish the deposit
insurance fund during the banking crisis, making matters worse
by making the good institutions weaker and less able to lend.
We should change current law so that this is no longer the case
with respect to the DIF, and this certainly should not be the
case with a new fund set up to deal with larger bank and
nonbank failures.
c. Resolution Decisions. The ultimate decision to resolve at least
the largest financial institutions should be the province of a
systemic council, which I will discuss in greater detail
shortly. The decision should take into account both individual
institutional concerns and systemic concerns. Our current legal
requirements for resolving the troubled financial system is
flawed in that it is one-dimensional, causing the FDIC to make
the call on the basis of what would pose the ``least cost to
the DIF,'' not on the basis of the least cost to the economy,
or to the financial system. I emphasize that this is not a
criticism of the FDIC; that agency is doing what it has to do
under current law. My criticism is of the narrowness of the law
itself.
d. Resolution Mechanics. In terms of which agency should be in
charge of the mechanics of resolution itself, there are a
number of ways the Congress could come out on this question,
all of which have pluses and minuses. Giving the responsibility
to the FDIC makes sense in that the FDIC has been engaged
successfully in resolving banking organizations and so has
important resolutions expertise. One could also argue that the
primary regulator that knows the institution best should be in
charge of the resolution, calling upon the DIF for money and
back up. The primary regulators do in fact have some useful
resolutions and conservatorship experiences, though they have
not typically been active in the area, in part due to the lack
of a dedicated fund for such purposes. Or one could argue for a
special agency, like the RTC, perhaps under the control of the
new systemic risk council.
I have not settled in my own mind which of these models works best,
except to be certain that the institution in charge of resolutions has
to be highly professional and that a special process must be in place
to deal with the extraordinary issues presented by the failure of an
extremely large and interconnected financial institution.
In sum, I urge Congress to create a new function that can require
the resolution of a large, complex financial institution. This new
function can be handled as part of the responsibilities of the Systemic
Risk Council discussed below. The mechanism that calls for resolution
of a large troubled financial institution need not be the same
institution that actually engages in the resolution activity itself.
Any of the FDIC, the primary regulator and/or a new resolution
mechanism could do the job of actually resolving a large troubled
institution if properly organized for the purpose, though certainly
much can be said for the FDIC's handling of this important mechanical
function, given its expertise in the area generally. Even more
important, it is absolutely key that we clarify existing law so that
the decision--and the mechanics--to resolve a troubled institution is a
question first of financial stability for the system and then a
question of least-cost resolution.
4. A new systemic risk identification and mitigation mechanism must be
created by the Federal Government; A financial council is best
suited to be responsible for this important function.
Nature of the Problem. The financial crisis we have been living
through makes clear beyond a doubt that systemic risk is no
abstraction. Starting in the summer of 2007, we experienced just how
the rumblings of a breakdown in the U.S. subprime housing market could
ripple out to Germany and Australia and beyond. Last year, we witnessed
the devastating effects the demise of Lehman Brothers, a complex and
interconnected financial company, could have on the financial system
and the economy as a whole. The entire international financial system
almost came to a standstill post Lehman Brothers failure.
Notwithstanding the magnitude of the problem and the possible
outcomes of a Lehman Brothers failure, our financial regulatory
mechanism was caught relatively unaware. For more than a year preceding
the Lehman Brothers catastrophe our regulatory mechanism was in denial,
considering the problem to be a relatively isolated subprime housing
problem.
The same failure to recognize the signs of an impending crisis can
be laid at the feet of the regulatory mechanism prior to the S&L
crisis, the 1987 stock market meltdown, the banking crisis of the early
1990s, the emerging market meltdown of 1998, and the technology crisis
of 2000-2001. No agency of Government has functioned as an early
warning mechanism, nor adequately mitigated systemic problems as they
were emerging.
Only after the systemic problem was relatively full blown have
forceful steps been taken to quell the crisis. In some cases the delay
in taking action and initial governmental mistakes in dealing with the
crisis have cost the Nation dearly--as was true in the S&L crisis. The
same can be said of the other crises of the preceding century where for
example in the case of the Great Depression, steps taken by the
Government after the problem arose--to withdraw liquidity from the
market--actually made the problem markedly worse.
Admittedly, identifying potential systemic problems is hard. It
involves identifying financial ``bubbles,'' unsustainable periods of
excess. However, though difficult, economists outside of Government
have identified emerging bubbles, including the past one. Furthermore,
there are steps that can be taken to mitigate such emerging problems,
for example, increasing stock margin requirements or tightening lending
standards or liquefying the markets early in the crisis.
The Need To Create a New Governmental Mechanism. This Committee is
wisely contemplating the creation of a Systemic Risk Council as a new
mechanism to deal with questions of systemic risk. There is general
agreement that some new mechanism is needed for identifying and
mitigating systemic problems as none exists at the moment.
Indeed, the current Treasury Department has also wisely highlighted
the importance of considering systemic risk as one of the issues on
which to focus as a central part of financial regulatory modernization.
Former Treasury Secretary Paulson, too, who spearheaded Treasury's
``blueprint,'' focused on this important issue. There is now a
reasonable consensus that there are times when financial issues go
beyond the regulation and supervision of individual financial
institutions.
Why a Council in Particular Makes the Most Sense. There are a
number of reasons why no current agency of Government is suited to be
in charge of the systemic risk issue, and why a council with its own
staff is the best approach for dealing with this problem.
1. Systemic Risk: A Product of Governmental Action or Inaction. It
is essential to emphasize that historically, virtually all
systemic crises are at their root caused by Government action
or inaction. Though individual institutional weakness or
failure may be the product of these troubled times and may add
to the conflagration, the conditions and often even the
triggering mechanisms for a systemic crisis are in the
Government's control.
i. For example, the decision to withdraw liquidity from the
marketplace in the 1930s and the Smoot-Hawley tariffs were
important causes of the Great Depression;
ii. The decision to raise interest rates in the 1980s coupled with
a weak regulatory mechanism and expansion of S&L powers led to
the S&L failures of the 1980s;
iii. The decision to produce an extended period of low interest
rates, the unwillingness to rein in an over-levered consumer--
indeed quite the contrary--and high liquidity coupled with a
de-emphasis of prudential regulation is at the root of the
current crisis.
2. No Current Regulatory Agency Is Well Suited for the Task. Our
existing regulators are not well suited, acting alone, to
identify and/or mitigate systemic problems. There are a variety
of reasons for this.
a. Substantial Existing Duties. First, each of our existing
institutions already has substantial responsibilities.
b. Systemic Events Cross Existing Jurisdictional Lines. Second,
systemic events often cross the jurisdictional lines of
responsibilities of individual regulators, involving markets,
sector concentrations, monetary policy considerations, housing
policies, etc.
c. Conflicts of Interest. Third, the responsibilities of
individual regulators can create built-in conflicts of
interest, biases that make it harder to identify and deal with
a systemic event.
d. Systemic Risk Not Fundamentally About Individual Private Sector
Institution Supervision. Fourth, as noted above, it bears
emphasis that the actions needed to deal with systemic issues
(identification of an emerging systemic crisis, or the
conditions for such a crisis, and then action to deal with the
impending crisis) are largely not about supervising individual
private-sector institutions.
e. Systemic Events May Involve Any One Agency's Policies. Systemic
crises may emanate from the polices of an individual financial
agency. That has been true in the past. It is hard to have
confidence that the same agency involved in making the policy
decisions that may bring on a systemic crises will not be
somewhat myopic when it comes to identifying the policy law or
how to deal with it.
f. Too Many Duties and Difficulties In Oversight. There is a
legitimate concern that adding a systemic risk function to the
already daunting functions of any of our existing financial
agencies will simply create a situation where the agency will
be unable to perform any one function as well as it would
otherwise. Furthermore, Congressional oversight is made
considerably more difficult where an agency has multiple
responsibilities.
g. Too Much Concentrated Power. Giving one agency systemic risk
authority coupled with other regulatory authorities moves away
from a situation of checks and balances to one of concentrated
financial power. This is particularly true where systemic risk
authority is incorporated in an agency with central banking
powers. Any entity this powerful goes precisely against the
wisdom of our founding fathers, who again and again opposed the
centralization of economic power represented by the
establishment of the First and Second Banks of the United
States, and instead repeatedly insisted upon a system of checks
and balances. They were wary, and I believe the current
Congress should likewise be wary, of any one institution that
does not have clear, simple functional responsibilities, or
that is so large and sprawling in its mission and authority
that the Congress cannot exercise adequate oversight.
3. Multiple Viewpoints With Focused Professional Staff. A Systemic
Risk Council of the type contemplated by Committee has the
virtue of combining the wisdom and differing viewpoints of all
the current financial agencies. Each of these agencies sees the
financial world from a different perspective. Each has its own
expertise. Combined they will have a more fulsome appreciation
of a larger more systemic problem.
Of course, a council alone without a leader and staff will be less
effective. To be a major factor in identifying and mitigating a
systemic issue, the council will need a strong and thoughtful
leader appointed by the President and confirmed by the Senate.
That leader will need to have a staff of top economists and
other professionals, though the staff can be modest in size and
draw on the collective expertise of the staffs of the members
of the council.
Accordingly, I urge Congress to adopt a system whereby the Federal
Reserve along with its fellow financial regulators and supervisors
should form a council, the board of directors, if you will, of a new
systemic risk agency. The agency should have a Chairman and CEO who is
chosen by the President and confirmed by the Senate. The Chairman
should have a staff:
The function of the systemic risk council's staff should be
to identify potential systemic events; take actions to avoid
such events; and/or to take actions to mitigate systemic events
in times of a crisis.
Where the Chairman of the systemic council believes he or
she needs to take steps to prevent or mitigate a systemic
crisis, he or she may take such actions irrespective of the
views of the agencies that make up the council, provided a
majority of the council agrees.
5. Taking additional steps to enhance the professionalization of
America's financial services regulatory mechanism should be a
top priority.
America is blessed with an extremely strong group of dedicated
regulators at our current financial services regulatory agencies.
However, we must do much more to provide professional opportunities for
our fine supervisory people:
a. As I have said many times before, many colleges and universities
in America today offer every conceivable degree except a degree
in regulation, supervision, financial institution safety and
soundness--let alone the most basic components of the same.
Even individual courses in these disciplines are hard to come
by.
b. We should encourage chaired professors in these prudential
disciplines.
c. What I hope would be our new institutional regulatory agency
should have the economic wherewithal to provide not just
training but genuine, graduate school-level courses in these
important disciplines.
In sum, we need to further professionalize our regulatory,
examination and supervision services, including by way of enhancing
university and agency professional programs of study.
6. Regulate all financial institutions, not just banks. All financial
institutions engaged in the same activities at the same size
levels should be similarly regulated.
We cannot have a safe and sound financial services regulatory
system that has to compete with un-regulated and under-regulated
entities that are engaged in virtually identical activities:
a. It simply does not work to have a large portion of our financial
services system heavily regulated with specific capital charges
and limits on product innovation, while we allow the remainder
of the system to play by different rules. For America to have a
safe and sound financial system, it needs to have a level
regulatory playing field; otherwise the regulated sector will
have a cost base that is different from the unregulated sector,
which will drive the heavily regulated sector to go further out
on the risk curve to earn the hurdle rates of return needed to
attract much needed capital.
b. In this regard, I want to emphasize that good regulation does not
mean a lot of regulation. More is not better; bigger is not
better; better is better. Sound regulation does not mean
heaping burdens upon currently regulated or unregulated
financial players--quite the contrary. I have come to learn
after a lifetime of working with the regulatory services
agencies that some regulations work well, others do not work
and perhaps even more importantly many banks and other
organizations are made markedly less safe where the regulator
causes them to focus on the wrong item and/or piles on more and
more regulation. Regulators too often forget that a financial
services executive has only so many hours in a day. Targeting
that time on key safety and soundness matters is critical to
achieving a safer institution.
7. Protecting consumer interests and making sure that we extend
financial services fairly to all Americans must be a key
element of any regulatory reform. We cannot have a safe and
sound financial system without it.
We cannot have a safe and sound financial regulatory system that
does not protect the consumer, particularly the unsophisticated, nor
can we have a safe and sound financial system that does not extend
services fairly and appropriately to all Americans.
The Administration has in this regard come out with a bold proposal
to have an independent financial services consumer regulator. There is
much to commend this proposal. However, this concept has been quite
controversial not only among bankers but even among financial services
regulators. Why? I think at the center of what gives serious heartburn
to the detractors of this concept are three matters that deserve the
attention of Congress:
a. First, critics are concerned about the burdens that such a
mechanism would create. These burdens are particularly
pronounced without a single prudential regulator like the one I
have proposed, because without such a change, we would again be
adding to our alphabet soup of regulators.
b. Second, I believe critics are justifiably concerned that the new
agency would at the end of the day be all about examining and
regulating banking organizations and bank-related organizations
but not the un- and under-regulated financial services
companies, many of which are heavily implicated as causes of
the current crisis.
c. Third, there is a concern that the new mechanism will not give
rise to national standards but rather, by only setting a
national standards floor, will give rise to 50 additional sets
of consumer rules, making the operation of a retail banking
organization a nightmare.
For myself, I feel strongly that an independent consumer regulatory
agency can only work if these three problems are solved. And I believe
they can be solved in a way that improves upon the current situation
for all stakeholders. My recommendations follow:
Focus On Un- and Under-regulated Institutions. First, I
would focus a new independent consumer financial regulatory
agency primarily on the un- and under-regulated financial
services companies. These companies have historically caused
most of the problems for consumers. Many operate within well-
known categories--check cashers, mortgage brokers, pay-day-
lenders, loan sharks, pawn brokers--so they are not hard to
find. It is here that we need to expend the lion's share of
examination and supervisory efforts.
Minimize Burden. Second, consistent with my comments on
prudential supervision, I would work to have maximum
effectiveness for the new agency with minimum burden. In this
regard, it is hard to judge such burden unless and until we can
see all the financial services regulatory modernization
measures. Chairman Dodd and Ranking Committee Member Shelby,
you along with many of your fellow Committee Members should be
commended for waiting to act on any piece of financial services
regulatory modernization until we can see the entire package--
for precisely these reasons.
National Standards for Nationally Chartered Entities.
Third, we need to establish uniform national standards for
nationally chartered financial organizations. We are one
Nation. One of our key competitive advantages as a Nation is
our large market. We take a big step toward ruining that market
for retail finance when we allow every State to set its own
standards with its own enforcement mechanism or entities that
have been nationally chartered and are nationally supervised.
Do we really want to be a step behind the European Union and
its common market? Do we really want to cut up our country so
that we are less competitive vis-a-vis other large national
marketplaces like China, Canada, and Australia? I hope not. I
do not think many of the detractors of the current independent
consumer agency proposal would continue to oppose the
legislation--irrespective of how high the standards are--if the
standards are uniform nationally and uniformly examined and
enforced.
Utilization of Existing Supervisory Teams. It is worth
noting that one way to deal with the burden question that has
been suggested by Ellen Seidman, former Deputy to the National
Economic Council and former Director of the OTS, is to allow
the new agency to set rules and allow the banking agencies to
continue to be in charge of examination and enforcement. There
is a great deal to say for this approach. However, I am
reserving my own views until I see the entire package evolve,
absolute musts being for me the three items just mentioned:
strict burden reduction, true national standards, and a focus
on the unregulated and under-regulated financial services
entities.
Conclusion
In conclusion, Mr. Chairman, I again want to commend you, your
colleagues, and the Committee staff for the serious way in which you
have attacked this national problem. The financial crisis has laid bare
the underbelly of our economic system and made clear that system's
serious vulnerabilities. We are at a crossroads. Either we act boldly
along the lines I have suggested or generations of Americans will, I
believe, pay a very steep price and our international leadership in
financial services will be shattered.
Thank you. I would be pleased to answer any questions you may have.
______
PREPARED STATEMENT OF MARTIN N. BAILY
Senior Fellow, Economic Studies, The Brookings Institution
September 29, 2009
Thank you Chairman Dodd, Ranking Member Shelby, and Members of the
Committee for asking me to discuss with you the reform of Federal
regulation of financial institutions. \1\
---------------------------------------------------------------------------
\1\ Martin Neil Baily is the Bernard L. Schwartz Senior Fellow in
the Economic Studies Program at the Brookings Institutions, the cochair
of the Pew Working Group on Financial Sector Reform and a member of the
Squam Lake group of academics studying financial reform. He was
Chairman of the Council of Economic Advisers under President Clinton.
The opinions expressed are his own but he would like to thank Charles
Taylor, Alice Rivlin, Doug Elliott, and many other colleagues for
helpful comments.
---------------------------------------------------------------------------
I would like to share with the Committee my thoughts on
consolidation of the Federal financial regulatory agencies and what it
would take to make them successful in the future. However, this is part
of a larger puzzle--the reorganization of Federal financial regulation
generally and, in some respects, it is difficult to discuss the
narrower topic without examining the broader context. I will therefore
also say something about possible complementary changes in the roles of
the Federal Reserve, the SEC and the proposed CFPA.
A summary of my testimony today is as follows:
The best framework to guide current reform efforts is an
objectives approach that divides regulation up into
microprudential, macroprudential, and conduct of business
regulation.
The quality of regulation must be improved regardless of
where it is done. Regulatory and supervisory agencies must have
better qualified, better trained and better paid staff with
clear objectives to improve safety and soundness and encourage
innovation. Regulatory personnel must be accountable for their
actions.
A single Federal microprudential regulator should be
created combining the regulatory and supervisory functions
currently carried out at the Fed, the OCC, the OTS, the SEC,
and the FDIC. This regulator should partner closely with State
regulators to ensure the safety and soundness of State
chartered financial institutions, sharing supervisory
authority.
The U.S. needs effective conduct of business regulation.
The SEC is currently charged with protecting shareholders and
the integrity of markets and must improve its performance in
this area. In my judgment, the SEC should also create a new
division within the agency to protect consumers, that is to
say, it would add a CFPA division and become the consolidated
conduct of business regulator. Although my first choice is for
a single conduct of business regulator, a well-designed
standalone CFPA could also be effective.
The Fed should be the systemic risk monitor with some
additional regulatory power to adjust lending standards. In
this it should work with a Financial Services Oversight
Council, as has been proposed by the Treasury.
The Objectives Approach to Regulation
I support an objectives-based approach to regulation.
The Blueprint for financial reform prepared by the Paulson Treasury
proposed a system of objectives-based regulation, an approach that is
the basis for successful regulation in Australia and other countries
overseas. The White Paper prepared by the Geithner Treasury did not use
the same terminology, but it is clear from the structure of the paper
that their framework is an objectives-based one, as they lay out the
different elements of regulatory reform that should be covered.
However, they do not follow through the logic of this approach to
suggest a major reorganization of regulatory responsibilities.
There are three major objectives of regulation:
First is the microprudential objective of making sure that
individual institutions are safe and sound. That requires the
traditional kind of regulation and supervision--albeit of
improved quality.
Second is the macroprudential objective of making sure that
whole financial sector retains its balance and does not become
unstable. That means someone has to warn about the build up of
risk across several institutions and take regulatory actions to
restrain lending used to purchase assets whose prices are
creating a speculative bubble.
Third is the conduct of business objective. That means
watching out for the interests of consumers and investors,
whether they are small shareholders in public companies or
households deciding whether to take out a mortgage or use a
credit card.
An objectives-based approach to regulation assigns responsibilities
for these three objectives to different agencies. The result is clear
accountability, concentration of expertise, and no gaps in coverage of
the financial services industry--even as its structure changes and new
products, processes and institutional types emerge. No other way of
organizing regulation meets these important criteria while avoiding an
undue concentration of power that a single overarching financial
services regulator would involve. \2\ The main focus of this testimony
will be to make the case for a single microprudential regulator,
something I believe would enhance the stability of the financial
sector. Having a single microprudential regulator is not a new idea. In
1993, the Clinton Administration and the Paulson Blueprint in 2008
proposed the same thing.
---------------------------------------------------------------------------
\2\ See, ``Pew Financial Reform Project Note #2: Choosing Agency
Mandates'', by Charles Taylor.
---------------------------------------------------------------------------
It is important to remember that how we organize regulation is not
an end in itself. Our plan must meet the three objectives efficiently
and effectively, while avoiding over-regulation. In addition for
objectives-based regulation to work, it is essential to use the power
of the market to enhance stability. Many of the problems behind the
recent crisis--executive and trader compensation, excessive risk
taking, obscure transaction terms, poor methodologies, and conflicts of
interest--could have been caught by the market with clearer, more
timely and more complete disclosures. It will never be possible to have
enough smart regulators in place that can outwit private sector
participants who really want to get around regulations. An essential
part of improving regulation is to improve transparency, so the market
can exert its discipline effectively.
The Independence of the Federal Reserve
In applying this approach, it is vital for both the economy and the
financial sector is that the Federal Reserve has independence as it
makes monetary policy. Experience in the U.S. and around the world
supports the view that an independent central bank results in better
macroeconomic performance and restrains inflationary expectations. An
independent Fed setting monetary policy is essential.
The Main Regulators and Lessons From the Crisis
The main Federal microprudential regulators had mixed performance
at best during the recent crisis.
OTS did worst, losing its most important institutions--WaMu,
IndyMac, and AIG--to sale and outright failure. Without any economies
of scale in regulation, OTS suffered from a small staff in relation to
their supervisory responsibilities. Its revenue was dominated by fees
on a very small number of institutions, leading to regulatory capture.
And, as many have observed, OTS lax standards attracted institutions to
a thrift charter and it because the weakest link in the Federal
financial depository regulatory chain. The lessons were: regulatory
competition can create a de facto race to the bottom; and large
institutions cannot be supervised and regulated effectively by small
regulators--not only because of the complexity of the task but also
because of capture.
The Office of the Comptroller of the Currency (OCC) fared only
somewhat better. Their responsibilities were far wider and their
resources were far greater. Nevertheless, several of their larger
institutions failed and had to be rescued or absorbed. While an element
of the problem was that there were parts of these institutions where
their writ did not reach--OCC-regulated banks bought billions of
dollars of CDOs, putting many of them into off-balance-sheet entities--
it was not the only problem. Somehow, even this relative powerhouse
failed to see the crisis coming. The lessons were: even the best of the
Federal regulators may not have been up to the demanding task of
overseeing highly complex financial institutions; and balkanized and
incomplete coverage by microprudential regulators can be fatal.
The FDIC is rightly given credit for having championed the leverage
ratio as an important tool of policy. While the Fed and the OCC became
increasingly enamored of Basel II over the past 10 years, the FDIC
suffered repeated criticism for their stick-in-the-mud insistence on
the leverage ratio. On that issue, they have been vindicated not only
here in the U.S., but internationally. But they did not do so well in
prompt corrective actions during this crisis. Their insurance fund
dropped from $45bn to $10bn in 12 months. Several of the firms that
failed were well capitalized just days beforehand. The lesson is that
liquidity and maturity transformation can matter as much as leverage in
a crisis. Prompt corrective action focused on capital ratios alone is
not enough.
While some State regulators have a fine record, nonbank financial
institutions, largely overseen at the State level, were a major source
of trouble in the recent financial crisis. Often working with brokers,
these institutions originated many of the subprime, prime, and jumbo
mortgages that have subsequently defaulted. They provided the initial
funding for mortgages, but then quickly sold them to other entities to
be packaged and securitized into the CDOs that were sliced and diced
and resold with high credit ratings of dubious quality. They made money
by pushing mortgages through the system and did not carry risk when
these mortgages defaulted. Many State regulators failed to control bad
lending practices. The main lessons: skin in the game is needed to keep
the ``handlers'' of securitizations honest; and any reform of financial
regulation has to somehow strengthen State regulation as well as
Federal.
Perhaps the most difficult regulator to assess in the current
crisis is the Federal Reserve.
More than any other institution, it has prevented the financial
system from falling off a cliff through often brilliant and
unprecedented interventions during the worst days of the crisis. I have
expressed publicly my admiration for the job that Ben Bernanke has done
in managing this crisis with Secretary Geithner and others. Taxpayers
are understandably angry because of the funds that have been spent or
put at risk in order to preserve the financial sector, but the
alternative of a more serious collapse would have been much worse. The
historical experience of financial crises here in the United States and
around the world is that a banking collapse causes terrible hardship to
the economy, even worse than the current recession. Bernanke and
Geithner have helped avoid that disaster scenario.
However, the Fed did nothing at all for 14 years to prevent the
deterioration in mortgage lending practices, even though Congress had
given it the authority to do so in 1994 under HOEPA. Several of the
bank holding companies under Fed supervision faced severe problems in
the crisis--its microprudential regulation was ineffective. And, while
the Fed has repeatedly claimed that systemic risk management was their
responsibility, they failed to anticipate, or even prepare for, the
crisis in any meaningful way.
In short, in its role as a regulator of bank holding companies, the
record of the Fed is not good. Bank regulation has been something of a
poor relation at the Fed compared to the making of monetary policy. The
Fed as an institution has more stature and standing than any other
Federal financial institution, but this stature comes from its control
over monetary policy, not on its role in bank supervision and
regulation. In addition, the Fed's powers were limited. It could not
gain access to key information from many large financial institutions
and had no power to regulate them. Lehman and Bear Stearns are two
examples.
While, the Fed has increased its knowledge and understanding of the
large banks as a result of managing the crisis and conducting the
stress tests, the lessons are: having an institution with a secondary
mandate for consumer protection (under HOEPA) does not work well; and
the Fed's focus on monetary policy also makes it difficult to direct
enough institutional focus on supervision.
Finally, there is the Securities and Exchange Commission which did
an abysmal job in this crisis. It told the public that Bear Stearns was
in fine shape shortly before the company failed; in fact it failed to
supervise effectively any of the bulge bracket firms, Merrill Lynch,
Bear Stearns, Goldman Sachs, Morgan Stanley, and Lehman). It did
nothing to restrain the credit agencies from hyping the ratings of
CDOs. And it did not stop Madoff and others from defrauding investors.
However, the leadership has changed at the SEC and I believe it has
learned important lessons from the crisis: its strong suit is not
microprudential regulation of institutions; it must focus on investor
protection and the integrity of the markets--not only the traditional
ones like the stock and bond markets, but also the securitization
market--including the development and implementation of policies to
revamp securitization credit ratings.
One vital issue to recognize in regulating the large financial
institutions is that they are run as single businesses. They decide
what their business strategies will be and how to execute them most
effectively. The specific legal forms they choose for their different
divisions is determined by what they think will work best to achieve
their strategic goals, given the tax, regulatory and legal environment
that policymakers have set up. Under the current regulatory system, the
Fed supervises and regulates the bank holding company while, for
example, the OCC supervises the U.S. banks that are the subsidiaries of
the holding company. Most of the large financial institutions are in
several lines of business and, at present, are regulated by more than
one agency. Inevitably, this encourages them to shift activities to the
subsidiary and hence the regulator that is most tolerant of the
activity they want to pursue. Balkanized regulation is unlikely to stop
the next crisis.
This short review is not inclusive. There are credit unions that
have a separate regulator and there are important issues around the
GSE's and their regulation and around derivatives and their regulation
that I will not tackle in this testimony. This review has been critical
of the regulatory agencies but I want to note that there are many
people to blame for the financial crisis, including bankers who took
excessive risks and failed to do due diligence on the assets they
purchased. Economists generally did not predict that such a severe
crisis was possible. Very few people saw the possibility of a 20
percent or more decline in the price of housing and almost nobody saw
the depth of problems that have resulted from the sharp declines in
house prices.
What Structure Best Meets the Objectives of Financial Regulation?
Regulatory Performance Must Be Improved Regardless of Where It Is Done
There must be improved performance in the supervision and
regulation of financial institutions regardless of who is doing it.
There were rooms full of regulators sitting in all of the large
regulated financial institutions prior to the crisis and they failed to
stop the crisis. This means there should be more accountability for
regulators, so that they are censured or removed if they do not perform
the role they were hired to do. It means they should be better paid. It
seems paradoxical to reward a group that did not do so well
historically, but if we want better regulators then they must receive
salaries that make their jobs attractive to high quality people, those
who can understand complex institutions and products and who may have
the option of earning high incomes in the private sector. Adequate
training must be available. Better quality regulation is a ``must-
have'' of financial reform and must be part of the legislation now
being considered. A lot of improvement can be made even under existing
legislation if regulators have the incentives and abilities to do their
jobs.
Some people argue that regulation has been the cause of the problem
and that if the Government were removed from the equation then the
financial sector would regulate itself, with weak companies failing and
the strong companies surviving. Overall, I am a strong supporter of
letting markets work and letting companies fail if they cannot be
efficient or innovative. This includes financial institutions that
should be allowed to fail if they do make bad decisions and fail to
meet the market test. The financial sector has unique features that
make it different from most other industries, however. Failure in one
institution can spill over to others and problems in the financial
sector can rock the whole economy, as we have seen in this crisis.
Regardless of one's perspective on this issue, however, it is clearly a
mistake to create worst of both worlds. If the Government provides a
safety net for consumer deposits and props up financial institutions in
a crisis, then there must be effective high quality regulation that
will protect the interests of taxpayers.
The Case for a Consolidated Microprudential Regulator for the Financial
Sector
A single prudential regulator would become a powerful institution
with stature in the policy community that could hire talented staff and
attract strong and able leadership. It would be formed by drawing
together the best people from the existing supervisors and regulators
in the OCC, the OTS, the SEC, the FDIC, and the Federal Reserve, it
would hire financial experts in areas where more expertise was needed,
and it would be the primary supervisor of the institutions that make up
the financial sector of the United States. The head of the organization
would be chosen by the President with the consent of the Senate and
would serve for a term of several years. It would be worth considering
a structure like that of the Federal Reserve, with a board that served
staggered 16 year terms. Thus constituted, the financial regulator
would have the standing and capability to stand up to the heads of
leading financial institutions and to be an independent arbiter. It
would be a partner with and advisor to the Administration, Congress and
the Federal Reserve.
The financial sector does not stand still. It evolves and innovates
and new institutions and products are born. A single prudential
regulator with the necessary staff and skills would be best positioned
to evolve along with the industry and adapt regulation to a changing
world. Having a single prudential regulator would make it much easier
to avoid gaps in regulation and discourage the kind of regulatory
evasion that contributed to the crisis. It would also reduce the
regulatory burden on financial institutions because it would avoid much
of the duplication that now exists.
A single prudential regulator would supervise and regulate large
institutions and small and be able to maintain a level playing field
for competition. It would be able to examine all of the activities of
the large global banks and make sure they were not accumulating
excessive risks through a combination of activities in different parts
of their business.
There is a great deal to be said for competition in our economy.
Ultimately, competition in the private sector drives innovation and
growth and provides choices to consumers. It is the lifeblood of our
economy. It is not clear, however, that competition among regulators a
good thing. The serious danger in regulatory competition is that it
allows a race to the bottom as financial institutions seek out the most
lenient regulator that will let them do the risky things they want to
try, betting with other people's money. One possible advantage of
regulatory competition is that it could make it easier for companies to
innovate whereas a single regulator might become excessively
conservative and discourage new products even if these would bring
substantial benefits. However, given the experience of the recent
crisis, the dangers created by multiple regulators, including a race to
the bottom, are greater and outweigh the possible advantages of
competition among regulators.
An effective single prudential regulator acting as a cop on the
beat could actually increase the level of effective competition among
private companies in the financial sector, thus making the private
market work better. In addition, it would be very important that the
mandate of the single prudential regulator include the promotion of
innovation and economic growth. The U.S. financial sector has been one
of the strongest in the world and has been one of our major exporters.
Prior to the crisis there was great concern that the New York financial
markets were losing their global competitive position--See, for example
the Bloomberg-Schumer report. The goal of sustaining a dynamic and
competitive sector remains vital.
Another advantage of creating a single Federal prudential regulator
is that it would enhance the independence of the Federal Reserve in
making monetary policy. It gets the Fed out of the regulatory business
and lets it concentrate on its main tasks.
The Role of the FDIC
With a single microprudential regulator, the FDIC would lose the
supervisory and regulatory authority it has now. Staff from the FDIC
that have performed well in this crisis would move to the new
prudential regulator, so there would not be a loss of knowledge or
expertise. The role of the FDIC as manager and supervisor of the
deposit insurance fund would continue. In this position, it would also
be able to sound warnings about depository institutions in
difficulties, acting as a backup for the new unified prudential
regulator. Another possibility is that the FDIC would become the
principle agency dealing with the resolution of failing institutions.
\3\
---------------------------------------------------------------------------
\3\ I have testified to this Committee before on the dangers of
``too big to fail'' or ``too interconnected to fail.'' An important
aspect of regulatory reform is to make sure badly run financial
companies are allowed to fail in a way that does not imperil the whole
system, either through a resolution mechanism or through a special
bankruptcy court. The FDIC would play an important role with either
system.
---------------------------------------------------------------------------
The SEC as the Conduct of Business Regulator
Under the single prudential regulator described above, the SEC
would lose its authority to supervise nonbank financial institutions,
which would reside instead with the prudential regulator. The SEC would
continue to have a very important role as a protector of the interests
of shareholders, a bulwark against insider trading, market
manipulation, misselling and other practices that can undermine our
capital markets. There is a case for giving the SEC additional
authority to provide consumers protection against financial products
that are deceptive or fraudulent.
The Treasury White Paper proposed establishing a new standalone
agency, the CFPA, to provide consumer protection and it is
understandable that such a proposal is made given what has happened.
There were a lot of bad lending practices that contributed to the
financial crisis. As noted earlier, many brokers and banks originated
mortgages that had little chance of being repaid and that pushed
families onto the street, having lost their savings. There was also
misbehavior by borrowers, some of whom did not accurately report their
income or debts or manipulated their credit scores. I agree with the
Administration and many in Congress--notably Chairman Dodd--on the
importance of protecting families against a repetition of the bad
behavior that proliferated in recent years.
My first choice would be to place the responsibility for consumer
protection in a new division within the SEC rather than creating a
separate agency. The proliferation of regulators was a contributory
factor in the crisis, so that adding a new agency is something that
should be done reluctantly. While the SEC did badly in the crisis,
there has been an important change in leadership and the new head of
the agency is clearly someone of strength and talent who has pledged
reform in the operations of the agency. Congress should ask the SEC to
form a new CFPA division within its ranks charged specifically with
consumer protection. \4\
---------------------------------------------------------------------------
\4\ The Federal Reserve did not do a good job in protecting
consumers in the period leading up to this crisis, nor did it stop the
erosion of mortgage lending standards that contributed to build up of
toxic assets in the financial system. Since the crisis, however, the
consumer protection division within the FED has been strengthened and
is now an effective force with strong leadership. The personnel from
the consumer protection division of the FED, together with the best
personnel in this function in other agencies, could be moved into the
new CFPA division.
---------------------------------------------------------------------------
Placing the tasks of the CFPA into the SEC would create a single
strong conduct of business regulator with divisions specifically tasked
to protect both consumers and small and minority shareholders. It would
also make it easier to gain acceptance for greater consumer protection
from the financial industry. The CFPA has become a lightning rod for
opposition to regulatory reform. Given that the financial sector is
largely responsible for the crisis, it is surprising that this sector
is now lobbying so hard against greater consumer protection. Greater
protection for consumers is needed and that would also provide greater
protection for taxpayers. However, having the CFPA functions as a
division within the SEC would accomplish that goal while calming
industry fears.
Having the CFPA functions within the SEC is my first choice, but if
Congress decides against this approach, I could support a standalone
agency. The Treasury White Paper does a good deal to allay the fears
that the new agency would stifle innovation, including: the overall
focus on unfair, deceptive, and dangerous practices, rather than risk,
per se; the instruction to weigh economic costs and benefits; the
instruction to place a significant value on access to financial
products by traditionally underserved consumers; the prohibition
against establishing usury limits and; the option to consider previous
practice in regard to financial products. The Treasury recognizes the
dangers of having an agency that would overreach and its proposed
structure would avoid that possibility. \5\
---------------------------------------------------------------------------
\5\ See, additional discussion of these issues by Douglas Elliott
of Brookings and also by the current author posted on the Brookings Web
site. The financial reform project of the Pew Charitable trusts has
also posted material on the topic.
---------------------------------------------------------------------------
One final issue with the CFPA is preemption. The Treasury proposal
indicates that State regulators would have the power to enact consumer
protection legislation that was stronger than that in the Federal
statute. I understand the case for States' rights in this arena, but
the prospect of a myriad of different State rules is daunting and has
the potential to reduce the efficiency of the massive U.S. marketplace.
There has been enormous progress towards a single market in financial
products, leveling the playing field for businesses and consumers, so
that the terms of loans or other financial activities are the same in
all States. Whether or not Federal consumer protection rules preempt
State rules is not a major issue for safety and soundness, but having
single set of consumer rule uniform in all States would improve
economic efficiency. As a result, I support the view that Federal rules
should preempt State rules in this area.
Regulating State Chartered Financial Institutions
Starting with a clean sheet of paper, I would prefer to see all
banks and relevant nonbank financial institutions have Federal charters
and be supervised by the unified prudential regulator. However, that is
not the situation we are in and I recognize the importance of States'
rights and the desire to have local institutions that can help local
businesses by using the power of personal knowledge and relationships.
It is a fact of life that there will continue to be State chartered
banks subject to State supervision.
In the short run, it is unlikely that we will see again State
chartered nondepository institutions that are originating and selling
bad mortgages. The markets have been burned and will remember for a
while that such institutions may not be selling quality products. Over
the years, however, memories will fade and regulatory reform enacted
today should avoid problems in the future as far as possible. I urge
Congress to require State regulators to partner with the Federal
prudential regulator in order to harmonize safety and soundness
standards and to exchange information for State chartered banks and
nonbanks. The Federal prudential regulator should set out minimum
standards that it would like to see in State run financial
institutions. And State regulators should be required to exchange data
with the Federal regulator and work in cooperation with them. This is
already how things work for most banks and it is important that we do
not see in the future a situation where State charters are exploited by
nonbank financial institutions to undercut the safety of the financial
system.
The Federal Reserve as Systemic Risk Monitor or Regulator
The Treasury White Paper has proposed that there be a council, an
extension of the President's Working Group on financial stability to
coordinate information and assess systemic risk. The Working Group has
played a valuable role in the past and I support its extension to
include the leaders of all institutions with power to regulate the
financial sector. As others have said, however, committee meetings do
not solve crises.
The proposal outlined earlier in this testimony is for a single
microprudential regulator, which would deprive the Fed of all its
microprudential functions. However, I propose that monitoring and
managing systemic stability and responding to increased exposure to
systemic risks formally be added to the Fed's responsibilities. The
strong performance of the Fed in managing this crisis strongly suggests
that this institution should be the primary systemic risk monitor/
regulator. Moreover, this role is a natural extension of monetary
policy, which can be thought of as the monitoring of, and response to,
macroeconomic developments. It fits with the dominant culture of
economists and the Fed's strong tradition of independence, which are
both needed for systemic risk management to be effective. It would
slightly cut into the role you have proposed for the Financial Services
Oversight Council, but not much.
For monitoring the economy and for making monetary policy the Fed
needs, among other things, quick access to a broad base of financial
information. Currently, the regulatory reporting is primitive. More
complete, relevant and real time data should be available to all
Federal financial regulators. A coordinated information strategy for
the Federal financial regulatory agencies ought to be one of the first
tasks of the FSOC. The Fed as systemic regulator would need to work
closely with the prudential regulator so that it knows what is going on
inside the big institutions, and the small ones. It would also need to
work closely with the Treasury and the FSOC, exchanging information
with all members that could help it see dangerous trends as they
emerge.
To respond to specific systemic risks, the Fed needs another
instrument in addition to its control over short term interest rates
and I suggest that Congress should grant the Fed the power to adjust
minimum capital, leverage, collateral and margin requirements generally
in response to changing systemic risks, in addition to the specific
power it has had to adjust margin requirements in stock trading since
the Great Depression. The microprudential regulator would set basic
minimum standards. The Fed would adjust a ``multiplier'' up or down as
systemic circumstances required. This additional power should be used
rarely and in small increments; recall how the Volcker-Carter credit
restrictions stopped the U.S. economy on a dime in 1980.
No one can guarantee that a systemic regulator will be able to
foresee the next bubble or crisis, but it is definitely worth the
effort to spot trouble forming. In particular, the Fed may be able to
spot a concentration of purchases of risky assets made with borrowed
funds. A systemic regulator could have seen that many banks had lent
large sums to LTCM to speculate in Russian bonds or other risky assets.
It should have been able to spot the build up of risky CDOs in SIVs
that were affiliated with the banks. It could potentially see if large
hedge funds or private equity companies were using borrowed funds and
concentrating on a particularly risk class of assets. Analysts who were
studying the real estate market prior saw signs of trouble well before
the crisis started.
Conclusions
A single strong agency would meet the objective of microprudential
regulation of all financial institutions that were subject to
regulation and supervision. It would work with State regulators,
especially to make sure the abuses that contributed to the crisis could
not be repeated. It would work closely with the conduct of business
regulator(s) (the SEC and the CFPA) and the Federal Reserve to ensure
that consumer protection is adequate, that monetary policymakers are
well informed and that all these institutions and the Treasury would
work together effectively to deal with a new crisis should it occur in
the future.
The Federal Reserve has shown its mettle in managing the crisis and
should be given the role of principle systemic regulator or monitor. It
would work closely with the members of the risk council in performing
this task. It should have the power to adjust borrowing rules prudently
if it sees a bubble developing driven by excessive leverage.
The SEC is the natural institution to become the conduct of
business regulator with a mandate to protect small and minority
shareholders and, with a CFPA division, also to protect consumers in
financial markets. A single prudential regulator plus a single conduct
of business regulator would constitute the so-called ``twin peaks''
approach to regulation that many experts around the world see as the
best regulatory structure. However, a well-designed standalone CFPA
could also be an effective protector of consumers and taxpayers.
Appendix: Lessons From the U.K. and Australia
Opponents of regulatory consolidation in the United States
frequently cite the experience of the United Kingdom, which has a
consolidated regulator, the Financial Services Authority (FSA) but did
not escape the crisis, indeed it has suffered perhaps even worse than
the United States. Given London's status as a global financial center
it was to be expected that the U.K. would face problems in the global
crisis, but it is surprising that the extensive regulatory reforms
undertaken in the late 1990s did not better insulate the country from
the effects of the financial crisis.
In 1997 the U.K. overhauled its financial regulatory system,
combining a myriad of independent regulatory authorities (including the
regulatory functions of the Bank of England, the Securities Investment
Board, and the Securities Futures Board, among nine total) into a
single entity. Then Chancellor of the Exchequer Gordon Brown argued
that the distinctions between banks, securities firms and insurance
companies had broken down, and that in this new era of more fluid and
interchangeable institutional definitions, the old regulatory divisions
no longer made sense. The FSA's statutory objectives are to maintain
market confidence, to promote public awareness on financial matters, to
protect consumers, and to reduce financial crime. To achieve those
ends, the FSA employs broad investigatory, enforcement, and
prosecutorial powers.
Although the external structure of regulation in the U.K. may
appear simple enough, there is a great deal of internal complexity.
There are two main branches within the FSA; one branch which deals with
retail markets and another branch, which focuses on wholesale and
institutional markets. Within each branch, there are further divisions
based on specific financial activities and institutional design,
including insurance, banking and mortgages, asset management, and
credit unions. There also exist some internal groups which look at
specific financial activities in each of the retail and wholesale
sectors. Therefore, in practice the FSA did not create an effective
single prudential regulator. Instead it preserved some of its older
agency divisions, albeit under a single umbrella. Critics of the FSA
have pointed to the haste with which the FSA was formed and the failure
of the new integrated regulator to fully overcome the old institutional
divisions of its former approach to regulation.
The FSA has admitted on its own to significant failings over
Northern Rock. An internal FSA report cited inadequate resources
devoted to overseeing the institution, including high personnel
turnover and limited direct contact with the institution (no one had
visited the bank for 3 years), and a failure to push management at the
bank to modify an eventually disastrous business model. \6\ The U.K.
Government was determined to develop London as the key financial center
in Europe and that London could compete effectively with New York. As
part of this strategy, they instituted ``light touch'' regulation, in
which financial institutions were given the goals or principles that
they should follow but were given considerable leeway to determine how
the goals should be met. While there is some merit in this approach, it
created significant danger and it meant in practice that U.K. financial
institutions took on excessive risks. Some U.K. banks developed a
reputation around the world for lending money to companies that local
banks would not touch and the regulators were not stopping them from
taking these bad risks.
---------------------------------------------------------------------------
\6\ Hughes, 2008.
---------------------------------------------------------------------------
Another problem is that there was totally inadequate communication
between the FSA and the Bank of England. The Bank of England was intent
on maintaining its independence and focused on its mission of fighting
inflation. When the crisis struck, the Bank was unwilling to step in
quickly to support troubled institutions and markets because it had not
been kept up to date about the condition of the banks and had not been
tasked with the job of maintaining system stability.
In summary, the U.K. experience does not provide an appropriate
counter example for the regulatory model proposed in this testimony.
They did not create an effective, strong single prudential regulator.
They did not make the Bank of England responsible for systemic
stability, nor did they ensure that the Bank of England was informed
about the condition of the U.K. banks.
Australia does not have a major financial center serving the global
market and so it cannot provide an ideal example for the United States
to copy. Nevertheless, the Australian regulatory reforms seem to have
been well designed and well-executed and there are some lessons to be
learned.
Australia determined that the ``twin peaks'' model was the right
one and they created the Australian Prudential Regulatory Authority
(APRA), which is responsible for prudential regulation while the
Australian Securities and Investment Commission (ASIC) oversees
conduct-of-business regulation. A cross-agency commission seeks to
resolve conflicts of overlap and facilitate communication between the
two agencies.
The Australian economy weathered the financial crisis better than
many other developed countries, and its experience owes much of its
better-than-average performance during the financial crisis to sound
policy choices and the effectiveness of its financial regulation. There
was not a housing bubble and there was not the same erosion in lending
standards as had occurred in the U.S. This was in part due to stricter
regulation of mortgage lending. Australia's prudential regulator had
raised capital requirements for banks investing in riskier mortgage
products. \7\ Consumer protection laws and foreclosure laws also
discouraged borrowers from taking out mortgages that they could not
afford.
---------------------------------------------------------------------------
\7\ Ellis, 2009.
---------------------------------------------------------------------------
Until 1998 Australian financial regulation resided with the
country's Central Bank and took an institutional approach. Following a
review of the country's overall financial system, the twin peaks
approach was put into place. As in the U.K., APRA's regulation is a
largely a principles-based approach, relying heavily on dialogue
between the regulators and the regulated institutions, but with a
considerably heavier touch by the regulators to guard against excessive
risk taking.
The ASIC oversees securities market and financial services
providers. ASIC has the power to impose criminal or civil sanctions
against financial firms or individuals. As a corporate regulator, ASIC
oversees company directors and officers, capital raising, takeovers,
financial reporting, etc. It also provides licensing and monitoring for
financial services firms. In addition, ASIC has been tasked to protect
consumers against misleading or deceptive conduct related to financial
products and services.
The Australian approach is cited as a model for other countries,
for example in the Paulson Treasury's blueprint, in part because it
allows flexibility and innovation, while maintaining protections. The
regulatory structure is not the only reason for the fact that their
economy avoided the worst of the financial crisis, but it seems to have
helped. One aspect of the Australian regulatory approach that could
serve as a model is the process by which it arrived at reform. Where
the road to reform in the U.K. was hasty and lacked adequate
consideration, the Australian reform process began with the Wallis
Inquiry in 1996 to review how financial system reform could be
structured in Australia. The inquiry looked specifically at how prior
attempts at deregulation had affected the Australian financial system,
what forces were at work changing the system further, and what would
provide the most efficient, effective and competitive regulatory
structure for the country going forward.
In summary, Australia provides a good positive example where a
single prudential regulator has worked well.
______
PREPARED STATEMENT OF RICHARD S. CARNELL
Associate Professor, Fordham University School of Law
September 29, 2009
Mr. Chairman, Senator Shelby, Members of the Committee: You hold
these hearings in response to an extraordinary financial debacle,
costly and far-reaching: a debacle that has caused worldwide pain and
will saddle our children with an oversized public debt. ``And yet,'' to
echo President Franklin D. Roosevelt's inaugural address, ``our
distress comes from no failure of substance. We are stricken by no
plague of locusts. . . . Plenty is at our doorstep.'' Our financial
system got into extraordinary trouble--trouble not seen since the Great
Depression--during a time of record profits and great prosperity.
This disaster had many causes, including irrational exuberance,
poorly understood financial innovation, loose fiscal and monetary
policy, market flaws, regulatory gaps, and the complacency that comes
with a long economic boom. But our focus here is on banking, where the
debacle was above all a regulatory failure. Banking is one of our most
heavily regulated industries. Bank regulators had ample powers to
constrain and correct unsound banking practices. Had regulators
adequately used those powers, they could have made banking a bulwark
for our financial system instead of a source of weakness. In banking,
as in the system as a whole, we have witnessed the greatest regulatory
failure in history. Our fragmented bank regulatory structure
contributed to the debacle by impairing regulators' ability and
incentive to take timely preventive action. Reform of that structure is
long overdue.
In my testimony today, I will:
1. Note how regulatory fragmentation has grave defects, arose by
happenstance, and persists not on its merits but through
special-interest politics and bureaucratic obduracy;
2. Recommend that Congress unify banking supervision in a new
independent agency; and
3. Reinforce the case for reform by explaining how regulatory
fragmentation helps give regulators an unhealthy set of
incentives--incentives that hinder efforts to protect bank
soundness, the Federal deposit insurance fund, and the
taxpayers.
I. Fragmentation Impedes Effective Supervision
Fragmentation Is Dysfunctional
Our fragmented bank regulatory structure is needlessly complex,
needlessly expensive, and imposes needless compliance costs on banks.
It ``requires too many banking organizations to deal with too many
regulators, each of which has overlapping, and too often maddeningly
different, regulations and interpretations,'' according to Federal
Reserve Governor John LaWare. It engenders infighting and impedes
prudent regulatory action. FDIC Chairman William Seidman deplored the
stubbornness too often evident in interagency negotiations: ``There is
no power on earth that can make them agree--not the President, not the
Pope, not anybody. The only power that can make them agree is the
Congress of the United States by changing the structure so that the
present setup does not continue.'' The current structure promotes
unsound laxity by setting up interagency competition for bank
clientele. It also blunts regulators' accountability with a tangled web
of overlapping jurisdictions and responsibilities. Comptroller Eugene
Ludwig remarked that ``it is never entirely clear which agency is
responsible for problems created by a faulty, or overly burdensome, or
late regulation. That means that the Congress, the public, and
depository institutions themselves can never be certain which agency to
contact to address problems created by a particular regulation.''
Senator William Proxmire, longtime Chairman of this Committee,
called this structure ``the most bizarre and tangled financial
regulatory system in the world.'' Treasury Secretary Lloyd Bentsen
branded it ``a spider's web of overlapping jurisdictions that
represents a drag on our economy, a headache for our financial services
industry, and a source of friction within our Government.'' Chairman
Seidman derided it as ``complex, inefficient, outmoded, and archaic.''
The Federal Reserve Board declared it ``a crazy quilt of conflicting
powers and jurisdictions, of overlapping authorities, and gaps in
authority'' (and that was in 1938, when the system was simpler than
now). Federal Reserve Vice Chairman J.L. Robertson went further:
The nub of the problem . . . is the simple fact that we are
looking for, talking about, and relying upon a system where no
system exists. . . . Our present arrangement is a happenstance
and not a system. In origin, function, and effect, it is an
amalgam of coincidence and inadvertence.
Opponents of reform portray a unified supervisory agency as ominous
and unnatural. Yet although the Federal Government regulates a wide
array of financial institutions, no other type of institution has
competing Federal regulators. Not mutual funds, exchange-traded funds,
or other regulated investment companies. Not securities broker-dealers.
Not investment advisers. Not futures dealers. Not Government-sponsored
enterprises. Not credit unions. Not pension funds. Not any other
financial institution. A single Federal regulator is the norm;
competition among Federal regulators is an aberration of banking.
Nor do we see competition among Federal regulators when we look
beyond financial services--and for good reason. Senator Proxmire
observed:
Imagine for a moment that we had seven separate and distinct
Federal agencies for regulating airline safety. Imagine further
the public outcry that would arise following a series of
spectacular air crashes while the seven regulators bickered
among themselves on who was to blame and what was the best way
to prevent future crashes.
There is no doubt in my mind that the public would demand and
get a single regulator. There is a growing consensus among
experts that our divided regulatory system is a major part of
the problem. There are many reasons for consolidating financial
regulations, but most of them boil down to getting better
performance.
Fragmentation Is the Product of Happenstance
Two forces long shaped American banking policy: distrust of banks,
particularly large banks; and crises that necessitated a stronger
banking system. Our fragmented regulatory structure reflects the
interplay between these forces. As FDIC Chairman Irvine H. Sprague
noted, this structure ``had to be created piecemeal, and each piece had
to be wrested from an economic crisis serious enough to muster the
support for enactment.''
Distrust of banking ran deep from the beginning of the Republic.
John Adams, sober and pro-business, declared that ``banks have done
more injury to the religion, morality, tranquility, prosperity, and
even wealth of the Nation than they have done or ever will do good.''
Thomas Jefferson asserted that states ``may exclude [bankers] from our
territory, as we do persons afflicted with disease.'' Andrew Jackson
won reelection pledging to destroy the Nation's central bank, which he
likened to a malicious monster. This powerful, longstanding distrust of
banking shaped U.S. law in ways that, until recent decades, kept U.S.
banks smaller and weaker (relative to the size of our economy) than
their counterparts in other developed countries.
Yet banking proved too useful to ignore or suppress. To cope with
financial emergencies, Congress acted to strengthen the banking system.
It created:
National banks to finance the Civil War and the OCC to
supervise national banks;
The Federal Reserve in response to the Panic of 1907;
The FDIC, its thrift-institution counterpart, and the
Federal thrift charter to help stabilize the financial system
during the Great Depression; and
The Office of Thrift Supervision in response to the thrift
debacle of the 1980s.
These and other ad hoc actions gave us a hodgepodge of bank regulatory
agencies unparalleled in the world. Each agency, charter type, and
regulatory subcategory developed a political constituency resistant to
reform.
The Bank Holding Company Act, another product of happenstance,
exacerbated this complexity. It ultimately gave most banking
organizations of any size a second Federal regulator: the Federal
Reserve Board. As enacted in 1956, the Act sought to prevent ``undue
concentration of economic power'' by limiting banks' use of holding
companies to enter additional businesses and expand across State lines.
The Act reflected a confluence of three disparate forces: populist
suspicion of bigness in banking; special-interest politics; and the
Federal Reserve Board's desire to bolster its jurisdiction.
Representative Wright Patman, populist chairman of the House Banking
Committee, sought to prevent increased concentration in banking and the
broader economy. Small banks sought to keep large banks from expanding
into new products and territory. A variety of other firms sought to
keep banks out of their businesses. The Fed gained both expanded
jurisdiction and a respite from Chairman Patman's attempts to curtail
its independence in monetary policy. \1\ The Act originally applied
only to companies owning two or more banks. But in 1970 Congress
extended the Act to companies owning a single bank.
---------------------------------------------------------------------------
\1\ Mark J. Roe, ``Strong Managers, Weak Owners: The Political
Roots of American Corporate Finance'', 99-100 (1994).
---------------------------------------------------------------------------
Special-Interest Politics Perpetuate Fragmentation
Regulatory fragmentation leaves individual agencies smaller,
weaker, and more vulnerable to pressure than a unified agency would be.
It can also undercut their objectivity. Fragmentation played a pivotal
role in the thrift debacle. Specialized thrift regulators balked at
taking strong, timely action against insolvent thrifts. Regulators
identified with the industry and feared that stern action would sharply
shrink the industry and jeopardize their agencies' reason for being. In
seeking to help thrifts survive, the regulators multiplied the ultimate
losses to the deposit insurance fund and the taxpayers. For example,
they granted sick thrifts new lending and investment powers for which
the thrifts lacked the requisite competence (e.g., real estate
development and commercial real estate lending).
By contrast, bank regulators who also regulated thrifts took
firmer, more appropriate action (e.g., limiting troubled institutions'
growth and closing deeply insolvent institutions). These policies bore
fruit in lower deposit insurance losses. State-chartered thrifts
regulated by State banking commissioners were less likely to fail--and
caused smaller insurance losses--than thrifts with a specialized,
thrift-only regulator. Likewise, thrifts regulated by the FDIC fared
far better than those regulated by the thrift-only Federal Home Loan
Bank Board.
II. Unifying Federal Bank Supervision
Fragmentation problems have a straightforward, common-sense
solution: unifying Federal bank regulation. Treasury Secretary Lloyd
Bentsen offered that solution here in this room 15 years ago. As
Assistant Secretary of the Treasury for Financial Institutions, I
worked with him in preparing that proposal. He made a cogent case then,
and I'll draw on it in my testimony now.
Secretary Bentsen proposed that we unify the supervision of banks,
thrifts, and their parent companies in a new independent agency, the
Federal Banking Commission. The agency would have a five-member board,
with one member representing the Treasury, one member representing the
Federal Reserve, and three independent members appointed by the
President and confirmed by the Senate. The President would designate
and the Senate confirm one of the independent members to head the
agency.
The commission would assume all the existing bank regulatory
responsibilities of the Comptroller of the Currency, Federal Reserve
Board, FDIC, and Office of Thrift Supervision. The Federal Reserve
would retain all its other responsibilities, including monetary policy,
the discount window, and the payment system. The FDIC would retain all
its powers and responsibilities as deposit insurer, including its power
to conduct special examinations, terminate insurance, and take back-up
enforcement action. The three agencies' primary responsibilities would
correspond to the agencies' core functions: bank supervision, central
banking, and deposit insurance.
This structure would promote clarity, efficiency, accountability,
and timely action. It would also help the new agency maintain its
independence from special-interest pressure. The agency would be larger
and more prominent than its regulatory predecessors and would supervise
a broader range of banking organizations. It would thus be less
beholden to a particular industry clientele--and more able to carry out
appropriate preventive and corrective action. Moreover, a unified
agency could do a better job of supervising integrated banking
organizations--corporate families in which banks extensively interact
with their bank and nonbank affiliates. The agency would look at the
whole organization, not just some parts. Secretary Bentsen put the
point this way:
Under today's bank regulatory system, any one regulator may see
only a limited piece of a dynamic, integrated banking
organization, when a larger perspective is crucial both for
effective supervision of the particular organization and for an
understanding of broader industry conditions and trends.
Having the same agency oversee banks and their affiliates both
simplifies compliance and makes supervision more effective. We have no
need for a separate holding company regulator.
Under the Bentsen proposal, the Fed and FDIC would have full access
to supervisory information about depository institutions and their
affiliates. Their examiners could participate regularly in examinations
conducted by the commission and maintain their expertise in sizing up
banks. As members of a Federal Banking Commission-led team, Fed and
FDIC examiners could scrutinize the full spectrum of FDIC-insured
depository institutions, including national banks. The two agencies
would have all the information, access, and experience needed to carry
out their responsibilities.
The Treasury consulted closely with the FDIC in developing its 1994
reform proposal. The FDIC supported regulatory consolidation in
testimony before this Committee on March 2, 1994. It stressed that in
the context of consolidation it had five basic needs. First, to remain
independent. Second, to retain authority to set insurance premiums and
determine its own budget. Third, to have ``timely access'' to
information needed to ``understand and stay abreast of the changing
nature of the risks facing the banking industry . . . and to conduct
corrective resolution and liquidation activities.'' Fourth, to retain
power to grant and terminate insurance, assure prompt corrective
action, and take back-up enforcement action. Fifth, to retain its
authority to resolve failed and failing banks.
A regulatory unification proposal can readily meet all five of
those needs. Indeed, Secretary Bentsen's proposal dealt with most of
them in a manner satisfactory to the FDIC. The Treasury and FDIC did
disagree about FDIC membership on the Federal Banking Commission. The
FDIC regarded membership as an important assurance of obtaining timely
information. The Treasury proposal did not provide for an FDIC seat,
partly out of concern that it would entail expanding the commission to
seven members. Now as then, I believe that the agency's board should
include an FDIC representative.
The Federal Reserve and FDIC complain that they cannot properly do
their jobs unless they remain the primary Federal regulator of some
fraction of the banking industry. These complaints ignore the sort of
safeguards in Secretary Bentsen's proposal. They also exaggerate the
significance of the two agencies' current supervisory responsibilities.
FDIC-supervised banks hold only 17 percent of all FDIC-insured
institutions' aggregate assets; Fed-supervised banks, only 13 percent.
Nor does the Fed's bank holding jurisdiction fundamentally alter the
picture: the Fed as holding company regulator neither examines nor
supervises other FDIC-insured institutions. The Fed and FDIC, in
carrying out their core responsibilities, already rely primarily on
supervisory information provided by others.
Thus it strains credulity to suggest that the FDIC cannot properly
carry out its insurance and receivership functions unless it remains
the primary Federal regulator of State nonmember banks. These banks,
currently numbering 5,040, average $460 million in total assets. How
many community banks must the FDIC supervise to remain abreast of
industry trends and remember how to resolve a community bank? Likewise,
the Fed cannot plausibly maintain that its ability to conduct monetary
policy, operate the discount window, and gauge systemic risk
appreciably depends on remaining the primary Federal regulator of 860
State member banks (only 10 percent of FDIC-insured institutions),
particularly when those banks average less than $2 billion in total
assets. Moreover, according to the most recent Federal Reserve Flow of
Funds accounts, the entire commercial banking industry (including U.S.-
chartered commercial banks, foreign banks' U.S. offices, and bank
holding companies) holds only some 18 percent of our Nation's credit-
market assets. In sum, the two agencies' objections to reform ring
false. They are akin to saying, ``I can't do my job right without being
the supreme Federal regulator for some portion of the banking industry,
small though that portion may be. Nothing else will do.''
Nor do regulatory checks and balances depend on perpetuating our
multiregulator jumble. ``Regulatory power is not restrained by creating
additional agencies to perform duplicate functions,'' Secretary Bentsen
rightly declared. A unified banking supervisor would face more
meaningful constraints from ``congressional oversight, the courts, the
press, and market pressures.'' Its decision making would also, under my
recommendations, include the insights, expertise, and constant
participation of the Federal Reserve Board and FDIC.
III. Regulatory Fragmentation Promotes Unsound Laxity
Most debate about banking regulation pays little heed to bank
regulators' incentives. That's a serious mistake, all the more so given
the recent debacle. As noted at the outset, regulators had ample powers
to keep banks safe but failed to do so. This failure partly involved
imperfect foresight (an ailment common to us all). But it also
reflected an unhealthy set of incentives--incentives that tend to
promote unsound laxity. These incentives discouraged regulators from
taking adequate steps to protect bank soundness, the Federal deposit
insurance fund, and the taxpayers. Economists refer to such incentives
as ``perverse'' because they work against the very goals of banking
regulation. These incentives represent the regulatory counterpart of
moral hazard. Just as moral hazard encourages financial institutions to
take excessive risks, these incentives discourage regulators from
taking adequate precautions. To improve regulation, we need to give
regulators a better set of incentives--incentives more compatible with
protecting the FDIC and the taxpayers.
Several key factors create perverse incentives for bank regulators.
First, we have difficulty telling good regulation from bad--until it's
too late. Second, lax regulation is more popular than stringent
regulation--until it's too late. Third, regulators' reputations suffer
less from what goes wrong on their watch than from what comes to light
on their watch. This is the upshot:
Bank Soundness Regulation Has No Political Constituency--Until
It's Too Late.
To make the incentive problem more concrete, put yourself in the
position of a regulator who, during a long economic boom and a possible
real estate bubble, sees a need to raise capital standards. The
increase will have short-term, readily identifiable consequences. To
comply with the new standards, banks may need to constrain their
lending and reduce their dividends. Prospective borrowers will
complain. Banks' return on equity will decline because banks will need
more equity per dollar of deposits. Hence bankers will complain. You'll
feel immediate political pain. Yet the benefits of higher capital
standards, although very real, will occur over the long run and be less
obvious than the costs. Raising capital levels will help protect the
taxpayers, but the taxpayers won't know it. Moreover, in pressing
weaker banks to shape up and in limiting the flow of credit to real
estate, you may get blamed for causing problems that already existed.
From the standpoint of your own self-interest, you're better off not
raising capital standards. You can leave office popular. By the time
banks get into trouble, you'll have a new job and your successor will
have to shoulder the problem.
Similar incentives encourage too-big-to-fail treatment. Bailouts
confer immediate, readily identifiable benefits. By contrast, the costs
of intervention (such as increased moral hazard and potential for
future instability) are long-term, diffuse, and less obvious. But you
can leave those problems for another day and another regulator. You
risk criticism whether or not you intervene. But on balance you run a
greater risk of destroying your reputation if you let market discipline
take its course. Unwarranted intervention may singe your career; a
seemingly culpable failure to intervene will incinerate it.
Bank regulators need better incentives far more than they need new
regulatory powers. Creating a unified regulator will make for a
healthier set of incentives.
Conclusion
Now is the right time to fix the bank regulatory structure: now,
while we're still keenly aware of the financial debacle; now, while
special-interest pressure and bureaucratic turf struggles are less
respectable than usual. Reform should promote efficiency, sharpen
accountability, and help regulators withstand special-interest
pressure.
Speaking from this table in 1994, Secretary Bentsen underscored the
risk of relying on ``a dilapidated regulatory system that is ill-
designed to prevent future banking crises and ill-equipped to cope with
crises when they occur.'' He observed, in words eerily applicable to
the present, that our country had ``just emerged from its worst
financial crisis since the Great Depression,'' a crisis that our
cumbersome bank regulatory system ``did not adequately anticipate or
help resolve.'' He also issued this warning, which we would yet do well
to heed: ``If we fail to fix [the system] now, the next financial
crisis we face will again reveal its flaws. And who suffers then? Our
banking industry, our economy, and, potentially, the taxpayers. You
have the chance to help prevent that result.''
PREPARED STATEMENT OF RICHARD J. HILLMAN
Managing Director, Financial Markets and Community Investment Team,
Government Accountability Office
September 29, 2009