[Senate Hearing 110-1001]
[From the U.S. Government Publishing Office]


                                                       S. Hrg. 110-1001
 
                  TURMOIL IN THE U.S. CREDIT MARKETS: 
EXAMINING THE REGULATION OF INVESTMENT BANKS BY THE U.S. SECURITIES AND 

                          EXCHANGE COMMISSION
=======================================================================


                                HEARING

                               before the

                            SUBCOMMITTEE ON
                SECURITIES AND INSURANCE AND INVESTMENT

                                 OF THE

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED TENTH CONGRESS

                             SECOND SESSION

                                   ON

  STEPS TAKEN BY THE AGENCY THEN AND NOW TO ENCOURAGE THE INVESTMENT 
 BANKS THAT IT REGULATES TO BETTER MANAGE THEIR RISKS AND HOW THE SEC 
 CAN BE STRENGTHENED TO MEET ITS MISSION AS THE ADVOCATE FOR INVESTORS 
  WHILE OVERSEEING SECURITIES MARKETS AND FINANCIAL STABILITY OF WALL 
                              STREET FIRMS

                               __________

                         WEDNESDAY, MAY 7, 2008

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate /
                            senate05sh.html


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50-402                    WASHINGTON : 2009
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware           CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey          JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii              MIKE CRAPO, Idaho
SHERROD BROWN, Ohio                  ELIZABETH DOLE, North Carolina
ROBERT P. CASEY, Pennsylvania        MEL MARTINEZ, Florida
JON TESTER, Montana                  BOB CORKER, Tennessee

                      Shawn Maher, Staff Director
        William D. Duhnke, Republican Staff Director and Counsel

               David Stoopler, Professional Staff Member
                Nathan Steinwald, Legislative Assistant

                       Dawn Ratliff, Chief Clerk
                      Shelvin Simmons, IT Director
                          Jim Crowell, Editor

                                 ------                                

        Subcommittee on Securities and Insurance and Investment

                   JACK REED, Rhode Island, Chairman
                 WAYNE ALLARD, Colorado, Ranking Member
ROBERT MENENDEZ, New Jersey          MICHAEL B. ENZI, Wyoming
TIM JOHNSON, South Dakota            ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         CHUCK HAGEL, Nebraska
EVAN BAYH, Indiana                   JIM BUNNING, Kentucky
ROBERT P. CASEY, Pennsylvania        MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
JON TESTER, Montana

                     Didem Nisanci, Staff Director
              Tewana Wilkerson, Republican Staff Director


                            C O N T E N T S

                              ----------                              

                         WEDNESDAY, MAY 7, 2008

                                                                   Page

Opening statement of Chairman Reed...............................     1

Opening statements, comments, or prepared statements of:
    Senator Allard...............................................     3

                               WITNESSES

Erik Sirri, Director, Division of Trading and Markets, Securities 
  and Exchange Commission........................................    33
    Prepared statement...........................................     4
Arthur Levitt, Jr., Former Chairman, Securities and Exchange 
  Commission.....................................................    39
    Prepared statement...........................................    22
David S. Ruder, Former Chairman, Securities and Exchange 
  Commission.....................................................    43
    Prepared statement...........................................    24


                  TURMOIL IN THE U.S. CREDIT MARKETS: 
EXAMINING THE REGULATION OF INVESTMENT BANKS BY THE U.S. SECURITIES AND 

                          EXCHANGE COMMISSION

                              ----------                              


                         WEDNESDAY, MAY 7, 2008

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The subcommittee met at 10:04 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Jack Reed (Chairman of the 
Subcommittee) presiding.

            OPENING STATEMENT OF CHAIRMAN JACK REED

    Chairman Reed. Let me call the hearing to order.
    The events of the past year make it critically clear that 
there is a need to review the adequacy of the country's 
existing financial services regulations, use lessons from the 
current market problems as an opportunity to improve 
regulation, and review the adequacy of resources devoted to 
regulation. Before we can look forward to determine what, if 
any, changes need to be made, there needs to be a sober review 
of how we got to this point.
    The intent of today's hearing is to conduct such a review. 
It is critical that the review not only examine the authority 
of the Securities and Exchange Commission, but also assess the 
way it undertakes its responsibilities when it implements its 
regulations and supervises some of the largest securities firms 
through its Consolidated Supervised Entities (CSE) program. 
Through this program, the SEC has a window into these major 
firms that act as underwriters, issuers, dealers, and investors 
in many of the complex securities products that are in the 
market today.
    A little over a year ago, I chaired a Subcommittee hearing, 
along with my Ranking Member, Senator Allard, examining the 
role of securitization where witnesses from Bear Stearns, 
Lehman Brothers, S&P, and Moody's, who all four are within the 
oversight of the SEC, testified that problems in the subprime 
area were confined to a small part of the market. Of course, 
since then we have learned that the fallout from the subprime 
turmoil is deeper and broader than we were led to believe.
    Recent estimates on worldwide losses stemming from the U.S. 
subprime mortgage crisis range from $600 billion to $1 
trillion. To date, some of the largest banks and securities 
firms have recognized roughly $285 billion in losses. Moreover, 
writedowns in the financial services industry have led S&P to 
forecast 20 to 30 percent revenue reduction in the securities 
industry overall, with the potential for even greater revenue 
reductions.
    Throughout, the SEC and other financial regulators did not 
fully appreciate the risks that were piling up in SIVs and in 
the CDOs that have now collapsed and have come back on the 
balance sheets of some of these large institutions. Use of 
these ill-advised structures has led to massive losses and 
significantly depleted capital levels.
    On March 12th, merely days before the failure of Bear 
Stearns, I received a response from the SEC to my inquiry on 
disclosure and reporting requirements that applied to the 
structured finance market. In its response, the SEC stated that 
it is ``actively engaged in investigating possible fraud or 
breaches of fiduciary duty involving structured finance 
products, such as CDOs, and also whether bank holding companies 
and securities firms made proper disclosure in their filings 
and public statements of what they knew about their CDO 
portfolios and their valuations. The letter further stated that 
the Commission was taking appropriate steps to ensure that 
there was proper disclosure in terms of firms' CDO exposures 
and whether the deals considered suitability requirements when 
selling complex debt-related securities such as mortgage-backed 
securities.
    These are all appropriate actions by the regulator. 
However, in response to the current crisis, what needs to be 
addressed is how the SEC can avoid or mitigate the effects of 
these market problems for the future. We are interested in 
learning what knowledge has the SEC gained in response to the 
market turmoil and how is it applying that knowledge to improve 
oversight under the CSE program. Did the SEC's CSE program, 
with a focus on the CSEs' own models, lead to increased 
leverage and reduced capital? What is the SEC doing now to 
improve risk assessment procedures to ensure that future 
problems of this kind are caught at the outset and are not 
allowed to grow to the degree that they threaten the global 
economy and lead to the failure of another investment firm?
    What question does this raise about the reliance on CSEs' 
risk models which could not adequately measure the risk of new 
financial products? How are some of the CSEs allowed to place 
significant amounts of liabilities in SIVs and SPEs beyond the 
scrutiny of investors and, indeed, the regulator? How did the 
SEC monitor and ensure that potential conflicts were managed 
within CSE firms as issuers of mortgage-backed securities and 
the NRSROs? How should regulation of CSEs change the result of 
the Federal Reserve's dramatic action to stand behind certain 
firms which some have referred to as the ``too interconnected 
to fail'' doctrine? Finally, what is the balance between a 
principles-based approach and a rules-based approach that 
focuses more on examination and reviews of the firms' 
activities to gain a better understanding of these firms' 
operations?
    As everyone in the room knows, safety and soundness is not 
just about adequate capital levels, but also about ensuring 
that products offered by these entities are transparent and 
appropriate for consumers and investors and, indeed, the 
institutions themselves. We are again reminded that in times of 
easy money and access to cheap credit made possible by a low-
interest-rate environment, regulators need to be more vigilant, 
not less. And, finally, in times of crisis, it is as important 
to understand what went wrong as it is to heed the lessons 
learned so we do not see repeated events.
    Now I would like to recognize Senator Allard for his 
opening statement. Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. First of all, Mr. Chairman, I would like to 
thank you for convening this hearing of the Securities 
Subcommittee to examine regulation of investment banks.
    As Chairman Cox said at our recent hearing on Bear Stearns, 
and I quote, ``The SEC's mission--the protection of investors, 
the maintenance of orderly markets, and the promotion of 
capital formation--is more important now than it has ever been. 
The recent turmoil in credit markets has made this a 
particularly challenging time.''
    That may be a bit of an understatement.
    Since 2004, the Securities and Exchange Commission has 
allowed a broker-dealer holding company and its affiliates to 
undergo consolidated, what we call, SEC supervision. The 
Consolidated Supervised Entity (CSE) program was created partly 
in response to a European Union requirement that brokerage 
firms doing business in the countries needed to be regulated on 
a consolidated basis.
    Unlike bank regulations, we are not talking about a large 
universe. The CSE program covered five entities, so naturally, 
when one of them--Bear Stearns--imploded, it raised a number of 
questions regarding the adequacy of the CSE regulation.
    Many people have happily taken on the role of Monday 
morning quarterback and offered all sorts of suggestions or 
criticisms of the CSE program. And I commend Chairman Reed for 
taking a step that is becoming all too rare around here and 
holding a hearing to get the facts. We need to understand the 
history of the CSE program as well as its goals, functioning, 
and failings. Only by understanding the current landscape can 
we make decisions about potential legislative actions.
    I would like to welcome our witnesses to the hearing today. 
Erik Sirri has testified before us on a number of occasions, 
and it is good to welcome him back today. I know that Mr. Sirri 
is currently leading an agency-wide task force composed of 
senior leadership, so his comments will be helpful.
    It is also a pleasure to welcome two distinguished former 
SEC Chairmen, David Ruder and Arthur Levitt, back before the 
Senate. Both of you led the SEC through challenging times, and 
so you bring a unique perspective to today's discussion. Your 
experience as Chairmen gives us a keen understanding of the 
SEC, yet you have the luxury of being outside the politics of 
the SEC--something not enjoyed by the current Commissioners or 
staff.
    The question of how to best regulate large investment banks 
will, unfortunately, not be settled here today. However, this 
hearing is an important part of that ongoing process. I am 
confident that all our witnesses will aid our understanding of 
the matter. I sincerely thank them for being here today, and I 
look forward to their testimony.
    Thank you, Mr. Chairman.
    Chairman Reed. Well, thank you very much, Senator Allard.
    As Senator Allard indicated, we are pleased to be joined 
today by Dr. Erik Sirri, the Director of the Division of 
Trading and Markets at the Commission. We are also on our 
second panel very delighted to have our distinguished former 
Chairmen of the Securities and Exchange Commission, Arthur 
Levitt and David Ruder. And I would also point out that former 
Chairman William Donaldson very much wanted to attend.
    Chairman Reed. At this point I would like to recognize Dr. 
Sirri. Dr. Sirri.

        STATEMENT OF ERIK SIRRI, DIRECTOR, DIVISION OF 
         TRADING AND MARKETS, SECURITIES AND EXCHANGE 
                           COMMISSION

    Mr. Sirri. Chairman Reed, Senator Allard, I am pleased to 
have the opportunity this morning to describe the SEC's program 
for regulation of investment banks and the lessons learned from 
the recent turmoil in the credit markets.
    Under the statutory scheme that Congress devised, most 
recently reflected in the Gramm-Leach-Bliley Act, the SEC is 
responsible for regulating the broker-dealer subsidiaries of 
investment banks, but no regulator in the Federal Government is 
given explicit authority and responsibility for the supervision 
of investment bank holding companies with bank affiliates. For 
investment banks that do not have U.S. banks within the 
consolidated group, it provides for holding company supervision 
in a structure that is purely voluntary. The four largest 
investment bank holding companies in the U.S. are ineligible 
because they have specialized bank affiliates, such as 
industrial banks or certain savings banks.
    Because the existing statutory scheme does not address how 
and by whom investment bank holding companies with specialized 
bank affiliates should be supervised, and in part because of 
the implications of the European Union's Financial 
Conglomerates Directive, which required consolidated 
supervision either internationally or at the European level, 
the SEC adopted its Consolidated Supervised Entities--or CSE--
program for U.S. investment banks in 2004. This, too, is a 
purely voluntary program, but in 2004 and 2005, the five 
largest investment banks volunteered to participate.
    The CSE program has been recognized as ``equivalent'' to 
that of other internationally recognized supervisors for 
purposes of the EU's Financial Conglomerates Directive. It 
provides consolidated supervision to investment bank holding 
companies that is designed to be broadly consistent with the 
Federal Reserve's oversight of bank holding companies. It 
allows the Commission to monitor for financial or operational 
weakness in a CSE holding company or its unregulated affiliates 
that might place the U.S.-regulated broker-dealers or other 
regulated entities at risk.
    It is within this context that the SEC confronted the rapid 
deterioration of liquidity at Bear Stearns during the week of 
March 10th. I will not rehash the events of that week because 
they were covered amply in testimony before the Banking 
Committee last month. But I would like to reiterate to this 
Committee what Chairman Cox observed in his testimony before 
the full Committee on April 3, 2008. While the Federal Reserve, 
by extending temporary access to the discount window to Bear 
Stearns as well as to other major investment banks, forestalled 
a similar run on the bank from playing out elsewhere, it, 
nonetheless, remains for Congress to determine whether to 
provide more predictable access to an external liquidity 
provider and to harmonize any such measures with other aspects 
of the existing statutory scheme, in particular the framework 
established by Congress for considering the resolution of 
difficulties experienced by commercial banks, but not 
investment banks, similar to the framework in the Federal 
Deposit Insurance Improvement Act and the Federal Deposit 
Insurance Act for systemically important investment bank 
holding companies.
    In the wake of Bear Stearns, the SEC has taken a number of 
steps and additional protections that are being contemplated by 
CSEs in the wake of Bear Stearns. In addition to strengthening 
the liquidity requirements for CSE firms relative to their 
unsecured funding needs, we are closely scrutinizing the 
secured funding activities of each CSE firm, with a view to 
lengthening the average term of secured and unsecured funding 
arrangements. We are currently obtaining funding and liquidity 
information for all CSEs on a daily basis and discussing with 
CSEs the amount of excess secured funding capacity for less 
liquid positions. Further, we are in the process of 
establishing additional scenarios, focused on shorter duration 
but more extreme events that entail a substantial loss of 
secured funding, that will be layered on top of the existing 
scenarios as a basis for sizing liquidity pool requirements. 
This additional analysis is providing the basis for requiring 
firms to take steps such as increasing the term of secured 
funding and the diversity of funding sources. Also, we are 
discussing with CSE senior management their longer-term funding 
plans, including plans for raising new capital by accessing the 
equity and long-term debt markets.
    Because the CSEs now have temporary access to the Primary 
Dealer's Credit Facility--or PDCF--which would operate as a 
backstop liquidity provider should circumstances require, and 
assures the necessary breathing space to implement the various 
measures outlined above, the SEC is in frequent discussions 
with the Federal Reserve Bank of New York about the financial 
and liquidity positions of the CSEs and issues related to the 
use and potential use of the PDCF. The SEC and the Federal 
Reserve Board are developing a formal Memorandum of 
Understanding that would provide an agreed-upon scope and 
mechanism for information sharing, both related to the PDCF and 
other areas of overlapping supervisory interest. Moreover, 
should Congress enact legislation to provide access to an 
external liquidity provider under exigent conditions in the 
future, the SEC stands ready to develop a process by which the 
Commission would formally communicate with the Federal Reserve 
or other relevant agencies in the event that an institution 
required access to any successor facility. Finally, the 
Chairman has publicly requested dedicated funding for the CSE 
program and a significant expansion in staff.
    In conclusion, Bear Stearns' experience has challenged a 
number of assumptions, held by the SEC and by other regulators, 
relating to the supervision of large and complex securities 
firms. The SEC is working with other regulators to ensure that 
proper lessons are derived from these experiences and that 
changes are made to the relevant regulatory processes to 
reflect those lessons.
    An imperative from the Bear Stearns crisis is addressing 
explicitly how and by whom large investment banks should be 
regulated and supervised, and specifically whether the 
Commission should be given an explicit mandate to perform this 
function at the holding company level, along with the authority 
to require compliance. We look forward to working with you on 
these broader questions.
    Thank you again for this opportunity to discuss these 
important issues, and I am happy to take your questions.
    Chairman Reed. Thank you very much, Dr. Sirri, for your 
testimony, and you have raised some very interesting topics, 
and I appreciate the thoughtfulness of your statement and the 
work you are doing today to review and then look ahead to what 
we can do to make the situation better.
    You state in your testimony that at no point did Bear 
Stearns' customers risk losing any of their cash, which raises 
sort of the issue of what was the focal point of the CSE. Was 
it simply to regulate the broker-dealer/customer relationship? 
Or was it the broader issue of regulating the entity? And I 
think you suggested an answer, which is it was not quite sure 
in the SEC mind. Can you comment on that?
    Mr. Sirri. Sure. I think you bring up two different but 
both very important aspects of our supervision generally. We 
obviously supervise broker-dealers, and in supervision of a 
broker-dealer, any broker-dealer, the focus is on preservation 
and the safety of a customer's security and cash. That goes for 
broker-dealers that sit outside consolidated supervised 
entities as well as the large broker-dealers that are inside of 
them.
    The CSE program is a program that deals with the holding 
company that surrounds these large broker-dealers and deals 
with the financial and operational controls for risk that 
reside at the holding company. Those controls for risk also 
affect the broker-dealer itself.
    The goal of the CSE program is to ensure that the risk is 
managed in such a way that none of the regulated subsidiaries 
of that holding company, whether U.S. broker-dealers, foreign 
broker-dealers, U.S. banks, or foreign depository institutions, 
are impaired because of issues in unregulated affiliates of 
that holding company.
    Chairman Reed. You suggest also, I think, in your testimony 
that explicit directions, legislative directions to you about 
your role of supervising investment banks would be appropriate. 
Is that a fair conclusion?
    Mr. Sirri. Yes, it is.
    Chairman Reed. And can you give us an outline of what you 
would think would be sort of the parameters of this role?
    Mr. Sirri. Sure. I want to point out that now, at the 
current time, our supervision, our CSE supervision, is by rule. 
It is through a modification to our net capital rule. What we 
are talking about when it comes to legislation is actually 
providing some legislative clarity that would allow us to have 
examination authority, capital setting and monitoring 
authority, and authority to impose various kinds of progressive 
restrictions on the firm itself based on its risk controls, its 
financial and operational risk controls.
    I think we feel it is important to have the certainty that 
would arrive from having our authority embodied in legislation. 
Our rule-based system today accomplishes many of these, but 
there is an amount of certainty and clarity that arises from 
legislation that we think would be helpful.
    Chairman Reed. And another obvious point would be the fact 
that it would no longer be voluntary, that this would be 
mandatory if a firm fell into the guidelines or the definition?
    Mr. Sirri. Well, a firm could elect to fall under these 
guidelines. For example, a firm, if it wished to be supervised 
on a consolidated basis today, elects to come into it. I think, 
you know, it is for you to decide, and we are happy to have 
these conversations with you. But I think beginning a framework 
we are talking about, it is important that these holding 
companies be supervised. So it could be crafted on a voluntary 
basis, but if it were and one of these systemically important 
firms elected not to opt into it, I think there would be a 
difficult question of who was supervising that holding company.
    Chairman Reed. Also, I presume that you are not going to 
wait, that you are actually reviewing the rules as we speak to 
see if additional proposed rules should be made public and 
request comments. Is that fair?
    Mr. Sirri. It is a fair comment. I think we are reviewing 
many things. We are reviewing the way that we have supervised 
the firms and ways that we have been discussing. We are working 
in an integrated way with the Federal Reserve. We are looking 
at our rulemaking itself to see if those things can be improved 
and if there are steps that we can take in the interim. All of 
these things are on the table with the goal of accomplishing 
the goals of the CSE program.
    Chairman Reed. You mentioned, Dr. Sirri, that you are 
entering into a Memorandum of Understanding with the Federal 
Reserve, and that, I presume, has been significantly influenced 
by the Bear Stearns situation, where they actually went in and 
essentially supported the investment banking industry. Can you 
comment on the Memorandum of Understanding, where you are and 
where you are going with that?
    Mr. Sirri. Sure. The Memorandum of Understanding at the 
moment is in process. It is an interim draft, so it is in its 
early stages. The purpose of it is to cover a situation that we 
have now seen to say how are we going to work with the Federal 
Reserve in situations with the kind of exigencies that arose in 
Bear Stearns. But the Chairman has also asked us to look at our 
relationship with the Federal Reserve generally and see if in 
this Memorandum of Understanding we could broadly codify our 
working relationship with the goal of making it more useful and 
more clear.
    Chairman Reed. Let me switch to a specific topic, that is, 
from 2004 to 2007, at least three of the entities that you 
supervised under the CSE program--Bear Stearns, Lehman 
Brothers, and Merrill--made major purchases of subprime 
mortgage origination firms, placing them within the top 10 
subprime mortgage originators in the country.
    What is the scope of your authority over these 
subsidiaries? Did you actively engage in any type of review of 
the transaction or the effect on the investment bank?
    Mr. Sirri. We were fully aware of those transactions, and 
we were aware of their purposes. We understood what we did with 
respect to the risks to the firms. One of the reasons that 
these firms cited for these transactions was to have better 
control of the quality of the mortgages that came in from the 
outside into these firms.
    Chairman Reed. That sounds somewhat ironic at the moment. 
Did you have the occasion or the ability to coordinate with the 
regulators of these mortgage firms, if they were regulated, 
State regulators or anyone else? Did you do that?
    Mr. Sirri. I am not sure that we had--particularly at the 
CSE level, I am not sure that we had conversations with the 
entities that regulated those mortgage firms.
    Chairman Reed. Now, the rationale was that they wanted to 
ensure better quality. Did you actually have the occasion to 
look at the process of origination and securitization so that 
you could evaluate what was going on with these subsidiaries?
    Mr. Sirri. What we tried to understand, again, the purpose 
of the CSE program was to look at the holding company level 
risk controls. So to the extent that these risks that were 
imposed by the mortgage process, whether they involved the 
purchase of a mortgage originator or whether these mortgages 
were acquired at a market basis, we looked at the kind of risks 
they imposed on the firms.
    Chairman Reed. But how deep did you drill down? I mean, did 
you go in and talk at the level of the firm about the ratings, 
the categorizations? Or were your examiners able to go out and 
look at the actual process and make an independent assessment?
    Mr. Sirri. We did not make independent assessments. What we 
focused on were the risk controls within the firms and how they 
handled those risks, but we did not go out, say, to the 
mortgage originators and visit them.
    Chairman Reed. Another aspect of this issue between 2004 
and 2007 is the proprietary trading activities of these firms. 
Did you have a chance to assess the management of risks 
associated with proprietary trading? And the specific issue of 
trading for their own accounts in a different way that they 
were trading in public accounts or offering securities to the 
public, was that ever part of your review?
    Mr. Sirri. For the CSE program itself, we definitely paid 
attention to their proprietary trades. So, for example, we knew 
of their proprietary positions for various classes of 
securities and derivatives. Those would include equities, 
typical debt, as well as mortgage instruments, derivatives, and 
cash instruments. So we were aware of those positions. We were 
aware of the risk controls for those positions. And we were 
aware of the policies and operational controls they had in 
place.
    Chairman Reed. But you were not consciously or 
institutionally aware of any discrepancies between positions 
they were taking for their own account versus positions for 
public account?
    Mr. Sirri. When you say ``public account,'' I am--what you 
mean here is----
    Chairman Reed. The information and recommendations that 
were given to clients.
    Mr. Sirri. Sure. I understand.
    Chairman Reed. Suggestions to buy this, et cetera.
    Mr. Sirri. I understand exactly what you mean. You are 
referring to sales practices, the way they approached customers 
in the purchase of these securities.
    Chairman Reed. Yes.
    Mr. Sirri. That would not properly be part of the CSE 
program. That said, you know, we do have, as part of our 
oversight of broker-dealers, authority over broker-dealers and 
their sales practices. So that was not part of the CSE program, 
but even now as we speak, we as a Commission are reviewing 
those sales practices, the suitability of those 
recommendations. And to the extent those recommendations were 
unsuitable, I think, you know, we will be looking at that.
    Chairman Reed. Thank you, Dr. Sirri.
    We have the luxury of myself and Senator Allard, so I think 
we will do a second round, Senator, so go ahead. I have got one 
more series of questions. Senator Allard, please. And thank you 
for letting me go on.
    Senator Allard. You bet. I just have a direct question to 
follow up on how this all came about. The fundamental question, 
do you believe the Bear Stearns implosion was an indictment of 
the CSE program and its failings or was it unforeseeable?
    Mr. Sirri. I believe that what happened at Bear Stearns was 
unprecedented. A liquidity event that characterized the failure 
of Bear Stearns was something we just had not seen. This was 
not the case as in the case, say, of a Drexel or other broker-
dealers or large firms that have failed, of holding a class of 
instruments whose value declined over time and the firm was 
forced to liquidate. That did not happen at Bear Stearns.
    What happened at Bear Stearns was that secured funding 
typified by repurchase transactions in which a ``money good'' 
piece of security or some instrument is given to someone who 
provides you funding, but that mechanism fell apart. That is a 
secured funding market, which means that the paper I give you, 
the security that I give you, provides you confidence and 
security in the short-term loan you make me. That mechanism we 
always believed was governed by the quality of the collateral I 
provided you. The quality that Bear Stearns provided--
treasuries, agency securities, as well as some other securities 
whose value was perhaps more questionable--that market fell 
apart. It fell apart in a way that we never anticipated. In our 
scenarios for risk management and I must say in the scenarios 
for risk management that were maintained by many regulators in 
the world, as well as other street firms, that was 
unprecedented. We obviously are more intelligent about that 
now, and we are incorporating that new reality into our risk 
management process.
    Senator Allard. Do you think you were too reliable on the 
value of real estate and the paper that went with the real 
estate because you had brokers, you had land appraisers, which 
is controlled by State regulation, and you assumed that that 
was working, but I know of instances in Colorado there was some 
serious breakdown in that relationship, and ordinarily with the 
consumer relying on between the title company and the broker 
and the appraiser, it tended to break down because of various 
market pressures, I think at the local level, and I think that 
the assumption was that this real estate had more value than it 
really did because of how that system was breaking down.
    How do you view that as it was coming up to your level when 
you were evaluating--taking on the value of the security?
    Mr. Sirri. It is a good question. I think there are two 
separate issues here. You are pointing out a good question 
about the quality of the collateral, the underlying value of 
that collateral. The second issue is the process by which 
repurchase transactions are done.
    Senator Allard. Yes.
    Mr. Sirri. In the repurchase market, the failing in the 
repurchase markets that we saw occurred in agency securities 
that were essentially money good. These are pass-through 
securities from Federal agencies that, because of their 
implicit guarantees around them, did not have the kinds of 
concerns that you are citing.
    The concerns that you are citing are also very important. 
They could relate to commercial mortgage-backed securities, 
which thus far, although we are watching very carefully, we 
have not seen the kind of issues that might loom large perhaps 
in the future. In the residential mortgage-backed security, 
which are the pieces of paper that underlay residential 
mortgage-backed, you know, collateralizations and CDOs, there, 
of course, we did see issues.
    I do want to correct one statement I made to Senator Reed. 
I was corrected by my colleagues in back. The CSE program, in 
fact, did visit originators, both at Bear Stearns and Lehman, 
and we checked with their audit oversight. So let me correct 
that statement, if I might, that our team did go out and visit 
two of the three that captured them. So I apologize for the 
mistake there.
    Senator Allard. The other question, this originated, this 
whole idea of the CSE originated because we had these 
investment banking holding companies that wanted to get 
involved in the European markets, and so there was a 
requirement from the European market that you had to have a 
regulated entity. And when you put together those regulations 
initially, were they basically the same regulations that 
European companies--a similar nature--had to deal with? Or were 
they less regulatory or more regulatory? How would you classify 
them?
    Mr. Sirri. What the European Union was concerned about in 
their Financial Conglomerates Directive was that there be a 
single supervisor for the consolidated holding company and that 
supervisor be able to look at the risk controls at the holding 
company level as they affected the holding company and the 
various regulated subsidiaries. That was the core issue.
    If those firms that chose to do business in the EU did not 
have a consolidated supervisor, the EU would have forced them 
for their business in Europe to create a sub-holding company 
that had, if you will, a miniature consolidated supervisor. 
That was expensive in terms of doing business in Europe.
    The consolidated supervision program that we put in by rule 
is broadly consistent with the kind of risk management 
controls, operational financial controls that are the holding 
company level in Europe and in the United States. So that I 
would say Europe, the Federal Reserve in the United States, and 
the Securities and Exchange Commission are broadly consistent 
in that area.
    Senator Allard. Now, they have different accounting 
standards and approaches on accounting. How do you compensate 
for that?
    Mr. Sirri. For us, we are looking at risk controls. So what 
is absolutely true is that valuation of securities is 
critically important in the risk management process. We don't 
use accounting numbers per se in the risk management processes. 
The good thing, the thing that makes this easier, is that risk 
management in a securities firm is largely done on a marked-to-
market basis.
    Senator Allard. OK.
    Mr. Sirri. And marked-to-market is independent of your 
accounting framework.
    Senator Allard. OK. So if we had problems with the 
regulatory environment here in this country, what does that say 
about the regulatory environment in Europe with a similar 
instrument?
    Mr. Sirri. Well, I think both us, the United States and our 
regulatory oversight, and worldwide securities and systemic 
regulators are thinking very carefully about the issue of 
liquidity when it comes to regulation of financial 
intermediaries. This issue is being revisited in the Basel II 
capital requirements. We are thinking more deeply about it, 
about what it means for securities firms, because liquidity is 
so much their lifeblood. And I know that in our conversations 
with the Federal Reserve, Tim Geithner is also thinking very 
deeply about those questions.
    Senator Allard. OK. Let me move on to the PART program. I 
am a strong proponent of the President's PART program, where 
you put out measurable goals and objectives and then the OMB 
comes in and does an evaluation and they evaluate the program 
as to whether it is effective or not effective, depending on 
whether the agency actually even put any goals and objectives 
in. And I noticed in looking over the Internet on the PART 
program that you have not been evaluated--this particular 
program has not been evaluated by PART.
    Could you give the Subcommittee a brief kind of PART-type 
analysis of the program? Do they have measurable goals and 
objectives, for instance?
    Mr. Sirri. The Division of Trading and Markets has been 
evaluated in the PART framework, and we received the highest 
evaluation. So that is for the division as a whole, but the CSE 
program was part of it. But let me----
    Senator Allard. So the CSE program has been evaluated on 
goals and objectives?
    Mr. Sirri. Trading and Markets, the division in which the 
CSE program oversight sits----
    Senator Allard. I know.
    Mr. Sirri [continuing]. Has been evaluated by PART. But I 
think you are asking about the CSE program itself.
    Senator Allard. Right. That is what I am after.
    Mr. Sirri. Exactly. So I just wanted to point out there has 
been some measurement there.
    Let me try to answer your question directly. I think if you 
were to try and craft a system--all these things are difficult 
when it comes to supervision--a system of outcomes and 
measures, outcomes--inputs and outcomes here, I think we would 
have to think about issues related to, you know, quality, 
issues like the amount of liquidity that is being held within 
these firms. So let me give you a concrete example.
    Before the SEC came in and supervised on a consolidated 
basis, these firms had no requirement to hold liquidity at the 
holding company level. They just did not need to because there 
was a gap, as I said in my testimony, in Gramm-Leach-Bliley. As 
part of our supervisory program, we require tens of billions of 
dollars of liquidity at the holding company level, to the point 
that now for the largest of these firms, there is in excess of 
$90 billion of free cash sitting at the holding companies of 
these firms. That is cash that is unencumbered and that can be 
spent at the end of the day today. That cash was not there 
prior to our oversight of these programs. So I think a 
reasonable type of outcome measure would be something that 
related to the amount of free liquidity that was placed in 
these firms as a result of our oversight, perhaps as scaled to 
the risk of these firms. I think something like that would lend 
itself to a PART-type framework.
    Senator Allard. We are going to send you a question after 
the hearing, at least from my office, and I think maybe the 
Committee would be interested, too, and what I would like to 
have you do, a PART-type analysis. In other words, what is the 
specific purpose of the CSE program? Get that down on a piece 
of paper for us. And what are the specific measurable goals and 
how well is it achieving those goals? And how can it be 
improved?
    Mr. Sirri. I would be happy to give you that.
    Senator Allard. That is sort of all encompassing, and I 
would like to see what kind of response we get back on that.
    Mr. Sirri. Thank you.
    Senator Allard. Thank you.
    Chairman Reed. Senator Schumer.
    Senator Schumer. Thank you, Chairman Reed, and thank you 
for calling this hearing. I thank our witnesses.
    I guess the thing I would say is that I understand why the 
CSE program is there. It came about because of the great 
dilemma we face in regulation here, which is globalization, and 
that is, we are in global financial markets, we have national 
regulation, and it really allows a flight to the lowest common 
denominator if we are not careful. And that does two things: 
First, it hurts jobs in America, which I care a lot about. I 
think it is cavalier to say just keep all the regulations the 
same here, and then if the jobs flee, that is nothing, there 
are hundreds of thousands of people in America, hundreds of 
thousands in my area who work there. But, second, it does not 
accomplish anything. We are talking now, for instance--this is 
a different area, but it is related, increasing margin 
requirements on oil futures. In my view, that ought to be done. 
But if we just do it here, all oil futures will be traded in 
London, and we will not accomplish anything. We just will not 
accomplish anything.
    So there is a balance here, and I know why you set up the 
CSE program, and that is because, otherwise, American companies 
would have had two choices: have two sets of regulation 
governing them, and that is not very good, especially when the 
regulations are in conflict. Just try to do it. It sounds 
benign. Try to be there when you are hearing different things 
from different regulators. Or they would have gone to Europe 
and had their regulation, for whatever that is worth. So I 
understand why you have it, and I think any call to abolish it 
is irresponsible given the dilemma.
    Having said that, it is weak regulation by nature. And I am 
for much stronger--you know, I think in the 1980s we had sort 
of an exquisite balance between entrepreneurial vigor and 
regulation. You need a balance. If you have too much of one, 
you do not get the benefits of capitalism. You have too much of 
the other, and you get the excesses of capitalism. And so 
having a good balance makes a great deal of sense.
    The trouble is that fundamentally when you regulate--one of 
the main reasons we regulate holding companies is safety and 
soundness, not only of the institution but of the system, 
systemic risk. And the SEC has never been a good safety and 
soundness regulator. It is not intended--the Fed is basically 
the experts on safety and soundness, particularly to the 
system. The SEC regime worked great. The basic view was since 
most of the people who were involved had some degree of 
sophistication that disclosure and going after fraud and other 
types of things was the way to go. But that is not the same 
way--it is not even the same mind-set as safety and soundness 
regulation. The Fed was always regarded as a friendlier 
regulator because it was more interested in safety and 
soundness, and the SEC was regarded as a more hostile regulator 
because it was interested in disclosure and fraud. And before 
technology had the two, banking and investment banking, blend--
and, again, Glass-Steagall dealt with a reality, not created a 
reality--or getting rid of Glass-Steagall, which, again, in all 
due--I defended it for the longest time. But, second, the whole 
atmosphere of regulation is different.
    And so I think, frankly, Mr. Chairman, the problem here is 
far greater than how well is CSE functioning. We need to revamp 
our structure of regulation. We have a different financial 
structure than we did when all of this was set up. And we need 
a strong regulator. We need, in my judgment, a more unified 
regulator. And we need a regulator who can look at a company 
like Bear Stearns from both points of view together as opposed 
to having the SEC look and see if Bear Stearns is disclosing or 
defrauding its potential investors; and, second, a different 
regulator--in this case, the Fed--coming in at the last minute 
and not knowing and not being prepared, saying we are worried 
about safety and soundness.
    So I think that, again, the weakness of CSE is not the 
fault of the program itself. The weakness of CSE, which I would 
like to see a stronger regulatory regime, is because of the 
changes in the system, both technology and globalization. I 
think one of the reasons we had trouble with Bear Stearns, 
there should have been some regulator who went in in the summer 
and said, ``You have got to raise capital. You have got to 
reduce your exposure to mortgages.'' The SEC never does that. 
And it is not adept at doing things like that. And the Fed did 
not have jurisdiction, and the Bear Stearns mess fell between 
the cracks.
    And that is why I think, Mr. Chairman, one of the things we 
should be doing on this Committee is studying how we change our 
system of regulation. I would not do it quickly. I would do it 
carefully. And somehow we have to figure out a framework where 
whatever we do is in sync with the other major financial 
centers, London and Hong Kong and others, so you do not have--
we can do all the regulating we want on our own. If everything 
goes somewhere else, as I said, we have not accomplished 
anything regulatory-wise, even if you do not care about the 
jobs, which I do.
    Would you just comment on my little rambling peroration 
here? Because I have thought a lot about this. I care a lot 
about this, obviously.
    Mr. Sirri. Well, it is clear you have thought about it 
because what you said was extremely insightful. Let me begin 
with where I think you started, and I want to agree with you 
completely. You made a point about regulation and the balance 
that it strikes in the context perhaps--you used the example of 
oil futures and margin requirements in oil futures and the 
point that that business would just flee that higher margin 
setting.
    In our supervision of firms, generally, stepping even back 
from the CSE program, we are always conscious of that. We may 
have a wish at times to tighten regulation in a particular 
place, but the firms that we are talking about, the large 
globally incorporated firms that we are talking about, will 
shift that business in other places.
    I was speaking on a panel the other day with the general 
counsel of a very, very large financial intermediary, and I 
made a point about something where we thought additional 
oversight was needed. And the gentleman, whom I knew well, who 
is a very intelligent man, turned to me and said, ``Well, you 
may elect to do this, but we will just do business in one of 
the other 17 countries in which we are incorporated.'' And that 
is a reality that we face every day and which I think I 
appreciate that you said.
    Turning to the CSE program itself, you parsed regulation, I 
think quite correctly, into, the way I understand it, three 
distinct buckets, if you will.
    You pointed out that the SEC is typically involved in 
issues about sales practices or, you know, disclosure, our 
typical regime for investor protection. And that is a core 
mission of the SEC.
    You then pointed out that the Federal Reserve often takes 
on issues of supervision and prudential regulation. That is 
typically where they reside.
    And you pointed out there was, in fact, a third function, 
the function of a guarantor, also something that is often done 
by the Federal Reserve.
    The CSE program actually allows the SEC to fit in there in 
a particular way. We view the CSE program as a prudential 
program. It is not a disclosure program. It is not an investor 
protection program. Admittedly, it is done through rule and not 
through statute, something that our Chairman has said he would 
like to see change. But the framework that we have there is one 
that says if you want to get this alternate capital treatment 
for broker-dealers, then you must submit to the following, and 
to condense that down, it means supervision at the holding 
company and going through a set of undertakings. Within that 
set of undertakings, we have the ability to compel a firm to 
unwind a line of business, to compel a firm to increase their 
capital, to compel a firm to raise more liquidity at the 
holding company.
    I admit that it is not the same as statutory authority, but 
it is derived from a rule. What we do not have the ability to 
do is to provide a monetary safety net through access to a 
discount window.
    Senator Schumer. But it is true that the people at the SEC 
do not have a long history, long experience, even in that 
second function, do they?
    Mr. Sirri. I am going to step up to that and say that for 
the building itself, we are building that pays greatest 
attention to investor protection. For this program itself, it 
is staffed uniquely. It is staffed with PhDs in finance, in 
economics, masters in statistics. It is staffed differently 
than any other program. There is but one attorney in that group 
when I came in. It is a group that is very, very similar to the 
staffing at the Fed or any kind of regulator like that in such 
a program,
    So, whereas, I will absolutely agree with you that it is 
the case that we are not typified by such staffing, for the 
purposes of this program it is staffed effectively, and it 
meets very well those requirements. Myself being--I am a 
finance PhD type. I was happy to see that kind of staffing when 
I came in because it is the kind of toolkit you need to do the 
work that is required. It is a quantitative discipline.
    Senator Schumer. Could I just ask--and I beg the Chairman's 
indulgence--how many staff are there that are, you know, non-
secretarial/clerical, but actually doing the looking?
    Mr. Sirri. There are 25 professionals involved in the CSE 
program. The Chairman has indicated that he would like to raise 
staffing of that to the level of 40 people, and that staffing 
would come both--in various aspects of the program.
    Senator Schumer. Thank you, and sorry for going over my 
time.
    Chairman Reed. Thank you, Senator Schumer.
    Senator Casey.
    Senator Casey. Mr. Chairman, thank you very much, and I 
want to thank you, Doctor, for being here and for your 
testimony. Some of this may be redundant in terms of your 
testimony and some of the earlier questions, but I wanted to 
clarify or amplify the record on a few questions.
    One is, I guess, a broad question about conflicts or 
potential conflicts. Could you just take me through the 
perspective of the SEC's ability in the role the SEC plays in 
monitoring conflicts between the rating organizations, the so-
called NRSROs, and the consolidated supervised entities, the 
CSEs, as underwriters? Could you just kind of walk through in 
terms of this program how you will deal with and try to prevent 
conflicts?
    Mr. Sirri. Sure, I would be happy to.
    Credit rating agencies fell--our oversight of credit rating 
agencies was extremely, extremely light, only through ``no-
action'' letters that we granted. That was up until late 2006 
when the Credit Rating Agency Reform Act was passed. We passed 
rules. The Commission approved final rules in June of 2007 to 
operationalize that new act. That covered several things. 
Broadly, that covered several things.
    We specifically are charged with drafting rules and 
enforcing issues around transparency for the credit rating 
agencies, as well as mitigating certain conflicts of interest. 
That goes for any firm that--that goes for the CSEs as a 
whole--excuse me, the credit rating agencies as a whole. So in 
that sense, the CSEs are not unique amongst underwriters who 
would come to these credit rating agencies. But let me turn to 
the conflict of interest point you asked about.
    In the rulemaking that we did, we basically prohibited 
certain kinds of conflicts. An example of one of those would be 
that someone, an employee who is involved in the actual 
crafting of a credit rating could not own the security being 
rated. That would be an example of a conflict we thought was 
unsupportable, and so we prohibited that directly.
    More broadly, we require policies and procedures to manage 
other conflicts. Examples of that would include the notion that 
there is payment made by the person, the underwriter, bringing 
the security. That payment is being made. Their paper is being 
rated. There is a clear conflict there. So policies and 
procedures would need to be in place to manage that conflict.
    Our Chairman has asked us to engage in rule writing 
immediately to try to improve and strengthen the regulatory 
framework for these entities. That rule writing will cover 
transparency, and it will cover additional rules in the area of 
conflicts of interest.
    Senator Casey. Let me ask you where you are in that 
process. In other words, is this a question of procedures in 
place for conflicts of interest that have yet to be fully 
implemented or tested? Or do you still have more work to do in 
terms of developing procedures?
    Mr. Sirri. It is a good question. We have been engaged in 
an examination of the credit rating agencies, so we have used 
our examination authority. We have been in there with teams at 
the three large credit rating agencies. Those examinations, we 
are not going to wait for them to be complete. They will inform 
our rulemaking because we have learned some things there. So an 
example of something that we may ask the Commission to consider 
would be perhaps a kind of prohibition that says that if a firm 
is involved in providing certain kinds of consulting or advice 
services to an underwriter related to a particular offering, 
they not be allowed, they be completely prohibited from rating 
that offering.
    I cannot tell you the precise form of that, but that is 
something that staff is giving consideration to.
    Senator Casey. So the rulemaking is ongoing.
    Mr. Sirri. The rulemaking is advanced at our stage in terms 
of a draft stage within the building. It is, of course, up to 
the Commission to decide when they want to consider it. But the 
Chairman's instructions to me as the Director were to do that 
with all haste and try to bring that forward as rapidly as 
reasonably possible.
    Senator Casey. Thank you. And I wanted to ask you the 
second question or second area of questioning about the 
examiners. I was the elected Auditor General of Pennsylvania 
for two terms and then State Treasurer after that, and one 
thing we were always concerned about in the context of State 
government in terms of auditors who were auditing public 
programs is that our auditors, our experts in that department, 
were well trained so they could go up against some pretty touch 
customers. That is mostly within the context of State 
government.
    But could you describe for us the profile of the typical 
examiner? What kind of training do they get or what are you 
hoping that they would get, their background, their experience? 
Just the profile that either you demand or you are developing 
for an examiner.
    Mr. Sirri. It is an interesting issue to raise. Of course, 
there never have been examiners of credit rating agencies per 
se. These entities were registered as advisors before, so our 
Office of Compliance, Inspections, and Examinations did so some 
books and records type exams, but they are not going at the 
thrust of your question.
    I think the kinds of backgrounds that are reasonable, that 
you want to have here are varied. There is no one type of 
person. So, for example, the models that are run of credit 
rating agencies are very similar to the models that are run at 
principal investors, people who would be putting their own 
money at risk. That would include investment banks, hedge funds 
and such, because they are evaluating the probability that 
payments are made to the various tranches of securities.
    So, in fact, you need some--the credit rating agencies 
themselves need some fairly highfalutin talent to do that. We 
in turn need some people who are very teched up to understand 
those models.
    Now, again, the statute is very clear. We are not to 
second-guess their models or their methods. That is not what I 
am talking about. But within the statute, we want to understand 
that if they say they are applying their model in a certain 
way, that they, in fact, are applying that model in a certain 
way and that it is not being fudged, it is not being tilted for 
a favored client. Because the process is a process that is 
algorithmic, it is quantitative, you need people with similar 
skills. So I think that would account for one set of folks.
    Farther down the line, we need people who have just typical 
compliance and auditing backgrounds to go at the kind of 
conflicts issues, some of the ones that you were raising. So, 
for example, what are the indicia of situations where you 
believe that process--you know, codified written processes and 
procedures are not being obeyed? We need people who have skills 
at looking for that.
    We will be reviewing e-mails, so you need people who are 
willing to sit and read a lot of e-mails, and that is yet a 
different kind of person.
    So I think we really need a portfolio of people, and to be 
honest, I think we will be learning as we go because it is a 
new process. We have been using people from our Office of 
Compliance, Inspections, and Examinations to do this work now, 
but I expect, you know, that over time we will develop a 
specialized group of people here.
    Senator Casey. I know I am out of time almost, but just one 
quick question about personnel and resources. Do you think as 
we stand here today that you have the resources and the--I will 
try to use a primitive or simplistic phrase here, but the ramp-
up capability to get this job done? Or do you need an infusion 
of either personnel or resources to do that?
    Mr. Sirri. We have been having that conversation 
internally. I believe our Chairman asked the Appropriations 
Committee for an increase in our staffing in the program for 
credit rating agencies.
    Senator Casey. It is a good idea to do that around here.
    Mr. Sirri. So he has asked for that. He has emphasized that 
this is a critically important part of what we do, and he is 
committed to say that he wants to see an increase in staffing 
in that area.
    Senator Casey. Thank you very much.
    Chairman Reed. Thank you very much, Senator Casey, and 
let's take a brief second round.
    Senator Allard. Yes, Mr. Chairman, I just have one other 
question I can think of with other questions and everything.
    Chairman Reed. Well, let me proceed quickly to my 
questions. Then I will turn it over to you, and then welcome 
our distinguished Chairmen who are going to join us.
    Now that the discount window is open to investment banks, 
that raises two possibilities: one is that they will be better 
risk managers; the other possibility is that now that they have 
in the wings the cavalry, they will be more cavalier. What do 
you think will happen? And how are you going to structure it so 
it is better risk management?
    Mr. Sirri. Well, as part of that process, we have been 
meeting with the Federal Reserve to go over exactly those 
issues. Of course, the Federal Reserve is most focused on 
exactly that. I have met with Tim Geithner, and I met with him 
when we were meeting with the firms. I think he understands 
better than anyone the notion of moral hazard that you are 
citing that says that if you have access to this facility, you 
might actually let certain things lapse.
    There are some things that allow us--that give me comfort 
in this area. We, of course, know what their risk management 
practices were and what the benchmark was before they had 
access to these facilities. Admittedly, that baseline may be 
low, and it is something we want to raise. But at least we can 
tell when there is recidivistic behavior in that area.
    I think we know we want to step up capital liquidity 
requirements for these firms and our risk oversight for these 
firms. So the extent that we can implicitly--we can ask those 
kinds of questions that say, look, when we run a risk scenario 
and we see that they do not have adequate funding for pools of 
assets, if their answer to us is, ``Well, don't worry, we have 
access to the window there,'' that is not going to be an 
acceptable answer in the long run unless, you know, that is a 
wholesale change that Congress would be involved in.
    So I think the precise answer to your question is that we 
would just not--in asking very precise, targeted questions, we 
would suss our way through those kinds of answers and see that 
our risk scenarios make them provide for the kind of funding 
they need.
    Chairman Reed. Let me focus on an issue that a number of 
commentators have raised, and that is that under the 
alternative net capital rule, potentially questionable assets 
like subordinated debt, deferred return of taxes, and some 
securities for which there is no ready market, were allowed to 
be classified as risk-free capital. And for one, David Einhorn 
has suggested that the implication of this has been a reduction 
in the amount of required capital to engage in increasingly 
risky activities.
    At this moment, when we are all looking for sounder capital 
positions, have these net capital rules produced exactly the 
opposite effect, capital that is far from risk free?
    Mr. Sirri. There has been a great deal of confusion around 
capital, liquidity, and whether you are talking about the 
broker-dealer itself or the holding company. There is an 
alternate capital treatment applied to the broker-dealer when 
they opt into this program. But I will tell you that when those 
broker-dealers opted into the program, a value at risk or some 
type of model like that was put in place that may have allowed 
for a lower minimum. But, in fact, what happened is that 
broker-dealers elected to keep higher levels of capital in 
there, so you basically saw almost no reduction in capital in 
those broker-dealers from before they entered the CSE program 
to after. It may have been that the minimums allowed them to 
take some out, but as a practical matter, they did not.
    But what I really want to emphasize is the massive gain in 
liquidity that was provided at the holding company level. Those 
are tens of billions of dollars that were just not there. If 
there was a practical reduction in liquidity at the broker-
dealer, it is on the order of $1 to $2 billion. You are talking 
about tens of billions of dollars that came in. Net from coming 
into this program, I think it is fair to say that there was no 
decrease in capital at the broker-dealer, and there was a 
massive increase in liquidity at the holding company.
    Chairman Reed. There is another aspect of this whole issue 
of liquidity and capital, and that is the asset issue, Level 3 
assets in particular. There has been some question about the 
impact of these Level 3 assets on the balance sheets of these 
companies. Do you have a rough notion of how much on the 
balance sheets are Level 3? You don't have to be specific and 
detailed. But, also are you looking at these assets, since 
essentially the Level 3 means they are hard to price and maybe 
impossible to price, which would also suggest hard to sell? Can 
you comment?
    Mr. Sirri. Sure, I can. You are referring to FAS 157. There 
are three buckets of assets there. You are referring to--FAS 
157 fundamentally looks at the availability of inputs to price 
those assets, and you are pointing out a problem where, you 
know, over time that lower bucket may have--you know, assets 
may have dropped into that lower bucket.
    You know, we are tracking that. The Commission has 
recently--the Chairman has asked and the Division of 
Corporation Finance has issued a letter providing for 
additional guidance by issuers to talk about the kind of--the 
nature of the assets that are held in that Level 3 area. I know 
there is a lot of discussion going on recently about value at 
risk, so we are tracking this area very carefully, paying 
particular attention--I can also tell you that we have such 
discussions at the President's Working Group, and we talk about 
marked-to-market accounting and the effects of FAS 157. So 
there is a great deal of attention being paid to this right 
now.
    Chairman Reed. Let me ask a final question that is related. 
We talked about capital. We talked about assets. And you have 
also suggested the issue of leverage. One of the issues that is 
throughout the financial system is, it seems, the increasing 
amount of leverage on balance sheets. Bank regulators have 
consistently been requiring reduction in leverage. Are you 
taking the same approach toward these regulated entities? And 
was that done with Bear Stearns in particular?
    Mr. Sirri. For us, you know, we have many discussions about 
leverage. When comparing leverage to a bank and leverage to a 
securities firm, the comparison is very, very difficult because 
of the different nature of the securities firm. They held a lot 
of match book repo. Their assets are typically very, very 
liquid because they hold securities.
    I think rather than speak about leverage per se, we talk 
about liquidity and capital. So as you raise capital, you 
implicitly decrease leverage. And as you raise liquidity, you 
implicitly lower the risk that is typified by leverage.
    So we have been focusing primarily on those, but they are a 
different way of getting at the risks that are typified by the 
leverage that you talked about.
    Chairman Reed. Thank you very much, Dr. Sirri.
    Senator Allard.
    Senator Allard. Thank you, Mr. Chairman. I have a couple of 
brief questions.
    Would you classify those group of businesses that fall 
under the CSE regulatory as ``too big to fail''?
    Mr. Sirri. ``Too big to fail'' is a difficult way to 
characterize them. I would characterize these as systemically 
important firms. I think when one thinks back to something like 
Bear Stearns, it is not necessarily the case that the firm is 
too large to fail. It was, after all, the smallest of the CSE 
firms. But it was the manner and the rapidity with which it got 
into trouble.
    Were you to have a CSE firm that, let's say in a 
hypothetical example, found itself holding classes of assets 
that deteriorated in value over time, that firm may find itself 
slowly degrading in financial condition, hypothetically, over a 
period of 6 months. In such a world, it is quite likely that 
that firm could unwind and contract its balance sheet in such a 
way that the notion of too big to fail or too interconnected to 
fail might not be that large an issue. The key thing that came 
up most recently with Bear Stearns was the absolute rapidity 
with which funding disappeared.
    So, whereas, I am not--I appreciate the import of your 
question with too big to fail, but I would also add the 
dimension of rapidity and the interconnectedness of these 
firms.
    Senator Allard. If you take the smallest of the firms, 
which is Bear Stearns, and you did not allow them to fail, felt 
like you had to have Government support in that particular 
case, doesn't that send a message that they are too big to 
fail?
    Mr. Sirri. Well, again, Drexel Burnham a number of years 
ago also failed, but it failed over a period of time. I 
cannot--you know, this is a world that did not happen, but were 
the funding issues at Bear to have played out over a longer 
period of time, assistance in terms of liquidity may not need 
to have been provided. So I think when one of these firms gets 
into trouble rapidly, liquidity support is needed, and I think 
that is the import of--I understand that to be the import.
    But what I want to make the distinction is that were that 
trouble to play out more slowly, liquidity support might not be 
required. And I think, as I remember some of the comments that 
the individuals from the Federal Reserve made in their 
testimony, they talked about phrases like ``breathing room'' 
and ``time'' being important. I know our Chairman talked about 
that as well.
    Senator Allard. Now, I want to talk a little bit about the 
timeline. In opening of the Prime Dealer Credit Facility, it 
gave the SEC some breathing room that you talked about to do a 
real careful analysis of the CSE program. How much time does 
the Prime Dealer Credit Facility buy you? And what is your 
timeline?
    Mr. Sirri. Well, we went to work immediately on the kind of 
issues that we are talking about, questions about liquidity and 
risk management. That happened. Those conversations began, in 
fact, before the Bear Stearns event. We realized that we needed 
to revisit some basic questions. They continue on today.
    The Primary Dealer Credit Facility was opened by the 
Federal Reserve, so I cannot speak to how long that--I just 
cannot speak to how long they will keep it open. But I will 
tell you we are coordinating with the New York Fed in our 
oversight of these firms, and, you know, I expect that in those 
conversations we will be working with them, talking to them 
about how we see oversight of these firms in such a way, and 
they will be telling us about their thoughts of the Primary 
Dealer Credit Facility.
    They have announced that it was--they have said at the 
outset it was a 6-month facility. Whether they choose to 
shorten or lengthen it is a question I just cannot answer.
    Senator Allard. So we have got the 6-month facility. You do 
not know whether it will go beyond that or not.
    Mr. Sirri. I just cannot answer that question.
    Senator Allard. OK. Thank you, Mr. Chairman.
    Chairman Reed. Thank you, Senator Allard, and thank you, 
Dr. Sirri, for your testimony.
    At this time I would like to welcome the second panel. I 
would like to welcome David Ruder and Arthur Levitt, former 
Chairmen of the Securities and Exchange Commission, 
distinguished Chairmen. When Chairman Levitt took over, he was, 
as many of his predecessors and successors, an advocate for 
investor rights, and he was particularly effective in creating 
the Office of Investor Education and Assistance. He also was 
active in reforming NASD, the penny stock rule, and many other 
critical efforts to protect investors and markets alike.
    Chairman Ruder assumed responsibilities a few weeks before 
the 1987 market crash, and some of the steps he took are still 
guiding the activities of the SEC today.
    Both gentlemen are graduates of Williams College, and so we 
are proud to organize this reunion of Williams College.
    Mr. Levitt. Thank you.
    Chairman Reed. And we are glad to see you here. Chairman 
Levitt, would you begin, please?

 STATEMENT OF ARTHUR LEVITT, JR., FORMER CHAIRMAN, SECURITIES 
                    AND EXCHANGE COMMISSION

    Mr. Levitt. Thank you very much, Chairman Reed, Ranking 
Member Allard, Members of the Subcommittee. Thanks for the 
opportunity to testify in front of you today and sitting 
alongside my very distinguished fellow Chairman, and for 
holding this hearing on such an important and timely topic.
    The downfall of Bear Stearns, the uncertainty and 
volatility in the capital and debt markets, and the close to 
$300 billion in writedowns and the resulting losses by some of 
the world's largest financial institutions have created a 
crisis on Wall Street--one that rightly has gotten the 
attention of all of us who worry about the health of our 
capital markets.
    Yet the current crisis is one that involves Main Street as 
much as Wall Street. It has directly touched the lives of 
millions of people--investors and homeowners alike.
    And that is why I think it essential that we determine 
precisely what went wrong, to provide a basis for determining 
if there was a breakdown in regulation, and if any new 
regulatory structures and powers may be needed to restore trust 
in our markets and prevent this kind of run from happening 
again.
    As David, Bill Donaldson, and I recently argued in the New 
York Times, we believe that a high-level, bipartisan, and 
impartial examination must be launched to explore a series of 
possible business and regulatory failures that has produced 
this credit crisis. This is what President Reagan did after 
Black Monday in 1987, and I hope we soon have a similar 
Presidential level task force examining these complex issues.
    From where we stand today, it is apparent that a variety of 
players--including regulators, ratings agencies, standard-
setters, and gatekeepers as well as institutional investors--
simply did not live up to their responsibilities.
    In some cases--such as mortgage brokers--it was because 
there was a lack of meaningful regulation.
    In other cases--such as ensuring banks had adequate 
underwriting standards for loans--the relevant regulators 
simply refused to act.
    And in other cases, regulatory standards did not keep pace 
with financial engineering.
    Those who bought these new complex, financial instruments 
had no idea as to the extent of the risks that they were 
assuming since the creators of these instruments were either 
purposely--and legally--hiding these risks by placing them off 
the balance sheet in structured investment vehicles; or the 
banks themselves were clueless as to the magnitude of such 
risks.
    At the same time, investors were basing investment 
decisions on the judgments of rating agencies who were either 
conflicted or just plain careless in how they exercised their 
immense credit rating power.
    Moving forward, there are some obvious holes that need to 
be plugged immediately, and none more glaring than the issues 
surrounding the credit rating agencies.
    While those agencies have initiated a process of 
constructive self-analysis and in some cases reform, Congress 
must take these conflict-of-interest issues head on or at least 
empower the SEC with the proper oversight and disciplinary 
powers so they can do the job.
    The issue I believe is critical to the proper functioning 
of our markets.
    Just looking to the longer term, we must also consider 
whether new regulatory structures and authority may be needed 
to restore public confidence in the markets.
    I am a great believer in free markets as the very best way 
to allocate capital. At their best, markets are self-regulating 
and self-correcting.
    Integral to the functioning of a free market, however, is 
the presence of someone to ensure that the rules of the road 
are enforced fairly and swiftly. That is why we need to make 
sure that, moving forward, the market's referees keep pace with 
the players.
    What worries me is that these creations of the financial 
engineers, while adding liquidity and depth to the market, have 
simply not been self-correcting but, rather, they have been 
destructively destabilizing.
    Assessing and monitoring the risk that these products have 
introduced into the financial system goes beyond the ability of 
one nation's central bank. Indeed, I think it is a problem that 
begs for a global solution.
    It does not mean that solutions to the current crisis are 
beyond our reach. There is a series of steps we can take in our 
own regulatory structure to improve the functioning of our 
markets.
    That is why I welcomed Secretary Paulson's recommendations 
about the structure of our financial regulatory architecture. 
There are aspects to it that I like very much, some that I do 
not, but I think it is a vitally important starting point in 
getting a dialog going that will continue, I believe, for 
months and years to come.
    Without getting into the details, let me sketch what I 
believe investors need from a capital markets regulator.
    First and foremost, any market regulator must put investor 
interests above all others. It is not only good for investors, 
but it is this focus which has made our capital markets the 
envy of the world.
    Second, as part of this commitment, such an agency must 
ensure that the public gets whatever information it needs to 
make informed investing decisions.
    Third, it must be a law enforcement agency. Vigorous 
enforcement of the rules of the road is a powerful deterrent to 
bad behavior and usually prevents the use for heavy-handed 
regulation.
    Fourth, to be effective in any of these roles, the 
regulator must have the resources in terms of funding, tools, 
staffing, and competencies to get the job done right.
    Right now, I fear that the SEC does not have what it needs 
to meet the demands of the day.
    The SEC's 2009 enforcement budget does not keep pace with 
inflation. Staffing levels have not kept pace with the urgent 
work that needs to be done. And the Enforcement Division, I 
believe, has been unnecessarily hamstrung in negotiating 
corporate penalties because of recent procedural changes at the 
Commission. The result has been a lessening of the imposition 
of corporate penalties against egregious wrongdoers and a 
reduction in the corporate penalty numbers over the past year.
    Fifth, it is important that, by design, any capital markets 
regulator be independent--be independent of the White House--
and de-politicized from the fights of the day.
    Finally, as we consider the future of the SEC and financial 
regulation in general, let us not forget that more powerful 
than any rule that can be written, regulation that can be 
passed, or standard that can be set is the power of the bully 
pulpit.
    Whatever leadership is chosen for a future agency, it needs 
to be led by an individual who understands the importance of 
public pronouncements and signals that are sent to the 
marketplace, signals in terms of the kind of aspirations that 
that leader wants for the Commission, whether he gets it or 
not. This is something that SEC Chairmen have understood from 
its founding 75 years ago up until the present day, and it must 
be preserved.
    In sum, the future of the financial markets and of the 
regulatory structures we construct to oversee them is in flux, 
and it should be.
    The gravity of the situation we are in today calls for 
everything to be on the table. Make no mistake: no agency, no 
existing structure, no gatekeeper should be immune from a 
thoroughgoing, hard-headed analysis of its relevance to today's 
extraordinarily complex electronic markets.
    As we move forward with such a review, we must keep in mind 
that the strength of America's capital markets lies in how high 
our standards of transparency, independence, and accountability 
may be.
    And no matter what changes we undertake, we have got to 
ensure that we have in place a market regulator that is as 
sensitive to the demands of the individual investor Main Street 
as it is to the demands of the institutional investors on Wall 
Street.
    Thank you.
    Chairman Reed. Thank you very much, Chairman Levitt.
    Chairman Ruder, please.

 STATEMENT OF DAVID S. RUDER, FORMER CHAIRMAN, SECURITIES AND 
                      EXCHANGE COMMISSION

    Mr. Ruder. Mr. Chairman, Senator Allard, and Members of the 
Subcommittee, my testimony today will address the role of the 
Securities and Exchange Commission in regulating investment 
banks in today's complex global financial markets. I will 
discuss the SEC's regulatory obligations stemming from the 
recent credit crisis and its obligations relating to 
supervision of the securities markets, concluding that the SEC 
should have increased resources in order to fulfill its 
regulatory missions. I will argue that the SEC should not be 
required to substitute principles-based regulation of 
investment banks for its current enforcement-based regulation. 
I will urge the SEC to continue to communicate with investment 
banks regarding market innovations and risk positions. I will 
advocate giving the SEC new powers enabling it to improve its 
oversight of the financial stability of investment bank holding 
companies.
    Any investigation of the role of investment banks in the 
credit crisis will probably evaluate the role and 
responsibilities of the Securities and Exchange Commission, as 
you have started to do this morning. Now, one question will be 
whether the SEC's enforcement practices and other policies 
regarding investment banks will be adequate.
    In my view, the SEC's enforcement program is vital to its 
mission. The SEC has extensive power to impose sanctions on 
investment banks through court injunctive or administrative 
actions. The SEC's enforcement activities are effective because 
they not only punish wrongdoing, but also send strong messages 
of deterrence.
    In the wake of the credit crisis, the SEC is undertaking 
investigations. Once it has gathered sufficient evidence, it 
will undoubtedly bring regulatory actions. Possible areas of 
inquiry regarding investment banks include failures to disclose 
the poor quality of structured securities when selling them to 
investors, sales of high-risk structured securities to 
investors for whom they were unsuitable, sales of auction rate 
securities without revealing possible market illiquidity, and 
failures to reveal known investment bank holding company low 
asset valuations to purchasers of holding company securities.
    The SEC's ability to bring enforcement actions is dependent 
upon the size of its enforcement staff, which I believe, as 
does Chairman Levitt, should be increased so that it may be 
better able to engage in enforcement activities related to the 
credit crisis. I believe the additional communication and 
monitoring responsibilities that I will discuss in the 
remainder of my testimony will also require additional 
resources.
    In March of 2008, the U.S. Treasury released a Blueprint 
for Reform of the Financial Regulatory System containing both 
near-term and long-term proposals for financial system 
regulatory reform. The Treasury blueprint contains proposals 
that would change the SEC's oversight of stock exchanges and 
investment banks from an enforcement system to a principles-
based system. First, the Treasury urges the SEC to adopt the 
CFTC's principles-based regulation approach to securities 
clearing agencies and securities exchanges. That approach 
involves discussions with the regulated entities regarding the 
appropriate means of achieving compliance with the principles.
    Treasury support for a principles-based system may come in 
part from a comparison with recent changes in the financial 
services regulatory system in the United Kingdom. In the U.K., 
regulation of banking, securities, insurance and investments 
has recently been merged into a single, unified regulator, the 
Financial Services Authority, utilizing a principles-based 
regulatory system. That system has been described by the FSA as 
follows:
    Principles-based regulation means, where possible, moving 
away from dictating through detailed, prescriptive rules and 
supervisory actions how firms should operate their businesses. 
We want to give firms the responsibility to decide how best to 
align their business objectives and processes with the 
regulatory outcomes we have specified. We will increasingly 
shift the balance of our activity toward setting out desirable 
regulatory outcomes in principles- and outcome-focused rules, 
enabling our people to engage with firms' senior management in 
pursuit of these outcomes. We expect firms' behavior, in turn, 
to change to adjust to this shift in emphasis.
    As a second step, the Treasury recommends a merger between 
the CFTC and the SEC and urges legislation that will merge 
regulatory philosophies and harmonize futures and securities 
statutes and regulations, including, I believe, adoption of a 
principle-based approach. I sought legislation calling for the 
combination of the SEC and the CFTC following the market crash 
of 1987, but to no avail. I welcome and support the current 
Treasury proposal, but I do not believe the merger should be 
the vehicle for imposing a principles-based regulatory system 
in the securities markets and the elimination of great portions 
of our enforcement-based system.
    Although I do not believe the SEC enforcement-based system 
should be abandoned, I am sensitive to the fact that the SEC is 
regulating U.S. investment banks and stock exchanges that are 
competing in a complicated and constantly changing world 
environment. And I believe, therefore, the Commission should 
embrace the communications objectives of principles-based 
regulation. Dramatic innovation and technological change in the 
world's securities markets have created a need for the SEC to 
communicate constantly with the leaders of our investment 
banks, securities exchanges, and futures exchanges, as well as 
with domestic and foreign regulators.
    I also believe that the Commission should engage in 
prudential regulation with regard to the solvency, liquidity, 
and financial stability of investment banks. The Commission 
should play an active role in monitoring the overall risk 
management practices of investment banks. When possible, it 
should obtain information about the risk positions of 
unregulated entities controlled by those banks, such as hedge 
funds, private equity, and off-balance-sheet entities.
    Investment banks that are part of a bank holding company 
are subject to prudential supervision by the Federal Reserve 
Board. Investment holding banks not regulated as part of bank 
holding companies are, as you have been discussing, subject to 
risk-based supervision by the SEC on its voluntary CSE program.
    The CSE program requires the supervised entities to provide 
the SEC on a regular basis with extensive information regarding 
group-wide capital and risk exposures, including market and 
credit risk exposures, as well as an analysis of the holding 
company's liquidity risk. In practice, the operation of this 
program is prudential because it involves attention to the 
affairs of the supervised investment bank holding companies on 
an individual basis, with close and regular contact between the 
SEC staff and the supervised entity.
    I believe the prudential supervision of investment bank 
holding companies by the SEC should continue and be expanded. 
It is extremely important that the risk positions of investment 
bank holding companies, including their unregulated affiliates, 
be known so that the SEC can confer with other regulators 
regarding systemic risk. This risk assessment regulatory 
function for investment banks should remain in the SEC because 
it is the agency that best understands the risk activities 
engaged in by investment banks. Indeed, using its expertise, 
the SEC might well cooperate with the Federal Reserve Board 
regarding the risk assessment of investment banks that are part 
of bank holding companies. I further believe that the voluntary 
program for SEC oversight of investment bank risk activities 
should be made mandatory through legislation, so that the non-
bank holding company investment banks will not have the power 
to withdraw from the supervisory system when they are 
dissatisfied with the SEC's supervision or unwilling to provide 
information.
    Thank you for the opportunity to be with you today.
    Chairman Reed. Well, thank you very much, Chairman Ruder. I 
want to thank both of you gentlemen. We are extremely grateful 
that you would come here today. We received thoughtful 
testimony from the Securities and Exchange Commission, but 
there are few people that have the perspective, the experience, 
and the deep concern for the Securities and Exchange Commission 
and the market overall than you two gentlemen. So thank you 
very, very much for coming today.
    I just want to follow up, Chairman Ruder, with a question 
for both of you, but let me direct it to you first. The 
difference between a principles-based regulation and rule-based 
regulation, I think I heard in your testimony that at a certain 
level principles-based regulation might be appropriate, but at 
another level rules should be imposed. Can you help me 
understand if there is a line of demarcation?
    Mr. Ruder. Yes. I think as Mr. Sirri was discussing, there 
is a difference between the systemic risk questions that need 
to be addressed throughout our system and the regulatory 
aspects of the SEC's supervision. The investment banks need to 
know by rules and an enforcement process that they may not 
engage in activities that are harmful to the investing public. 
They should not be allowed to have misrepresentations to engage 
in market activities that are unwholesome, to do a lot of other 
things that are prohibited by the Commission. I think that 
their activities in that regard ought to be effectively 
enforced by rules and enforcement.
    On the systemic side, I think it is very important for the 
SEC to be part of the risk-based supervisory system and to have 
its powers and staff increase so that it can do the kind of job 
that we all think it should be doing. And that is to me the 
prudential supervision part of it, and the other part of--the 
principles-based part of a regulation would be the 
establishment of a system where, instead of having a regulatory 
system based upon enforcement and punishment and deterrence, 
you would simply talk to the regulated bodies and say you 
really did not do such a good job this time, but we want you to 
tell us how you can do better in the future.
    I do not think that is a system that will work in the 
United States, but I do think that it is important that the SEC 
recognize the value of the communication process with the 
investment banks particularly. They need in their prudential 
supervision not only to look at what the risk problems are, but 
to look at the entire firm and see whether the firms' 
regulatory posture is one that the Commission wants. And for 
that we need a very close interaction between the firms and the 
Commission.
    Chairman Reed. Thank you very much.
    Chairman Levitt, your comments on this issue of principles 
versus enforcement.
    Mr. Levitt. I agree with Chairman Ruder----
    Chairman Reed. Could you turn your microphone on?
    Mr. Levitt. I agree with Chairman Ruder. Principles-based 
regulation is often based upon the U.K. FSA model. I do not 
think it has worked particularly well over there. I do not 
think it will work well over here. I think Chairman Ruder draws 
a very important distinction between the use of prudential 
regulation with respect to systemic issues, but the crux and 
core and heart and soul of the SEC, which is based upon 
investor confidence, comes about from enforcement-based 
regulation rather than the mushier prudential or principles-
based regulation that is practiced elsewhere.
    Chairman Reed. Well, let me follow up, I think, with a 
related question, and for both of you, but I will start with 
Chairman Levitt. In the Paulson recommendation, the suggestion 
that I saw was that the Federal Reserve sort of step up as the 
comprehensive regulator for all these different financial 
firms. Can you comment on that, Chairman Levitt?
    Mr. Levitt. I think it is premature to choose any agency 
right now. It is ironic that--the Federal Reserve certainly was 
not there with respect to the problems at Citibank. The Federal 
Reserve does have resources not available to the SEC or any 
other regulator. But I think such a judgment right now is 
premature until we study exactly what went wrong.
    I think there is more that we do not know about what has 
happened in the past 2 years than that we do know about it. And 
I think that has got to precede any judgment as to who does 
what. I would be extremely cautious before I allocated to the 
Federal Reserve Board the total responsibility of regulating 
our markets until such a study is done.
    Chairman Reed. Thank you.
    Chairman Ruder, your comments?
    Mr. Ruder. I believe that the SEC has the ability to 
understand the risk activities of our investment banks. I think 
its approach is to understand that risk and at the same time 
learn about the systemic risk that is involved. I do not think 
that the Federal Reserve Board really would be playing a 
regulatory role that recognizes the risk positions taken by our 
investment banks as part of the securities markets. So I would 
be very cautious in letting the Federal Reserve Board have 
power over the entire securities and banking system.
    Mr. Levitt. Paulson did raise a very interesting suggestion 
about having a new agency created that would be concerned about 
investor considerations. I think that is an important idea. 
Whether that would be combined with the SEC I think remains to 
be seen. But the notion of the importance, the primacy of 
investor protection, implied by Paulson's suggestion is one 
that I think we should give careful consideration to.
    Chairman Reed. Thank you. I will recognize Senator Allard, 
and then I would like to do a second round also. This is, 
again, a great opportunity for us to ask questions. But just a 
final quick point. The SEC today suggested there would be some 
legislative definition that supports their CSE program. Would 
you concur, Chairman Levitt and Chairman Ruder?
    Mr. Levitt. All I would say is that I think that the CSE 
program can be more clearly defined, can be mandated. I think 
there is a lot of fuzziness about it now. Clearly, it has not 
provided the answers. Clearly, it has been around and we have 
gone through what we have gone through. So a lot of work has to 
be done.
    Chairman Reed. Chairman Ruder.
    Mr. Ruder. As my earlier testimony indicated, I favor 
legislative support of that program.
    Chairman Reed. Thank you very much, gentlemen.
    Senator Allard.
    Senator Allard. Thank you, Mr. Chairman. I will have one 
round of questions. Then I am going to have to get to the 
floor. So I will leave you in charge at that particular point 
in time.
    Both of you now have indicated that you would support more 
of a congressional role in this and some authorizing 
legislation. How should the codified authority differ, if at 
all, from the current regulatory program?
    Mr. Ruder. Well, the current regulatory program involves 
the Fed supervising the bank holding companies and the 
Securities and Exchange Commission supervising the non-bank 
investment bank holding companies. I think that should 
continue, and I think the Commission should be given more power 
to look at the systemic risk aspects of the bank holding 
companies, and then to confer with the Fed about the 
appropriate regulatory postures.
    Senator Allard. Do you think we need to have some language 
in there that brings the Fed in specifically, then, do you?
    Mr. Ruder. The systemic risk-based part of this, yes. I 
must say that my great concern about this legislative program 
is a possible attack on the independence of the Commission. I 
believe that the Commission, the SEC, must remain as an 
independent agency and not subject to the political powers 
which might come from the Treasury or even from Congress, if I 
may say.
    Mr. Levitt. That is a great danger. I share that feeling. 
The politicization of the SEC would be, if there is such a 
thing, an economic tragedy. I think that clearly the SEC needs 
greater resources in terms of risk management. Chairman 
Donaldson built up that capability at the time of his 
departure. It has diminished somewhat in recent years, and as I 
understand from the testimony before, there is a rapid buildup 
of that capability. I think that has got to be emphasized.
    Unfortunately, it takes an event, a crisis, to mobilize the 
attention of all the players, all the gatekeepers, all the 
regulators, all the legislators, and we have a real crisis.
    Senator Allard. We had some questions earlier from a member 
of this panel here that talked about the amount of resources 
needed to be made available for the SEC to carry on with their 
regulatory setting process and staffing levels and all that. 
And you both have advocated for greater staff and budgetary 
resources for the SEC.
    What level do you believe is necessary to do the right job?
    Mr. Levitt. Well, I think that clearly, when you see a 
diminution of budget allocated to the SEC--and there has been a 
sharp diminution. In 2005, the SEC spent $917 million. In the 
most recent budget, it was down to $842 million. The director 
of the Los Angeles office this morning mentioned that he has 
had to cut staff by 10 percent. That kind of statement in the 
midst of what we have been seeing says something has gone 
wrong.
    I noticed that the Chairman of the House Banking Committee 
has called for a $30 billion increase in funding. It is 
difficult to place a number on this except to say that the need 
is great. It is not just dollar-related. I share Chairman 
Ruder's emphasis on the importance of prioritizing the 
enforcement program, the ability to have a cop on the beat, the 
ability to tell wrongdoers that our examiners, our enforcement 
people are out there looking at the marketplace and determining 
where steps should be taken. We have been moving in exactly the 
wrong direction, and I think that in--my long-winded response 
to your question is the agency needs greater resources in the 
areas of enforcement and inspection. Whether that be $30 
billion, $20 billion, or $40 billion I leave to the dialog 
between appropriators and the agency.
    Senator Allard. Well, I am an appropriator on the 
appropriating committee, too, so I was very interested in your 
response.
    Mr. Ruder. If I may comment, in 2002, the SEC's budget was 
$514 million. Following the Sarbanes-Oxley Act, which contained 
a dramatic increase in budget, the budget went up to $716 
million. And it since has gone up some, but only as Chairman 
Levitt has told you, to $906 million in the 2008 budget.
    I think that the Commission's job in this very complicated 
world is increasing in many ways that are not really apparent. 
The ability to deal with the complicated structural problems in 
the securities area, including competition between securities 
exchanges, the creation of new, innovative products, the 
problems of the counterparty risk management in the unregulated 
portion of this market I think--and I may say the Commission's 
Mutual Recognition Project will require great--more assets for 
the Commission. And I think Congress ought to look very 
carefully at the whole Commission's budget to see whether some 
dramatic increase in funding is not necessary in order for it 
to meet its market-protective objectives.
    Senator Allard. Yes, and I see also in here that the type 
of expertise that you have to have for the kind of oversight 
that we are talking about here is not readily available and may 
even demand a pretty high salary and benefits and whatnot, and 
just, you know, we need to make sure that we have that quality 
in the overseer as well as in the marketplace.
    Mr. Levitt. And the overseer must see that that money is 
spent wisely.
    Senator Allard. Yes.
    Mr. Levitt. And spent in the areas that corrects the 
problem.
    Senator Allard. Yes, where we need the expertise.
    Mr. Ruder. If you contemplate how the risk-based assessment 
might have taken place under the CSE program and ask yourself 
what kinds of skills would be needed to find the appropriate 
analysis, I think you really do need to look at much better 
paid and much more highly sophisticated individuals.
    Senator Allard. Thank you for your comments.
    Thank you, Mr. Chairman.
    Chairman Reed. And we will keep the record open for 5 
additional days for any statements or questions, and we would 
ask you gentlemen, if my colleagues submit questions, we look 
forward to your response. But let me ask a few quick questions.
    Following up on what Senator Allard said, I get the 
impression and I share the impression that at present in some 
respects the SEC is outgunned by the resources and expertise of 
those they are trying to regulate. Is that a fair assessment?
    Mr. Levitt. Yes.
    Chairman Reed. Can you put your microphone on when----
    Mr. Levitt. I am sorry. Of what regulators?
    Chairman Reed. Well, the SEC regulators.
    Mr. Levitt. Outdone by?
    Chairman Reed. Outdone by the people they are regulating, 
the investment banks, all the broker-dealers with--instead of 
three SEC officials, there are 27 regulated personnel there, 
PhDs, and with models that will stun you.
    Mr. Ruder. And the salaries are a little higher in the 
investment banking world.
    Chairman Reed. I have heard of that. But I think it raises 
several issues. One is the obvious point that both you 
gentlemen have made. We do have to invest in expertise at the 
SEC. And I think there is another issue, too, and it goes to 
the issue of anticipating innovation, because one of the 
problems and one of the issues today in the global markets is 
these products are innovative, so just as you develop kind of 
the feel for an expertise for a particular product, you find 
there is a different one.
    Let me ask just your impression. To what extent is the SEC 
prepared today not only to match their regulated populations 
out there, but to stay ahead or be ahead of the innovation? 
Chairman Levitt?
    Mr. Levitt. I don't think that any regulator has ever led 
the regulated in terms of almost anything, in terms of assets, 
in terms of legislative scope of activities. It is just 
impossible. I think it is the job of the regulator to survey 
the field and see where the greatest systemic threats and 
investor threats may lie and then address those, and address 
them not just by rulemaking but by their enforcement efforts 
and by the bully pulpit. I think that the SEC has the ability 
to take a look at the landscape and see the risks that were 
being taken to examine the extraordinary leverage that some of 
these firms had been implying--Bear Stearns, something like 36 
or 37 times--and say, ``Hey, wait a second. What is going on?'' 
And that note of skepticism, that note of caution and of care 
was absent from all sources.
    We had a runaway marketplace where leverage and greed 
trumped the efforts of the gatekeepers, the rating agencies, 
the auditors, and the regulators. And now we are playing catch-
up.
    Chairman Reed. Thank you.
    Chairman Ruder, your comments?
    Mr. Ruder. I have two comments. One is that although the 
SEC may be understaffed, it has a certain component of 
extremely bright, underpaid people whose dedication and loyalty 
will create results that are better than may take place in the 
larger firms.
    Second, I think if Congress is going to look at the 
structure and budget for the SEC, it might contemplate 
something in the budget to allow the Commission to go outside 
of the agency to hire specialized groups to deal with specific 
problems on a contract basis so that it will not have to have 
these people there all the time, but it might be able to 
accomplish what it needs to on a special project.
    Chairman Reed. Thank you. This is a rare opportunity. Dr. 
Sirri gave very thoughtful and I think very substantive 
testimony today. But as you listened, were there any comments 
you might have with respect to his testimony or any other final 
conclusions you might want to give to us in terms of advice as 
we go forward? Chairman Ruder?
    Mr. Ruder. Well, I thought one of his responses was 
marvelously bureaucratic because I could not understand it.
    [Laughter.]
    Mr. Ruder. But I will say that to look at the Commission 
and ask what it did in the CSE problem in the face of a market 
in which the Fed, the investment banks, the world banks, and 
the SEC did not really know what was going on is not an 
appropriate way to look at this. What we need to do is to look 
forward and find a mechanism to prevent similar problems in the 
future.
    Chairman Reed. Chairman Levitt.
    Mr. Levitt. I think that so much of the effectiveness of 
the agency lies in terms of cases that it brings or cases that 
it does not bring, speeches that are made, issues that are 
known as investor important. The Commission has dealt with over 
recent years and months the question of shareholder access, the 
change in the way enforcement cases have been ordered in terms 
of pre-clearance by the Commission, which I think has had some 
dampening effect on that enforcement program.
    The New York Stock Exchange has called for shareholders to 
have a direct vote rather than giving to brokers that 
responsibility. The SEC has been sitting on this issue for some 
months.
    I think these are all issues that could send a signal that 
the agency places investor interests above all others, and I 
would hope that the agency is encouraged to move ahead of some 
of these important issues.
    Chairman Reed. Thank you very much. Thank you for your 
testimony and your participation today and for your service to 
the Commission. I also ask that as we go forward and follow 
this issue, you are available for your advice and suggestions.
    Mr. Ruder. With pleasure.
    Chairman Reed. Thank you very much, gentlemen. I will 
adjourn the hearing.
    [Whereupon, at 11:49 a.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]

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