[Senate Hearing 110-1006]
[From the U.S. Government Publishing Office]




                                                       S. Hrg. 110-1006


         RISK MANAGEMENT AND ITS IMPLICATIONS FOR SYSTEMIC RISK

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

                                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

         RISK MANAGEMENT AND ITS IMPLICATIONS FOR SYSTEMIC RISK


                               __________

                        THURSDAY, JUNE 19, 2008

                               __________

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




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                            senate05sh.html



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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

                      Amy S. Friend, Chief Counsel

                    Mark Osterle, Republican Counsel

                       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

                              ----------                              

                        THURSDAY, JUNE 19, 2008

                                                                   Page

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

                               WITNESSES

Donald L. Kohn, Vice Chairman, Board of Governors, Federal 
  Reserve System.................................................     3
    Prepared statement...........................................    33
Erik Sirri, Director, Division of Trading and Markets, Securities 
  and Exchange Commission........................................     5
    Prepared statement...........................................    49
Scott M. Polakoff, Senior Deputy Director and Chief Operating 
  Officer, Office of Thrift Supervision..........................     7
    Prepared statement...........................................    55
Richard Bookstaber, Senior Research Associate, Bridgewater 
  Associates.....................................................    20
    Prepared statement...........................................    69
Richard J. Herring, Jacob Safra Professor of International 
  Banking, and Co-Director, Wharton Financial Institutions 
  Center, Wharton School, University of Pennsylvania.............    23
    Prepared statement...........................................    79
Kevin M. Blakely, President and Chief Executive Officer, The Risk 
  Management Association.........................................    27
    Prepared statement...........................................    86

 
         RISK MANAGEMENT AND ITS IMPLICATIONS FOR SYSTEMIC RISK

                              ----------                              


                        THURSDAY, JUNE 19, 2008

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
        Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The subcommittee met at 2:32 p.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. I will call the hearing to order, and I want 
to thank first the witnesses for joining us today. I know they 
made significant changes in their schedules to accommodate us, 
and I really appreciate that.
    This is a technical hearing in some regard. It does not 
have some of the drama or melodrama that we usually have around 
here, but I think it is very, very important. And I think we 
have to focus on these issues, and this is an opportunity to do 
so.
    The events of the past year exposed significant fault lines 
throughout our financial system. The impact of this financial 
crisis has been deep and broad. We have had financial firms 
with considerable writedown and losses, due mainly to their 
failure to recognize the risk embedded in complex financial 
products. This hearing will explore how supervisors oversee 
risk management at investment banks and seek to find ways to 
improve that supervision to reduce the likelihood that firm-
level risk can expand throughout the economy.
    Risk management is critical. We have seen firsthand that 
when done poorly, it has the potential to ripple throughout the 
wider economy and impact others who have probably never heard 
of a collateralized debt obligation or a mortgage-backed 
security. The decisions at these firms have not only resulted 
in a tremendous loss of value for investors who have seen their 
retirement and personal savings ended and eroded, but also 
imperiled the health of the wider economy.
    Some of the losses may have been averted if risk management 
were better incorporated into the culture of these firms. 
Warren Buffett has commented that the chief risk officers 
should now be the CEOs. He draws attention to an important 
point. The top management must consider risk as an integral 
part of the decisionmaking, not as some control function off to 
the side.
    The culture of risk management is all the more important in 
today's world given that both firms and products have become so 
complex. Some of these financial firms have grown so large that 
identifying the concentration of risk in subsidiaries and 
throughout firm activities and then aggregating those risks at 
the holding company is a very difficult project to achieve. 
Given this great complexity, systems and models used at firms 
to measure the attendant risk have also become much more 
intricate. Federal Reserve Bank of Boston President Rosengren 
recently noted, as others have as well, that models have their 
limitations. Relying solely on models is never the answer.
    Along with failures in risk models, we have seen failures 
in decisionmaking at firms. During the boom times, no one wants 
to listen to the risk officer telling you not to make more 
money because the risks are too high. But those who do not heed 
these voices are among those with the largest writedown.
    Regulators also need to be on top of the complex risk 
models and governance structures at these firms. With 
globalized markets and more market participants, we have 
greater points of possible failure that require attention. The 
U.S. subprime mortgage exposure was magnified throughout the 
world, with banks in Germany and France and investors in many 
other locales experiencing deep losses.
    This reality requires a precise focus on risk management 
with sophisticated supervision that enforces the rules so that 
firms adhere to models of good governance and sound risk 
management. Discussions about the current regulatory structure 
have focused on this need to look at functional regulation, 
also systemwide oversight. This hearing is part of the broader 
dialog that ultimately must lead to action. The SEC and the 
Office of Thrift Supervision both look at risk at securities 
firms and investment banks at the holding company level. We 
also have the Federal Reserve onsite at these firms now. One 
has to ask if this is the most effective way to approach 
oversight and whether we are achieving the right outcomes.
    Federal Reserve Bank of New York President Tim Geithner was 
recently quoted as saying that ``Risk management and oversight 
now focuses too much on the idiosyncratic risk that affects an 
individual firm and too little on the systematic issues that 
could affect market liquidity as a whole.''
    Our regulators need the proper tools to keep an eye on the 
risks that build up throughout the system, not just in 
individual firms. In the case of Bear Stearns, it appears that 
regulators were not completely aware of the potential risk of 
its failure due in part to its counterparty exposures through 
credit derivatives, necessitating the Fed's involvement. We 
need a system where the regulators have a window into the risk 
at a systemwide level and can make informed decisions rather 
than decisions based on a lack of knowledge about risk and 
concentrations.
    We are also in the process in this country of moving from 
the Basel I framework to a more advanced Basel II capital 
adequacy framework. This framework brings us closer to 
measuring capital based on risk, but also involves models which 
have limitations. To counter these limitations, we need to 
ensure that supervisors have the flexibility to put in place 
stronger capital requirements as necessary, which falls under 
Pillar 2 of the Basel II model. Though Basel II will take some 
time to fully implement, we must address concerns now about how 
to improve risk management and its oversight by regulators.
    There have been numerous reports by regulators to address 
some of these issues on risk management and systematic risk. 
Though these reports have recent vintage, the issues do not. 
The fact is that financial regulators have been talking about 
these risk concerns for quite some time. We need to ensure that 
studying these issues results in robust changes to the manner 
in which supervision is undertaken by regulators rather than 
mere discussion.
    A larger question that comes out of all this has to do with 
risk taking at these firms. Is the risk that these firms are 
taking best in the long run? At what point might innovation be 
shorthand for creating complex financial products that 
camouflage risk and fail to add true economic value to 
investors and the economy? Innovation that merely adds to the 
bottom lines of financial firms but then ultimately leads to a 
bust, if that is the situation, then we have to do much, much 
more.
    We are here, I think, to discuss a very technical but a 
very important topic, and I am pleased that our witnesses have 
joined us. I am also pleased that Senator Corker is with us, 
and, Senator, would you like to make an opening statement or 
any remarks?
    Senator Corker. Mr. Chairman, thanks for having the 
hearing, and out of respect for the witnesses, I would rather 
hear from them.
    Thank you.
    Chairman Reed. Thank you very much, Senator.
    We have three distinguished witnesses who are not strangers 
to this Committee. Dr. Donald Kohn is the Vice Chairman of the 
Board of Governors of the Federal Reserve System. Thank you, 
Governor. Dr. Erik Sirri is the Director of the Division of 
Trading and Markets, United States Securities and Exchange 
Commission. And Scott M. Polakoff is the Deputy Director at the 
Office of Thrift Supervision. Each of these gentlemen will talk 
about the risks that they oversee and what they are doing to 
implement recent findings. Your whole statement will be made 
part of the record, and if you would like to summarize, that 
would be entirely appropriate. Governor Kohn.

STATEMENT OF DONALD L. KOHN, VICE CHAIRMAN, BOARD OF GOVERNORS, 
                     FEDERAL RESERVE SYSTEM

    Mr. Kohn. Thank you, Mr. Chairman. I do appreciate the 
opportunity to appear today to discuss several issues related 
to the oversight of financial institutions.
    As Members of the Subcommittee are aware, 3 months ago the 
Federal Reserve Board approved the establishment of the Primary 
Dealer Credit Facility, or the PDCF. In taking this action, we 
judged that without increased access to the Federal Reserve's 
liquidity by major securities firms, overall financial market 
conditions would have deteriorated further and would have had a 
substantially adverse effect on our economy.
    The PDCF, which was authorized for a minimum period of 6 
months, makes available overnight funding to primary dealers. 
We recognize that the existence of the PDCF could diminish 
primary dealers' incentives to maintain adequate liquidity and 
capital buffers, and thereby increase systemic risk. And as a 
lender, we need to increase our knowledge of the financial 
positions of our potential borrowers.
    Accordingly, in connection with the establishment of the 
PDCF, we created a program in close cooperation with the 
Securities and Exchange Commission to monitor the funding and 
capital positions of primary dealers, focusing on those primary 
dealers not owned by financial holding companies supervised by 
the Federal Reserve.
    We are currently working on an agreement with the SEC to 
enhance information sharing both for primary dealers owned by 
financial holding companies and those that are not. Broadly 
speaking, in spite of any moral hazard associated with the 
PDCF, we believe that primary dealers are strengthening 
liquidity and capital positions to better protect themselves 
against extreme events. We believe their management has learned 
valuable lessons from the events of the recent financial 
turmoil that can translate into better risk management, and we 
continue to monitor the effect of the PDCF and are studying a 
range of options going forward.
    I would now like to discuss the Federal Reserve's recent 
activities relating to banking institutions we supervise. The 
Federal Reserve's broad supervisory responses to recent events 
include requiring banking institutions to improve risk 
management, augmenting existing supervisory guidance, and, 
where necessary, enhancing our own supervisory processes.
    For instance, supervisors are reinforcing and strengthening 
their assessments and testing of fundamental risk management 
processes, requiring vigorous corrective action when weaknesses 
are identified. We are ensuring that institutions take a more 
comprehensive and forward-looking approach to risk management, 
understanding the potential for the risks to crystallize in 
times of stress. We have also redoubled our efforts to ensure 
that senior management properly defines overall risk 
preferences, creates appropriate incentives, and promotes firm-
wide information sharing.
    Residential lending is a particular sector requiring 
continued supervisory attention. We are reminding institutions 
that they should conduct rigorous stress tests of potential 
future losses related to residential mortgage loans, home 
equity lines of credit, and mortgage-backed securities. We 
continue to encourage lenders and mortgage servicers to work 
constructively with borrowers at risk of default and to 
consider prudent workout arrangements to avoid unnecessary 
foreclosures. And we are working to finalize the proposed 
amendments to the rules under the Home Ownership and Equity 
Protection Act proposed in December.
    We have been stepping up our review of banks' 
concentrations in commercial real estate, especially in those 
areas of the country exhibiting signs of weakness. We continue 
to monitor credit card markets, other consumer lending sectors 
for potential weaknesses, and have taken steps toward improving 
consumer protection for credit card users. Leveraged lending is 
another key area of focus.
    Consistent with the recommendations of recent reports, we 
are also looking at how firms are addressing weaknesses in 
counterparty credit risk management practices highlighted by 
recent events. For instance, emphasizing that firms should use 
a variety of techniques, including stress testing and scenario 
analysis, to measure potential exposure of their contracts.
    We are also working with the private sector to make the 
market infrastructure for financial transactions more robust 
and resilient. Our examiners continue to remind bankers that 
allowance levels, loan loss allowance levels, should be 
reflective of loan portfolio quality based on sound processed 
and consistent with current supervisory guidance. We are 
working with institutions to improve liquidity risk management 
practices through guidance and through one-on-one discussions. 
And even though the banking system remains well capitalized, we 
are evaluating banks' use of internal capital markets and 
whether firms adequately incorporate possible stress events in 
determining overall capital needs, and we are encouraging firms 
to raise capital.
    Finally, the Federal Reserve is nearing completion of 
enhancements to its supervisory guidance to clarify our role as 
consolidated supervisor of bank and financial holding 
companies. Improving our role as consolidated supervisor, for 
which we rely on close coordination with primary supervisors 
and functional regulators, should provide broad benefits for 
the financial system and the economy.
    Thank you, Mr. Chairman.
    Chairman Reed. Thank you, Governor.
    Dr. Sirri.

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

    Mr. Sirri. Chairman Reed and Members of the Committee, I am 
pleased to have the opportunity this afternoon to describe the 
SEC's program for oversight of risk management practices at 
major investment banks.
    Since the events of mid-March that culminated in the sale 
of Bear Stearns, the SEC has revised its analysis of the 
adequacy of liquidity and liquidity risk management at these 
firms. The SEC has also engaged broadly with both international 
and domestic regulators to consider the far-reaching 
implications of these events.
    The Commission has strengthened liquidity requirements for 
the CSE firms. In particular, we are closely scrutinizing the 
secured funding activities of each CSE firm, with a view toward 
encouraging the establishment of additional term funding 
arrangements and a reduction of dependency on ``open'' 
transactions, which must be renewed as often as daily. We are 
also focusing on the so-called matched book of secured funding 
transactions where we are closely monitoring potential 
mismatches between the asset side, where positions are financed 
for customers, and the liability side of the matched book, 
where positions are financed by other financial institutions 
and investors. We are obtaining funding and liquidity 
information for all CSEs on a continuous basis and discussing 
with CSEs the amount of excess secured funding capacity for 
their less liquid positions.
    Further, together with the Federal Reserve, we have 
developed additional stress scenarios, focused on the 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. 
Also, we have discussed with CSE senior management their 
longer-term funding plans, including plans for raising new 
capital by accessing the equity and the long-term debt markets.
    The Bear Stearns' experience has challenged a number of 
assumptions, held by the SEC and by other regulators, related 
to the supervision of large and complex securities firms. The 
SEC is working with other regulators to ensure that the proper 
lessons are derived from these experiences and that changes are 
made to the relevant regulatory processes to reflect these 
lessons.
    The work is occurring in a number of venues, including 
working groups operating under the auspices of IOSCO, the Basel 
Committee on Banking Supervision, the Financial Stability 
Forum, and the Senior Supervisors Group.
    Because the CSEs now have temporary access to the Federal 
Reserve's Primary Dealer Credit Facility, which would operate 
as a backstop liquidity provider should circumstances require, 
the SEC is in frequent discussions with the Federal Reserve 
Bank of New York both about the financial and the liquidity 
positions of the CSEs and issues related to the use or the 
potential use of the PDCF.
    The SEC and the Federal Reserve Board are nearing 
completion of 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. This MOU will provide one 
mechanism for the agencies to gain a broad perspective on key 
financial institutions and markets. This MOU will also provide 
a framework for bridging the period of time until Congress can 
address through legislation fundamental questions about the 
future of investment bank supervision, including which agency 
should have supervisory responsibility, what standards should 
apply to investment banks compared to other financial 
institutions, and whether investment banks should have access 
to an external liquidity provider under exigent conditions in 
the future.
    Another area of ongoing regulatory concern relates to the 
volume of novations of OTC derivatives contracts, the related 
increase in collateral disputes, and other operational issues 
experienced by dealers during the week of March 10th. Further, 
the increased novation activity away from Bear Stearns during 
that week had signaling effects in the dealer community that 
may have contributed to the loss of confidence in that firm.
    The SEC has been a long-time participant in the effort to 
improve the confirmation backlog of OTC derivatives, which has 
made substantial progress over the last several years, and 
continues to be involved in discussions with the industry on 
improving OTC market infrastructure. The SEC and other 
regulators, under the leadership of New York Federal Reserve 
President Tim Geithner, are discussing whether and how the 
market for OTC derivatives contracts might benefit from a 
central clearing counterparty and elimination of confirmation 
backlog, among other things. The dealer community is also 
moving forward on an initiative to improve settlement of OTC 
contracts, a process that the SEC is also participating in.
    These intensified efforts to enhance risk management build 
on an extensive foundation that has developed over the years 
since the SEC began the CSE program in 2004. The Commission has 
taken lessons learned from the Bear Stearns event to improve 
the supervision of the remaining investment banks and to 
enhance existing relationships with other supervisors to 
address the issues that these and other financial institutions 
are experiencing in the current turbulent conditions.
    An imperative from the Bear Stearns crisis is addressing 
explicitly through legislation 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.
    Thank you again for the opportunity to discuss these 
important issues, and I am happy to take your questions.
    Chairman Reed. Thank you very much, Dr. Sirri.
    Mr. Polakoff.

  STATEMENT OF SCOTT M. POLAKOFF, SENIOR DEPUTY DIRECTOR AND 
     CHIEF OPERATING OFFICER, OFFICE OF THRIFT SUPERVISION

    Mr. Polakoff. Good afternoon, Mr. Chairman. Good afternoon, 
Senator Corker. Thank you for inviting me to testify on behalf 
of OTS.
    OTS' statutory responsibilities afford us the opportunity 
to observe risk management practices at commercial companies, 
depository companies, and investment banking companies. For 
example, we currently supervise holding companies such as 
General Electric, AIG, and Ameriprise Financial Group. Our 
supervisory program is internationally recognized by foreign 
regulators, including the U.K.'s FSA and France's Commission 
Bancaire, and has achieved equivalency status from the European 
Union.
    In addition, we continue to supervise a number of 
commercial firms that own thrifts and were grandfathered by the 
Gramm-Leach-Bliley Act. These companies include General Motors 
Corporation, Archer Daniels Midland Company, John Deere 
Corporation, Nordstrom, and Federated Department Stores. These 
are all companies that own thrifts and are, therefore, deemed 
savings and loan holding companies. The Gramm-Leach-Bliley Act 
also confirmed that OTS is the responsible Federal agency for 
the consolidated supervision of an investment banking company 
that owns a thrift. As a result, we also supervise Merrill 
Lynch and Company, Morgan Stanley, and Lehman Brothers Holding. 
Our goal, obviously, is to work with the SEC, which is the 
functional regulator of the broker-dealer, to complete our 
legal responsibilities.
    Because these investment companies own thrift institutions, 
they are subject to OTS' continuous consolidated supervision 
program that extends to the parent level as well as the thrift 
level. To provide some context, as of March 31st, Merrill 
Lynch's thrift held $31 billion in assets, Lehman Brothers' 
thrift had $12 billion, and Morgan Stanley's thrift had $5 
billion.
    Our risk-focused supervisory framework includes onsite and 
offsite monitoring, a rigorous risk assessment, in-depth or 
targeted on-site examination reviews by subject matter experts, 
regular reporting from the firms to us on key financial 
metrics, formal and informal discussions with senior leaders 
and risk managers within the organizations, and, importantly, 
coordination with functional supervisors in the United States 
and abroad.
    In the course of our reviews, we evaluate the effectiveness 
of risk management, the strength of the financial control 
structure, the fitness of management, and the strength and 
integrity of the firm's earnings and financial condition. 
Further, our assessment of capital adequacy is handled on an 
individualized basis, with requirements tailored to the parent 
company's risk profile. Our principles-based approach focuses 
on regulatory outcomes over prescriptive rules. This approach 
has ensured strong capital foundations overall for thrift 
holding companies. In fact, our analysis of capital levels at 
savings and loan holding companies showed that they compare 
very favorably with the capital levels of bank holding 
companies and evidence of the strength of our regime.
    We have worked closely with the firms and investors over 
the past year as they have raised significant sums of capital. 
Earlier this year, I met with John Mack and his Morgan Stanley 
team, Dick Fuld and his Lehman Brothers team, and John Thain 
and his Merrill Lynch team. These meetings were augmented by 
regular discussions between our supervisory staff and key 
leaders within the firm's risk control centers. This dialog is 
geared toward understanding the inherent risk in these 
institutions and ensuring OTS has the information it needs to 
make informed supervisory judgments.
    While the firms have been cooperative with us throughout 
the process, I want to underscore for the Subcommittee the 
importance of regulatory cooperation as well. The Gramm-Leach-
Bliley approach lays out a clear expectation that supervisors 
will coordinate and share information. This will continue to be 
our goal. We must ensure that there are no gaps in our 
supervision of these firms and no confusion on the part of the 
firms about the posture of regulators, particularly in times of 
market stress.
    On this front, we are striving for a more cooperative 
relationship with the SEC. We believe a robust information-
sharing understanding with the SEC is in the interest of both 
OTS and SEC, and we will continue to press for a more 
collaborative working relationship. At the direction of OTS 
Director John Reich and SEC Chairman Cox, Dr. Sirri and I, with 
our respective staffs, will meet again in 2 weeks to address 
this issue. As we fulfill our statutory obligations, we will 
continue our efforts to develop the type of relationship you 
expect from regulators in supervising these important firms.
    Again, Mr. Chairman, thank you for the opportunity to 
testify. I look forward to your questions.
    Chairman Reed. Thank you very much. Gentlemen, thank you 
for excellent testimony. I will take about 7 minutes, then go 
to Senator Corker, and then probably do a second round, too, 
because I think we will have adequate questions for two rounds.
    Let me just try to get a feel for some of the details of 
your regulation. I presume for this purpose, Governor Kohn, the 
Fed was recently on the scene with investment bankers, so you 
did not have a presence there with Federal Reserve personnel 
until very recently. Is that correct?
    Mr. Kohn. That is correct. Our presence dates from the 
PDCF.
    Chairman Reed. Dr. Sirri and Mr. Polakoff, one area is the 
very sophisticated nature of the products that now are being 
created and kept on the books. Is there a product review by SEC 
or the OTS in terms of products that are being presented? And 
how is that done?
    Mr. Polakoff. From our perspective, we try to work with the 
SEC. Many of these complex instruments take place at the 
broker-dealer. The SEC is the expert as the functional 
regulator for the broker-dealer, and we think from the Gramm-
Leach-Bliley approach, it makes sense for us to defer to the 
SEC's opinion of these instruments and then to leverage off 
their work from a consolidated perspective.
    Chairman Reed. And, Dr. Sirri, is there an approval 
process?
    Mr. Sirri. Yes. Within firms there is an approval process 
for new products, and through our supervision, one of the 
things we look at is the quality of that approval process. In 
particular, anytime you structure a new product, you are 
worried about the risks it entails. So we focus on whether the 
firm properly understands the risks that are embodied in a new 
product, whether it has a sufficient control system within the 
firm to support introducing that new product.
    Chairman Reed. Let me just follow up. Without trying to be, 
you know, glib, is it a ``check the box'' thing, that they have 
a review and they have this and they have that, and that is 
fine? Or is it looking at or trying to really get into the 
nature of the product and the potential effect on the 
marketplace? And if that is the case, you know, who does that? 
Do you do that?
    Mr. Sirri. That is a good question. It is not a ``check the 
box'' process at all. So there are, in a sense, two aspects to 
it. What we are concerned about in particular is the firm's 
process for looking at new products. So we pay particular 
attention to how that works. Is Treasury involved? Are the risk 
managers involved? Do they have the proper infrastructure in 
place to support a new product?
    Occasionally, new products will come up that particularly 
catch our attention. At that point, we will dive much deeper 
into that new product. My staff will occasionally, for example, 
conduct special studies about issues of concern. Those studies 
may focus on products; they may focus on processes. These 
studies could be months long, and they result in a specialized 
report that goes to both myself and members of the Commission.
    Chairman Reed. Do you have examples--or how routine is it 
for the SEC to object to a product and say, well, you cannot do 
this? Does that happen, or is this one where there is a 
negotiation about what they have to do to get it on the street?
    Mr. Sirri. As a general matter, we are not likely to object 
to a product per se because of its design features or we think 
it is not useful in the market or we think it might not serve--
you know, it might not be well designed. That is highly 
unlikely.
    It is quite possible, however, that we think a firm might 
introduce a product that might have, say, some embedded 
optionality in it or something about it that creates risk for 
which the firm does not have adequate controls or, say, for 
which the firm cannot adequately check how much of this is 
being sold or how it is being funded. Those are much more 
likely things that we are going to pay attention to.
    Chairman Reed. And let me ask you--and this is not about, 
you know, completely 20/20 hindsight, but looking at the Bear 
Stearns experience and the products that went through this 
process, has that caused you to reflect on how well a job you 
did or what changes you have to make, or were you satisfied 
that at least on the issue of product approval, it was 
adequate?
    Mr. Sirri. With respect to Bear Stearns, I think we are 
generally talking about mortgages and mortgage-backed 
securities. In late 2006, my staff finished a specialized 
report on mortgage products, not so much the approval product 
but a lot of risk management features around them, which leads 
one to naturally ask the question: If you studied such a thing, 
how could this go on? And the reason, I think, is because the 
kinds of risks that were embodied in these mortgage products, 
things we have talked about before, about correlation risks, 
about liquidity risk, were things that at the time were not 
properly understood, not properly appreciated. And I think the 
liquidity facilities that pool the liquidity necessary for 
those products were just not put in place.
    Chairman Reed. And that lack of understanding was on both 
sides, both the regulators and the proponents, the investment 
banks. Is that fair?
    Mr. Sirri. I think it is a fair statement that neither us, 
the street, nor other regulators appreciated all the attributes 
of these products, especially given what could happen to the 
market. I do not think any of us understood the rapidity with 
which liquidity could disappear from these markets. That was 
not a risk that was in our scenarios. I think, you know, we 
hear it talked about that as we go forward here, we are looking 
at new scenarios that account for such risk much more 
explicitly.
    Chairman Reed. Let me ask one question of all the 
panelists, and if I exceed my time, I will compensate. We have 
had a series of reports--the Senior Supervisor Group, the 
Financial Stability Forum, the Basel Joint Forum, the 
President's Working Group. Just today, I think, Secretary 
Paulson made another speech touching on issues of supervision 
and reform.
    Given all these and the experience, what is at the top of 
your list, Governor Kohn, in terms of the two or three things 
you think are most important going forward?
    Mr. Kohn. I think the three pillars of resilience for the 
system are capital, liquidity, and risk management, and those 
three are certainly at the top of our list. We have worked 
carefully and closely with the Basel Committee that just 
yesterday, I believe, or the day before, put out new guidance 
on liquidity management. And we will continue to work with the 
institutions we regulate and supervise on their liquidity 
management and how they are adequately readying themselves for 
the potential stress events, such as the type that Eric was 
talking about.
    In capital, we are working again with the Basel Committee 
to look at how Basel II needs to be adjusted in light of the 
events we have seen for securitizations, resecuritizations, 
off-balance-sheet entities. And in risk management, we are 
going to our entities we supervise using the SSG report and 
other information we have, and those that were found not to be 
employing best practices, we are working very, very hard with 
them to bring them up to speed.
    Chairman Reed. Dr. Sirri.
    Mr. Sirri. I think I could easily resonate with the points 
that Vice Chairman Kohn made: capital, liquidity, and risk 
management. I would put a particular emphasis for our firms on 
liquidity, because our firms are investment banks, securities 
firms, liquidity is terrifically important to them. So while we 
certainly pay attention to risk management practices and 
capital, I would just emphasize a slightly even elevated level 
for us, for our firms' liquidity.
    Chairman Reed. Mr. Polakoff, please.
    Mr. Polakoff. Mr. Chairman, I am going to add No. 1 as 
greed; No. 2 as appropriate risk management, not just risk 
management; and then three, liquidity.
    Chairman Reed. Can you elaborate?
    Mr. Polakoff. Yes, absolutely.
    So from the greed perspective, I think all of us at the 
table, but certainly OTS, has identified numerous situations 
where the risk management team brought to the proper senior 
management certain findings that would suggest it is time to 
either ease off the accelerator or start depressing the brake. 
Senior management has to take that information and make a 
decision, while at the same time recognizing such a decision is 
going to have a negative effect on revenues. What we saw was 
inappropriate action by senior management in some situations in 
doing so.
    Now there is many different ways to address that situation. 
A common guy like me, it comes down to the greed issue.
    Chairman Reed. I appreciate that because that is a human 
motivation that seems to be ubiquitous and eternal, 
unfortunately. But how are you doing that now? I mean, are you 
requiring, for example, risk officers who make a recommendation 
that is denied to somehow memorialize that so you can review it 
later?
    Mr. Polakoff. Interestingly, most of the firms have changed 
their own practices as a result of this turmoil. So we had some 
situations where we observed the risk management team reporting 
to the business line. Holy cow, that is unacceptable and needed 
to be fixed right away.
    We had some situations where senior management was not 
sufficiently involved in hearing from the risk management team. 
Unacceptable, had to be fixed.
    So actually, what has happened is the system has corrected 
itself most of the way. Unfortunately, the turmoil contributed 
to it.
    Chairman Reed. Just quickly--and excuse me, Senator--any 
comments about that from Dr. Sirri, in terms of correcting what 
seems to be these lapses in just the way risk is treated in the 
firm? Is that something you are working on, also?
    Mr. Sirri. It is, indeed. And I think the Senior 
Supervisor's Group report spoke very pointedly to the question 
of governance in these firms. We have been talking very 
generally about these firms as if they are one. But they are, 
in fact, not one. We see considerable variation across the 
firms we supervise. Some of them have very strong risk 
practices generally, in particular, on the governance side. I 
think there are other firms that we have supervised that showed 
distinct weaknesses on governance.
    And one of the things we noticed as this credit crisis 
progressed, was that we could see a relationship between the 
strength of those practices and some of the losses they took on 
their positions for various reasons.
    So I think we believe very strongly that governance is 
important, things like reporting lines, internal prices, we pay 
a great deal of attention to and I think the credit crisis has 
emphasized how important that is.
    Chairman Reed. Governor Kohn?
    Mr. Kohn. I completely agree. Risk management has to be 
integrated into every aspect of the institution's behavior and 
it has to have support from the very top of the institution, 
the board of directors, the CEO on down. Greed has been, as you 
said, Mr. Chairman, a natural driving influence on all of our 
behaviors to one degree or another. Compensation schemes can 
reinforce that. I think what we need is more robust risk 
management to offset the compensation schemes and the greed, 
and that is where we are all working.
    Chairman Reed. Thank you. Thank you all very much.
    Senator Corker.
    Senator Corker. Mr. Chairman, thank you. I appreciate, 
certainly, the testimony of all of you and what each of you 
does to strengthen our financial environment.
    Before I step into specific questions, can you give us a 
sense of whether you feel like the worst today--I mean, we are 
looking at systematic risk management. Is the worst over today 
during this episode, as it relates to Wall Street? Are we on 
the edge of another potentially market crushing moment? Without 
obviously mentioning specific entities, just overall the 
entities that you regulate, where would you say today that the 
health of those entities are in where we are today as it 
relates to this episode, if you will, we are dealing with? Each 
of you.
    Mr. Kohn. I would say, Senator, that banks and the 
investment banks we work with the SEC on have improved their 
capital positions, reduced their leverage, improved their risk 
management, and tried to work--and worked very hard--on making 
their liquidity both longer term and more robust to stress 
events.
    So I think we have come a long way. The markets are in a 
little bit better shape than they were--certainly a lot better 
shape than they were in the first half of March. But having 
said that, I do not think anybody can really guarantee what is 
going to happen next and what the risks are. So I would expect 
that we will see a gradual improvement in financial markets, 
that our institutions have taken steps to make that possible 
and to contribute to that. But there are no guarantees. And 
that is one reason why the three of us and those that we work 
with are working so hard on this risk management, liquidity, 
capital issue, to make the system more robust to the 
unexpected.
    Mr. Sirri. I think I would agree generally with that 
statement. There is nothing from my particular vantage point 
that gives me any unique ability to foresee the future or the 
future of credit markets that we have been talking about.
    I will say that we are striving mightily to improve the 
resilience of these firms. We know more now about the kind of 
shocks they can experience and I think we are working strongly, 
mightily to get them to be more resilient to those shocks. 
Capital, liquidity, risk management, pillars that we have been 
talking about, these are the things that we are focusing on so 
that whatever the future portends that we have got a much 
better chance of coming through it strongly.
    Mr. Polakoff. Senator, in addition to my colleagues' 
comments, what we have, I believe, is a loss of confidence by 
the consumer. And with two GDP quarters of under 1 percent, 
with consumer spending under 1 percent, with housing stock at 
over 10 months, this situation is going to take a while to work 
out. I think the regulators have a very robust program to work 
with the institutions that they have responsibility for. I 
think the institutions have instituted or continued with strong 
risk management programs. But we have a confidence issue in 
many different markets that will take a while to get to.
    Senator Corker. Dr. Sirri, Tim Geithner, I guess, just 
wrote a letter to the editor of the Financial Times suggesting 
that we ought to have a clearinghouse for some of the over-the-
counter derivatives and simply things, standardize things to 
some degree. I am just wondering if you would comment on that 
and what that might do to the pricing of these derivatives and 
certainly just the effect that it would have should that be 
necessary?
    Mr. Sirri. I read that letter, so I know what you are 
speaking about.
    The point of having a--the first thing to appreciate is the 
kinds of instruments that he was discussing, things like credit 
default swaps, are over-the-counter instruments. So they are 
simply bilateral contracts. They are you meeting me over the 
telephone, us agreeing to the terms to some sophisticated 
derivative instrument. In the end, I am exposed to you as a 
counterparty, by which I mean as the value changes over time I 
depend on you to pay me if you owe me money. There is no one 
else involved in that arrangement.
    Over time, investment banks, securities firms, commercial 
banks develop networks of these contracts and they become very 
hard to keep track of. People are exposed to all kinds of risks 
because of it, many, many exposures. Some of them even building 
upon each other.
    By creating a central derivatives clearinghouse of some 
type, what is known as a central counterparty, a certain amount 
of risk can be reduced from that system. There is really two 
types of risk. The first is that there may be some netting that 
is possible. If our derivatives contracts are sufficiently 
similar, you may have sold me something that I may have later 
bought from someone else, who may have in turn sold it to you, 
and we may all flatten out and level out, stopping payments 
from flowing and reducing risk.
    The second thing that is true is that netting can occur, 
certain kinds of--excuse me, not netting can occur, but we have 
a central counterparty. Once we have a central counterparty, I 
need to no longer worry about your particular credit. There is 
some entity that stands in the middle that is capitalized by 
some other group. So if you fail to make the payment to me, 
that other entity stands there.
    Most people have familiarity with this when they buy a 
stock on the New York Stock Exchange or NASDAQ. No one every 
worries who sold them that stock. The reason is it does not 
matter. There is some counterparty sitting in the middle that 
takes the risk if the person who sold you the stock does not 
give it to you.
    Senator Corker. So you agree that that would be helpful?
    Mr. Sirri. I do.
    Senator Corker. And it appears that Chairman Kohn has a 
thought.
    Mr. Kohn. Thank you, Mr. Chairman. I agree with what Erik 
said. I would just add the following. Because the risk is 
concentrated in a central clearinghouse, it is really crucial, 
critical, that that entity exercise appropriate risk management 
itself, that it have financial resources so that it can 
withstand the failure even of its largest participant, that it 
have good margining and risk management procedures in place.
    So a central clearinghouse can reduce risks, but it 
concentrates risks. So once that risk is adequately taken care 
of, overseen by a regulator, I think it has all the advantages 
that Erik was talking about. But it does need that central 
clearinghouse to be very, very strong.
    Senator Corker. So I assume that both of you agree with Dr. 
Bookstaber, who is going to testify here in just a minute, that 
we have a new breed of quantitative number crunchers that have 
created mechanisms that only a handful of people understand, 
and we ought to simplify that to some degree, to a large 
degree?
    Mr. Kohn. I am not familiar with his testimony, but I do 
think the market will be in the process of simplifying these 
instruments. That is part of the problem here, as the Chairman 
pointed out in his opening statement, that these instruments 
were so complicated and so complex, people did not really 
understand the risk associated. So I think the market is going 
to drive toward some simplification, standardization of a 
number of these instruments.
    Senator Corker. But how would we move toward--I could not 
agree more that something needs to be done to simplify. How 
would we move toward this clearinghouse-type mechanism being 
put in place?
    Mr. Kohn. President Geithner and the other regulators are 
working with the private sector right now to see that they are 
moving toward a central clearinghouse and that that 
clearinghouse has the appropriate oversight and the appropriate 
risk control. So this is a process that is ongoing.
    Senator Corker. Speaking of the private sector, what role 
should the private sector play in risk management in that, in 
essence, they really have more dog in the hunt than even the 
regulators do because it is going to affect them directly. And 
I am just wondering what can be done to even enhance their 
ability, if you will, to do that?
    Mr. Kohn. Well, I completely agree with you, Senator. It is 
really the private sector's responsibility to do this. The 
shareholders of these firms are the ones who will lose if the 
risk management systems do not work. It is their incentive to 
make them work.
    I think our job, as regulators, is to make sure that they 
are moving in the right direction, reinforce the incentives 
that the market has given, making sure that they are 
sufficiently robust so that their failure is much less likely, 
and their counterparties are sufficiently robust that if a 
major firm fails, then the system does not come down.
    So we are reinforcing and building on market----
    Senator Corker. Is there anything else we can do, though, 
to empower their ability at the private level to do even more 
assessment----
    Mr. Kohn. I think we are working very closely with them, 
both as a group in this counterparty risk management and on 
individual firms. And we are trying to act as a convener for 
the private sector to get together to take the collective 
action they need to take that would be very hard on an 
individual firm-by-firm basis to reduce the risk in the system. 
I think there is something we can do, and I think we are doing 
it.
    Senator Corker. I think you alluded to this earlier, but in 
essence these derivatives that are now so prevalent have 
concentrated risk instead of diversifying risk in many ways. 
Would you like to make a comment in that regard?
    Mr. Kohn. They have diversified risk in a number of ways, 
but I think they were not as diversified as some people thought 
they were, and people were not as cautious about or as 
knowledgeable about the counterparties and the concentrations 
that they might have had. So I think fundamentally, the 
derivatives are very good at diversifying risk and spreading it 
out, but the people who use them need to be informed and 
understand better what they are doing.
    Senator Corker. Mr. Chairman, my staff has grabbed me for 
some reason to leave for a second. I have some questions for 
Scott. I do thank you for your thoughts, by the way, on the 
negative equity certificates and I thought that was a valuable 
contribution.
    Mr. Chairman, I might step out and I may or may not be 
back. Thank you for your testimony.
    Chairman Reed. We hope you return, Senator.
    Senator Corker. Thank you, sir.
    Chairman Reed. Gentlemen, if I could follow up with some 
additional questions, following the line of Senator Corker 
about a potential clearinghouse for credit defaults swaps, 
would that require any legislative incentive or support?
    Mr. Kohn. I do not believe it would require any 
legislation. I think it is in the process of happening. It will 
require regulatory approval. A central clearinghouse must be 
supervised and regulated, and the clearinghouse will have to 
decide who it wants to be regulated by and who will require--
but I do not believe it requires any legislation.
    Chairman Reed. The choice of regulator would be theirs the 
way it is structured? In that sense it would be their choice or 
its choice?
    Mr. Kohn. Essentially, I think.
    Chairman Reed. Dr. Sirri, any thoughts?
    Mr. Sirri. I think that is right. They will have to decide 
how it is structured. Those discussions are underway. So it 
depends on how it is owned, how it is structured, that will 
determine supervision.
    Chairman Reed. Let me ask a general question to all of you, 
and that is the--and you touched upon it previously. That is 
what is now a routine mechanism for coordination between your 
three agencies? As Mr. Polakoff pointed out, he has statutory 
jurisdiction over three investment banks. You have, 
essentially, jurisdiction on the compliance of the identity 
program of the remaining major investment banks. The Fed is now 
there because of their lending facility.
    Is there a routine now in which information is shared on a 
regular basis? And getting to the point of, this would seem to 
me the first way you responded, systematic risk is getting all 
of the regulators around the table and talking about what they 
are seeing. Is that happening?
    Mr. Kohn. Yes, it is, Mr. Chairman. Certainly, especially 
there is a lot of information sharing with the OTS. And that 
goes back a long way, sharing information about depository 
institutions on the FFEC, working with them on consumer 
mortgage regulations, things like that.
    With the SEC, as both Dr. Sirri and I have noted in our 
testimony, we have stepped up the cooperation and coordination 
since the Bear Stearns crisis. And there is a lot of 
coordination, cooperation, talking back and forth.
    And we are in the process of entering into a memorandum of 
understanding about these information sharing issues and other 
oversight issues.
    Chairman Reed. Your comments, Dr. Sirri?
    Mr. Sirri. I would say there is quite a bit of information 
sharing and cooperation going on. We each have different 
mandates within these organizations and so I think our views on 
them depend on our mandates. I think--and I will let Scott 
speak for himself--but there are thrifts that I think they pay 
particular attention to. We pay particular attention to the 
broker-dealer and certain issues around them. I think with the 
primary dealer credit facility has particular emphasis that the 
Fed has now.
    With that said, there are common interests, as well as 
distinct ones. And I think we are striving to work together to 
make that more seamless. Chairman Cox and Chairman Rich have 
met together recently, as Scott said. I think we, with the 
Federal Reserve, are working on a memorandum of understanding.
    So I think we are finding our way to new territory for us 
to find our way through this kind of a situation. I think we 
are making good progress.
    Chairman Reed. I presume you have identified gaps and that 
you are, through this coordination process, trying to fill 
those gaps. I presume also, since you have not requested any 
formal legislative approval that you are confident that those 
are regulatory matters not requiring any additional 
legislation? Why don't you comment, Scott?
    Mr. Polakoff. Mr. Chairman, we are making progress. There 
is still more progress to be made. When we get away from the 
inside-the-Beltway approach, the examiners in the field need to 
communicate better. And I do not think necessarily, Mr. 
Chairman, it is gaps. I think it is duplicative efforts. So 
when there are meetings, relevant meetings, all the right 
parties need to be at the table. When there is analysis, all 
the right parties need to see the analysis.
    Each party will be better by leveraging off the product of 
each other, and I think we still need much more progress in the 
area, at least between Erik's team and my team. It may be with 
the Fed and the other banking regulators we simply have had a 
longer history and trust of working together.
    Chairman Reed. Any additional comments, gentlemen, in this 
general issue of getting it to be seamless?
    Mr. Sirri. Look, I think we all appreciate the importance 
that it has. We are in a unique time here. We are in a time 
where we have certain exigencies that have required us to work 
together in different ways.
    One thing Chairman Cox has said, as we work through this, 
is that he sees this as a somewhat temporary solution and that 
ultimately we will need legislation here. You raised the 
legislation question. I think working together today we do not 
need legislation to fulfill, to see us through this temporary 
period here. But I think ultimately a legislative solution is 
needed for a number of aspects here.
    Chairman Reed. You raise the issue of temporary. Governor 
Kohn, the lending facility, by the nature of the expediency and 
the urgency and the extreme nature of your action, is 
temporary?
    Mr. Kohn. That is correct.
    Chairman Reed. And so what would you anticipate being sort 
of the ballpark figure where you are no longer in this 
temporary mode and you have to pass the time to Mr. Sirri and 
then Polakoff, and therefore there might be the need for 
legislation? Can you elaborate? Or is that----
    Mr. Kohn. With regard to the lending facilities themselves, 
we are looking at this issue right now and have a number of 
alternatives under consideration and are talking about this 
within the Federal Reserve. I am not prepared to say something 
right now.
    I think part of the cooperation with Erik and his team is 
to look at, as he said in his testimony, this period of 
bridging two potential legislative actions. So I would say that 
even if those liquidity facilities, or when they begin to be 
wound down, we would expect still to have a cooperative 
relationship with the SEC.
    Chairman Reed. Let me ask you another question, Governor 
Kohn. We have talked about risk assessment. Dr. Sirri and Mr. 
Polakoff are sort of regulators. They do not have a fund like 
you do, and credit, and all those things. How about your risk 
assessment at the Federal Reserve in terms of the--particularly 
with respect to the collateral you have assumed from the Bear 
Stearns transaction. It was about $29 billion which you are 
liable for at this juncture?
    Mr. Kohn. Right.
    Chairman Reed. And I am also under the impression that you 
are operating under accounting rules that are not the same 
accounting rules that everyone has, in terms of recognizing the 
value. That is an issue, I hope, that you are looking at 
seriously.
    Mr. Kohn. That we expect that transaction to settle on or 
about June 26th and we expect--as President Geithner said--to 
publish on a quarterly basis the value of these assets using 
market value, fair value accounting. I think we will be 
adhering pretty much to generally accepted accounting 
principles for that particular limited liability corporation. 
We understand our responsibility to be transparent about what 
we have and what the risks are that we have undertaken.
    Chairman Reed. Thank you.
    A final question, and this goes to the--and you can 
probably help explain and increase my knowledge. But it strikes 
me that there are probably situations where you have looked 
very closely and you can look very closely legally at the 
regulated company, the investment bank, et cetera. But they 
have relationships with counterparties, with unregulated 
institutions, and many of them, I suspect.
    How do you get the same confidence in their counterparty 
that you would have in the regulated entity? And is there 
anything we need to do to give you more authority in that 
regard? Start with Mr. Polakoff.
    Mr. Polakoff. Mr. Chairman, many of the counterparties have 
rating associated with them. Frequently there is publicly 
available information. It does come down to concentration risk 
and it is simply one of the elements of a strong risk 
management program. How one measures counterparty risk, how one 
monitors counterparty risk, and then how one mitigates such.
    So it can be done even when the counterparty, as you 
mentioned, is frequently unregulated.
    Chairman Reed. And you are confident, as best you can, that 
this counterparty risk evaluation is going on and it is 
adequate at the moment?
    Mr. Polakoff. Yes, sir.
    Chairman Reed. Dr. Sirri.
    Mr. Sirri. Securities firms have all sorts of 
counterparties. I am going to primarily break them down into 
two. They could have counterparties because of proprietary 
trading that they do, and they could have counterparties that 
arise because of certain agency business they conduct.
    So for example, the prime brokerage business is an 
important one, where we watch counterparty risk. Prime 
brokerage is a business where entities such as hedge funds come 
to securities firms for their financing for their trades, for 
lending of securities, these kinds of things. Counterparties 
become very important then.
    Securities firms, the kind that we are talking about, have 
fairly well developed and very sophisticated counterparty risk 
management operations that go on there.
    That said, they are continually evolving and through the 
shocks that we have seen, the kind of things that happened 
post-Bear Stearns, we have watched how those counterparties 
behave. Do they move contracts away from a particular firm? Do 
they shift all of their business? How quickly do they run?
    And so one of the things we have learned from that is we 
had some beliefs on how they would behave before. Those beliefs 
have changed. We have learned something about how they behave. 
Those new beliefs are being incorporated into the models that 
we have these firms run. And so we are cycling that through all 
these firms to say now that we know something, how 
counterparties behave under stress, let us learn from that. Let 
us cause all the firms to factor that into their models, 
resulting as you would expect, in increased liquidity, 
increased capital, increased demands for risk management.
    Chairman Reed. Governor Kohn.
    Mr. Kohn. Sir, I would only add to what my colleague said, 
that this work that we are doing, that we have talked about on 
the infrastructure for the derivatives markets and the over-
the-counter markets, is a very important aspect to controlling 
counterparty risk and managing counterparty risk. So the more 
seamless we have that flow of information and settlement and 
clearing, the easier it will be for the securities firms and 
the commercial banks to understand their risk, where it is, and 
then to manage it. So that is critical to that aspect.
    Chairman Reed. Thank you very much, gentleman. Thank you 
for your service. As always, it has been an enlightening 
session. Thank you very much.
    Mr. Kohn. Thank you, Mr. Chairman.
    Chairman Reed. We will call the second panel forward.
    [Pause.]
    Chairman Reed. Gentlemen, thank you for joining us this 
afternoon.
    We are very pleased to have a distinguished panel of 
experts on the issue of risk analysis and risk assessment. Our 
first witness is Richard Bookstaber, a senior research 
associate at Bridgewater Associates. Mr. Bookstaber has a great 
deal of experience in the area of risk management, having 
worked in the field since the 1990s at Morgan Stanley, Salomon 
Brothers, and other firms. He brought this experience together 
in a book published last year titled ``A Demon of Our Own 
Design: Markets, Hedge Funds, and the Perils of Financial 
Innovation.''
    Dr. Richard Herring is the Jacob Safra Professor of 
International Banking and Co-Director of the Wharton Financial 
Institutions Center at the Wharton School, University of 
Pennsylvania. He is the author of numerous articles and books 
on various topics in financial regulation, international 
banking, and international finance, including risk-related 
topics. He is co-chair of the U.S. Shadow Financial Regulatory 
Committee and a member of the Financial Economists Roundtable, 
the Advisory Board of the European Banking Report in Rome, and 
the Institute for Financial Studies in Frankfurt. Welcome.
    Kevin Blakely is President and Chief Executive Officer of 
The Risk Management Association. Prior to this position, he was 
Executive Vice President of Key Bank in Cleveland, Ohio. He 
also served as chief risk officer of KeyCorp from 1994 to 2005, 
where he implemented a number of risk management processes. 
Before joining KeyCorp, Mr. Blakely was with the Office of the 
Comptroller of the Currency for 17 years.
    Gentlemen, your statements are all part of the record, so 
if you would like to summarize or any variation thereof, 
please. Mr. Bookstaber. Could you bring the microphone closer 
and push the button? Thank you.

  STATEMENT OF RICHARD BOOKSTABER, SENIOR RESEARCH ASSOCIATE, 
                     BRIDGEWATER ASSOCIATES

    Mr. Bookstaber. Thank you, Mr. Chairman. In the letter of 
invitation, we received three questions for discussion: the 
state of current risk management models and systems; the 
adequacy of risk management by risk officers and executive 
boards; what regulators could do to improve their response to 
future market problems; and how regulators can better equip 
themselves to monitor risk. I would like to address each of 
these questions in turn.
    In terms of the state of current models and systems for 
measuring risk management, large financial institutions 
evaluate the risk of their positions on a daily basis using 
systems and models that I believe are well developed and are 
adequate for the risks they are designed to measure. The 
problem is that the systems are not designed to measure--and in 
the current state of the world perhaps cannot be designed to 
measure--the risks that we care the most about, which are the 
risks related to market crises.
    To understand why they cannot, we must understand how 
market crises develop. Consider as an example a highly 
leveraged firm that has a sizable position in a market that is 
under stress. The firm faces losses and its collateral drops to 
the point that its lenders force it to start selling. This 
selling leads to a further drop in the market, which leads the 
collateral to decline still further, forcing yet more sales. 
This downward cycle reduces liquidity in the market so that the 
manager must start to sell positions he might be holding in 
some other markets. This selling drops the prices in these 
markets, and highly leveraged funds with exposure in these 
markets are then forced to sell. And thus the cycle propagates. 
The result is that the stresses in the first market might end 
up devastating another unrelated and perfectly healthy market.
    As a simple example of the unlikely yet powerful linkages 
that can occur with this sort of dynamic, consider the silver 
collapse in 1980. The decline in the silver market brought the 
cattle market down with it. The improbable linkage between 
silver and cattle occurred because the Hunt brothers needed to 
raise capital to post margin for their silver positions when 
those declined, and to do so they sold off the cattle positions 
that they happened to hold.
    Another example of this, the LTCM crisis in 1998, was 
precipitated by the default in the Russian debt market, even 
though LTCM did not have a substantial position in Russia. But 
some of those who did also had positions in markets where LTCM 
was active. When they were forced to sell in these markets, 
LTCM was caught up in the downward spiral. Many of these 
markets, such as Danish mortgage bonds, had nothing to do with 
Russia, save for the fact that they were in the crosshairs of 
the same leveraged investors that were holding the Russian debt 
exposure.
    The point is that during market crises, the usual economic 
linkages and historical market relationships do not matter. 
Rather, what matters are questions of who owns what, who is 
under pressure to liquidate, and what else do they own. And as 
I will discuss below, regulators do not have the requisite data 
to answer these questions.
    In terms of the adequacy of risk management by risk 
officers and executive boards, I would have to say that 
whatever the limitations of the risk models and systems, these 
were not the culprits in the case of the multibillion-dollar 
writedowns over the past year. These positions were patently 
visible; no detective work or models were required.
    Indeed, what occurred really leaves me scratching my head. 
It is hard to understand how this risk was missed. How can a 
risk manager see inventory grow from a few billion dollars to 
$10 billion and then to 30 and then $40 billion and not react 
by forcing the inventory to be brought down? My view is that it 
was a failure of management. The risk managers did not have the 
courage of their convictions to insist on the reduction of the 
inventory, or the senior management was not willing to heed 
their demands.
    More must be required of the risk manager than monitoring 
and understanding risks. He also must have the willingness and 
independence to force issues up the chain of command. And, 
furthermore, the CEO must have the capacity to assess the risk 
manager's advice and have the willingness to take bold action.
    Adequacy in these dimensions requires the correct 
incentives. As it stands now, those who are responsible for 
protecting the firm from unwarranted risks often have 
incentives that are more closely aligned with those of a risk 
taker.
    So what can regulators do to improve their response to 
future problems in the market? Here I would like to put forward 
two points for consideration.
    The first is establish a liquidity provider of last resort. 
In my October 2, 2007 testimony before the House Financial 
Services Committee, I proposed ``the Government maintain a pool 
of capital at the ready to be the liquidity provider of last 
resort, to buy up assets of firms that are failing.'' The 
Federal Reserve's action with respect to Bear Stearns is along 
the lines of this proposal.
    The reason for the Government to act as a liquidity 
provider of last resort is that by taking rapid and decisive 
action to infuse liquidity, regulators may break the cascade of 
an emerging crisis and curb a systemic threat.
    The concept of a liquidity provider of last resort has 
already been employed successfully in the private sector. The 
large hedge fund Citadel has used its capital to buy up the 
assets of other hedge funds that were in distress, in one case 
with the failure of Amaranth and again with the failure of 
Sowood. Citadel's actions did not bail out the failing firms. 
These firms still went out of business. But its actions 
forestalled positions being thrown into a jittery, uncertain 
market, and thereby prevented the failure of one firm from 
cascading out to have a systemic effect.
    Now, I hasten to emphasize that if the Government considers 
formalizing a role of this type, a liquidity provider of last 
resort to buy up assets of firms that are failing, it will not 
be stepping into the business of bailouts. There is no moral 
hazard problem because the firm will still fail. But the 
collateral damage will be contained; the market will not go 
into crisis, the dominos will not fall. And it might be one of 
those rare Government enterprises that actually turns a profit.
    Second, rethink the application of mark-to-market 
accounting. Marking positions to market is intended to price 
the positions according to what they would be worth if they 
were sold at the present time. The mark-to-market concept loses 
its meaning when applied during market crisis. Indeed, in times 
of crisis, mark-to-market accounting might even be 
destabilizing.
    In a crisis the market is drained of liquidity. Many who 
otherwise would be natural buyers are facing large losses, yet 
others are running for the sidelines. In this situation a mark-
to-market price is next to meaningless. If a financial 
institution has a large inventory, it could not sell at that 
price. And if the institution has no intention of selling, then 
the crisis-induced fire sale prices bear no relationship to 
what the positions will be worth in the long term.
    But pricing inventory on a mark-to-market basis can end up 
being destabilizing. It might force yet more assets into the 
market because the institution might appear to be below a 
regulatory capital limit, or it might need to satisfy the 
covenants of its creditors. It might erode the market's 
confidence in the viability of the institution. In such cases, 
mark-to-market accounting will cause the crisis to become more 
severe.
    I suggest regulators investigate the systemic risk 
implications of mark-to-market accounting rules.
    Now on the last question, how regulators can better equip 
themselves to monitor risk, I would put forward two points.
    No. 1, get the critical data. Prior to the recent financial 
crisis, my firm, Bridgewater Associates, performed an analysis 
of the incredible buildup of leverage in derivatives throughout 
the financial industry. The firm was able to put together a 
rough but useful picture; however, the clearest lesson from the 
exercise was how little anyone knew about where the risks lie.
    Regulators are ill-equipped to monitor risk because they 
lack the right data. That is particularly true when we are 
looking at the issues of crises and potential systemic risks. 
As I have already mentioned, what matters for these risks is 
who is leveraged, what they own, and what they owe to whom. Yet 
regulators do not have the essential information to monitor 
leverage. Nor can they track the concentration of investors by 
assets or by strategies. Nor can they assess the risks at the 
foundation of the huge swap and derivatives markets because 
they do not know the positions of all of the counterparties--
who owes what to whom and how losses would propagate if a set 
of counterparties failed.
    It is important for regulators to determine the data that 
are necessary and then get access to these data. And getting 
the critical data may require looking not just at commercial 
and investment banks, but also at hedge funds.
    Second, create a regulatory risk management function. In my 
congressional testimony, I suggested the need for ``a 
regulatory body, a Government-level risk manager with a role 
perhaps modeled after that of industry-level risk managers.'' I 
am pleased to see a similar recommendation come forward from 
the Department of Treasury in the form of the role of the 
market stability regulator.
    Such a regulatory body would acquire the relevant data and 
then use these data to monitor systemic risk. It would have the 
ability, either directly or in cooperation with other 
regulators, to put checks on the risk-taking activities of the 
institutions under its purview. It also would be the natural 
home for the liquidity provider of last resort. As with the 
issues of data acquisition, the success of such a function 
depends on it having oversight for all major risk-taking 
institutions, including hedge funds.
    With this, I will close my prepared remarks. I thank the 
Chairman for inviting me to provide this testimony, and I look 
forward to your questions.
    Chairman Reed. Thank you very much, Mr. Bookstaber.
    Professor Herring.

   STATEMENT OF RICHARD J. HERRING, JACOB SAFRA PROFESSOR OF 
   INTERNATIONAL BANKING, AND CO-DIRECTOR, WHARTON FINANCIAL 
INSTITUTIONS CENTER, WHARTON SCHOOL, UNIVERSITY OF PENNSYLVANIA

    Mr. Herring. Thank you very much. Good afternoon, Chairman 
Reed. I am very grateful and honored for the invitation to 
testify here today.
    I would like to address four questions in my allotted time. 
One is, How did Basel I contribute to the crisis, and would 
Basel II have prevented it? Second is, What weaknesses in Basel 
II have been highlighted by the crisis? Three, What lessons 
have been learned by risk managers and regulators? And, four, 
What additional regulatory tools need to be developed to limit 
systemic risk without exacerbating moral hazard?
    First, how did Basel I contribute to the current crisis? 
Well, Basel I actually created very strong incentives for 
regulatory arbitrage, and subprime mortgages were a very good 
example of that. If a bank wished to hold a subprime mortgage 
on its own balance sheet, it would be charged a full 100-
percent risk weight. On the other hand, if it created a special 
purpose entity off balance sheet and backed it up with a line 
of credit that was revocable and under 365 days, it would have 
a 0-percent capital charge. So by simply booking the asset, 
selling it to the special purpose entity, it could do that a 
number of times using its capital much more efficiently, 
generating fees for not only originating the loans but also 
servicing the loans and creating what was, in effect, an off-
balance-sheet banking system.
    Would Basel II have actually caused the system to be less 
prevalent? Optimists assert that Pillar 1 of Basel II would 
have reduced the incentives by requiring a modest capital 
charge for the short-term line of credit backing up the SPE. I 
am skeptical about whether that would have actually made much 
difference because the U.S. has had that rule in place for a 
couple of years, and Citibank actually had more SIVs 
outstanding than any other bank. It seemed not to have slowed 
it down at all.
    Every optimist claimed that Pillar 2 of Basel II is 
designed exactly to prevent this sort of abuse from taking 
place. It enhances the scope for regulators to require capital 
above the regulatory minimum if they believe that the bank is 
exposed to some risks that are not well captured by Pillar 1 
capital charges.
    Again, I am skeptical that this will have much practical 
importance because bank supervisors have a very tough time in 
criticizing or disciplining banks that appear to be in good 
condition and are highly profitable. It has just never been 
very effective.
    We have, in fact, a very good recent example of just how 
ineffective it can be. Only weeks before Northern Rock 
collapsed, the Financial Services Authority in Great Britain 
authorized it to use the IRB approach under Basel II, which 
reduced its capital requirement by about 30 percent, which was 
dividended out to shareholders, and there is absolutely no 
evidence that the FSA even contemplated adding a Pillar 2 
capital charge to compensate for it, although it could have 
done so on grounds that the Pillar 1 charge was inadequate or 
that the bank was exposed to an illiquidity shock or that its 
business model was simply too risky. But none of those things 
happened, and I think it is, in fact, very hard for it to 
happen.
    Finally, optimists say that Pillar 3, market discipline, 
would make a big difference because you would have better 
disclosure and better market discipline. I am skeptical on both 
counts, again. Pillar 3, as currently configured, does not 
really contemplate disclosure about SPEs or contingent 
commitments that would be at all useful to outside holders, 
although I understand that may well change at mid-year. 
Moreover, the way in which the authorities have dealt with this 
crisis has not really led to greater incentives for market 
discipline. In each of the cases--IKB in Germany, Northern Rock 
in the U.S., and Bear Stearns here--the authorities have acted 
in such a way that all counterparties and all creditors have 
been thoroughly protected from many of the consequences. And so 
there is really no incentive for market discipline in that.
    What are some of the defects in Basel II that have been 
highlighted by the crisis? Well, I think, again, there are 
defects in each and every pillar. Pillar 1 has two ways of 
levying capital charges. The simple way is the Standardized 
Approach, and the Standardized Approach relies very heavily on 
ratings by the ratings agencies. This strikes me as having two 
problems, one of them rather subtle and the other one really 
very apparent after our recent problem.
    The subtle problem is that the whole incentive for giving 
good, honest credit ratings changed markedly when the investors 
stopped paying for them, essentially, and it is made even worse 
when the demand for credit ratings is coming from regulated 
institutions that get lighter capital charges if they get 
better credit ratings. So I think it sort of adds to the 
pressures that tend to distort the credit rating system and 
lead to a world in which we have, say, structured credits and 
corporate credits bearing the same letter grades, even though 
they are strikingly different in actual risk.
    More importantly, however, I think that relying on ratings 
may introduce an element of systemic risk that we did not have 
before. If the ratings agencies get it wrong for an entire 
category of securities that are widely held, then that can be a 
systemic problem as opposed to simply getting it wrong for a 
corporation or even a country, which usually has a much lesser 
effect on the broader system.
    Pillar 2 is problematic because its treatment of liquidity 
is really very qualitative. I have not yet had a chance to 
study the new guidance from Basel, but certainly improvement is 
highly warranted. More importantly, Pillar 2 leaves out any 
attention to reputational risk, yet it was concern over 
reputational risk that led a number of institutions to spend 
billions of dollars to take securities back into their books or 
to prop up funds. This happened with money market mutual funds. 
It happened even with some hedge funds. But probably most 
importantly of all, Pillar 2 completely ignores business risk, 
yet business risk has been responsible for about 18 percent of 
the volatility of U.S. bank earnings over time, and it is the 
fundamental reason that any business will hold capital. Yet it 
is really ignored by the Basel system.
    Finally, with regard to Pillar 3, the new disclosures are 
really not adequate to help external investors understand the 
exposures of individual banks to either structured debt or 
SPEs. But, more fundamentally, I think Basel II is actually 
making it more difficult to compare capital adequacy across 
banks, both within countries and especially across countries. 
Part of this is because Basel II comes with lots of 
implementation options. The Europeans have well over 100 
different options, which have to be understood to understand 
what the capital number actually means. Moreover, differences 
in risk models mean that the very same asset held in two 
different banks may well have a different capital charge 
associated with it, which also makes it very hard to compare 
across banks.
    And, finally, although there have been attempts to achieve 
convergence between U.S. GAAP and IFRS or International 
Financial Accounting Standards, there are still huge 
differences. We got a glimpse of it recently when Deutsche Bank 
was obliged to go back to IFRS, having made the transition to 
U.S. GAAP previously. In January 2006, its treating position 
was 448 billion euros under U.S. GAAP, yet the same position 
counted as 1 trillion ten euros under IFRS. And that, too, 
creates problems in comparing across banks.
    What are the lessons that have been learned by risk 
managers and regulators? Well, lessons are an important 
stimulus for learning, and there has certainly been a 
considerable amount of learning by losing over this time. One 
of the problems has been simply one of having the right 
information and acting on it. It is terrifically difficult for 
a very large, complicated institution to be able to actually 
understand its exposures across a wide range. The studies we 
have seen that compare the banks that have done reasonably well 
in the current crisis with those that have not, usually begin 
with a much better management information system. And beyond 
that is what you do with it, and a number of firms simply had 
the information on hand, but did not really act very quickly.
    It is a matter of debate how soon you should have seen this 
coming, but I think, arguably, the losses that were reported by 
HSBC in February of 2007 were a time when any bank should have 
known that there was serious trouble coming down the pike. And 
yet we saw several institutions continuing to increase their 
participation in the market.
    Several firms experienced great difficulty in assessing 
liquidity risk. It appears that often the treasury function was 
not really fully integrated in the risk management system, and 
so there was little contingency planning for off-balance-sheet 
commitments or reputational commitments, such as funding 
sponsored money market mutual funds to enable them to avoid 
``breaking the buck.'' In some cases, this also involved 
sponsored hedge funds as well.
    Firms also experienced problems within the traditional risk 
silos, as they are called in the business, which are usually 
market risk, credit risk, and operational risk. The crisis 
exposed some of the limitations of value-at-risk or VaR-like 
analysis, particularly in dealing with illiquid instruments 
that are exposed to credit risk.
    They also showed a lack of attention to basis risk in 
hedging. There were correlations that simply did not work in 
the new crisis, and firms were very slow to realize that the 
changes were happening.
    Stress test scenarios also failed to prepare some 
institutions for the conditions that actually occurred. The 
crisis also exposed weaknesses in credit risk analysis. First 
and foremost was the failure to comprehend the deterioration in 
underwriting standards that occurred. But in addition, many 
firms had trouble tracking their multiplicity of exposures to 
various borrowers and counterparties, and in a very big, 
complicated bank, it is a very big challenge.
    With regard to operational risk, we have already commented 
on the weakness of many management information systems that 
were simply too slow to provide timely information about 
exposures across counterparties and products. But, also, I 
think there were problems in the lack of rigor for pricing 
systems. You could sometimes see the same asset priced 
differently if it were held in the firm's own portfolio or if 
it were being priced as collateral for a counterparty.
    The crisis also exposed problems across the traditional 
risk management silos in firms that simply failed to realign 
their management to deal with the convergence of risk types in 
new products such as subprime-related debt. And there was a 
failure to anticipate the correlation to cross these risk 
types.
    I really think I will not comment on what the regulators 
may have learned because you have just heard from them, and I 
think they are still in the process of letting us know what 
they have concluded. What I would like to conclude with, 
however, is a weapon that I think is essential but is missing 
from the regulatory toolkit.
    In March, with the hastily improvised bailout of Bear 
Stearns, it seems to me the Fed crossed a regulatory Rubicon 
without the right weapons. They were very concerned that Bear 
was going to apply for bankruptcy, and we know that under a 
bankruptcy filing, the central feature is to impose stays. 
Stays can be incredibly disruptive in a firm that trades 
actively in markets and has primarily financial assets. The 
problem is, although they certainly have their merit in helping 
the courts understand who owes what to whom and how to get the 
best price, the problem in imposing stays in this kind of firm 
is that it can generate very substantial systemic spillovers. 
Clients and counterparties may lose access to their funds, and 
that causes problems for their own clients and counterparties 
in addition. And the lack of clarity regarding hedge positions 
also may transmit problems to other counterparties.
    If Bear had been a bank, the Fed, working with the FDIC, 
actually would have had a highly appropriate tool for dealing 
with the problem. Bridge banks, which Congress developed during 
the late 1980s and have subsequently been adopted by the 
Japanese and the Koreans--and I am told the British are even 
interested--would have enabled the regulators--and it is not 
clear exactly which regulator in this case because it did not 
contemplate investment banks. But it would have allowed it to 
take over the institution temporarily, continue the 
systemically important features, and impose discipline on some 
counterparties that should have been monitoring more carefully.
    Now that the Fed has actually crossed this regulatory 
Rubicon, it really needs to be better prepared for the next 
failure, even though we hope it does not come. Better 
resolution policies I think deserve a really urgent position on 
the policy agenda for both the United States and globally as 
well.
    Thank you.
    Senator Reed. Thank you very much, Professor Herring.
    Mr. Blakely, please.

 STATEMENT OF KEVIN M. BLAKELY, PRESIDENT AND CHIEF EXECUTIVE 
            OFFICER, THE RISK MANAGEMENT ASSOCIATION

    Mr. Blakely. Chairman Reed, thank you for the opportunity 
to offer commentary today on the subject of risk management and 
systemic risk. I have been asked to address three specific 
issues: the state of current models and systems for measuring 
risk management at large financial institutions; adequacy of 
risk management by risk officers and executive boards, 
including the sharing of information and communication among 
senior management; and what regulators have likely learned 
about risk management and what they can do to improve their 
response to future problems.
    Let me start by saying that the financial services industry 
is experiencing a great deal of difficulty today. It has been 
battered by a severe liquidity shortage and plunging valuations 
of market-based assets. Those problems are now giving way to 
the next stage of distress, and that is, deteriorating asset 
quality, which may result in a new round of credit-related 
losses.
    Many have faulted financial models for playing a major role 
in the collapse of the capital markets, but I think that this 
charge is overstated. It is the human factor that played a 
greater role in the models' dysfunction. Humans built the 
models, fed them their historical data, provided the 
assumptions that drive them, and interpreted their outcome. 
Before we villainize models as the guilty party in the market's 
demise, we humans need to first take a look in the mirror and 
acknowledge our own significant role.
    As an industry, we now have a greater appreciation of 
models' limitations and have discovered the need to supplement 
them with forward-looking analyses. The discipline of risk 
management is an evolving one. While many improvements have 
been made, many more are yet to come. Greater board-level 
attention on matters of risk will help. In that regard, 
financial institutions would be well advised to consider adding 
members to their boards who are conversant in risk management. 
Boards need to make certain that management focuses not just on 
revenue production, but also on the understanding of and 
pricing for risk that the company takes. Key elements that will 
facilitate such an outcome include defining a risk appetite for 
the company and implementing an appropriate risk-based 
incentive compensation scheme. CEOs must play an active role in 
advocating the importance of risk and risk management. By 
witnessing the CEOs' interest in risk, subordinates would be 
compelled to follow suit. Such engagement fosters a healthy 
exchange of risk information, ideas, and strategies throughout 
the company. The CEO must also ensure that risk management is 
the responsibility of everyone in the company. Allowing 
abdication of that responsibility to the chief risk officer is 
a recipe for failure.
    Regulators have already provided many valuable insights 
into the causes of the market turmoil and are taking steps to 
respond to it. They are also beginning to focus on the threats 
to the financial system specifically and to the economy more 
generally. By performing scenario analyses on financial sectors 
such as the credit derivatives market, as they are now doing, 
they are trying to anticipate problems before they have a 
chance to manifest themselves. Regulators have done a noble job 
of tempering a bad situation, despite having jurisdiction over 
only a fraction of the financial services industry. Changes to 
the scope of regulatory oversight of the industry, some of 
which have been offered by the current Treasury proposal, may 
assist in that regard. An increased level of dialog between 
regulators and boards of directors on risk governance will help 
elevate its importance and understanding. Further, with the 
insights gained from their oversight role, regulators are in a 
great position to share sound risk management practices 
throughout the industry. Although much work needs to be done to 
remediate deficiencies revealed by the market crisis, all 
concerned parties must be cautious in their approach. 
Overreaction can make a tenuous situation only that much worse.
    That concludes my opening remarks, and I would be pleased 
to answer any questions you might have. Once again, thank you, 
Mr. Chairman, for the opportunity to offer comment.
    Chairman Reed. Thank you, Mr. Blakely. Thank you all, 
gentlemen, for excellent and thoughtful testimony.
    I know Professor Herring declined to comment on how well 
the regulators are doing, but my impression is that they are 
taking it extremely seriously, that they are looking at all the 
places that we would want them to look, but I think it is 
significant--and perhaps you might comment, all of you, 
please--that, you know, they did not suggest that there were 
any limitations in access to data or, as you would say, 
Professor, the right information. And I just wonder, not in 
sort of a ``gotcha'' sense, but in a sense of what you think 
specifically they should be doing--they very well might be 
doing it, but what they should be doing to sort of deal with 
what we have learned from this crisis to date. Let's start with 
Mr. Bookstaber and go right down the panel.
    Mr. Bookstaber. I was sort of surprised, looking at their 
testimony versus my recollection being on the other side. I did 
not quite see the level of interaction that was described 
there, and that may just be because of the time that has passed 
since I was in these positions on the sell-side firms.
    The key thing that I think is missing in regulation in the 
United States is a true partnership with the risk management 
people inside the firm. I always felt that the FSA model was a 
very good model. And it contrasts quite a bit from what I would 
think of as, say, the SEC model. You know, the SEC model is one 
where you have a legalistic view. You tend to work through 
subpoenas and so on, and basically it has a formalistic rule-
based approach.
    The alternative is to have somebody on the regulatory side 
who has risk management expertise actually work more closely 
with the risk manager within the firm. He can also serve almost 
as an ombudsman, so that if the risk manager observes a risk 
which he thinks is of concern and maybe he is not getting the 
ear of senior management or they disagree with him, here is an 
outside, objective party who can look at it and can escalate it 
in a way that he cannot. So that may be a way of getting around 
some of the problems that we observe with incentives or with 
senior management that either does not care about or does not 
understand risk within an organization.
    The other difference is that if you are rules based in how 
you do risk management and you work on the basis of rules and 
regulations, you get into a gaming situation, because you set a 
barrier and the game then is for the financial institutions to 
find ways to get around that barrier, whether it is going off 
balance sheet or creating some innovative swap. And so the 
result is not only that you defeat the regulation, but that you 
increase the complexity of the market in the process so that 
the regulation actually is counterproductive.
    So that, again, suggests a move more toward the notion of 
what I think of as the FSA approach to risk management.
    Chairman Reed. Thank you.
    Professor Herring, as you pointed out, FSA with respect to 
Northern Rock seemed to--I guess the moral of the story, there 
is no perfect form of regulation.
    Mr. Herring. Yes, I think that model does not look quite as 
sparkling as it did perhaps a year ago, although I am in 
general agreement with the point that Mr. Bookstaber is making. 
The kinds of improvements that appear to be headed in the 
future are really more in the line of sort of refining and 
adding to what is already an enormously prescriptive system. We 
have moved from a very loose system in some sense to something 
that is enormously detailed and hideously complex. And the 
kinds of improvements we see indicated in some of these 
documents, although the details are really not available to us 
on the outside, strike me as heading us in the direction of 
still more complexity and still a more prescriptive setting.
    I agree that fundamentally it is a losing game. The 
regulators are never going to be quick enough or astute enough 
or have enough resources to catch up with the very innovative 
capital markets and the bankers that are really innovative.
    What should be done? Well, it seems to me that the 
regulators have to enlist the assistance of market discipline, 
that the market discipline is the only real prospect for 
keeping up with the incredible kinds of innovations going on in 
these institutions.
    Now, you have to ask where that market discipline should 
come from, and it probably would not be the shareholders, 
because the shareholders have a very different payoff function 
than society or creditors or the regulators. They will want to 
try to maximize the present value of their investment, but they 
have no incentive to take account of spillover effects.
    On the other hand, creditors and counterparties do. 
Creditors and counterparties have a lot at stake if they 
actually believe that they are going to have to live with their 
choices. But my concern about the trend of bailouts over the 
last year is that creditors and counterparties are being pretty 
much assured that if it is a very large, very complicated 
institution, they are not going to have to worry. And I think 
that makes the system fundamentally more dangerous. I think we 
need to work toward a system where absolutely no institution is 
too big, too complicated, too interconnected to fail. And I 
think, in fact, we should have live, active plans to actually 
unwind any one institution, and that means having 
communications with press officers and knowing exactly who goes 
in where, because in that event you have some real prospect of 
market discipline. And if you use the bridge bank kind of 
format, you can do it without having massive disruption and 
spillovers in other markets.
    Chairman Reed. Thank you.
    Mr. Blakely, the same general issue. You know, what do you 
think the regulators learned? What should they be learning? 
What should they be doing? And, obviously, give them credit for 
working hard at this issue.
    Mr. Blakely. Absolutely, they are, and I think they deserve 
a lot of credit for what they have done so far. And, in fact, 
as we talked throughout the industry, the industry itself is 
very grateful for what the regulators have done.
    But as I think about what more could they be doing, I think 
that one of the things that I would really encourage them to do 
is focus on the risk governance process in institutions, 
because I am not sure that that is an area that enough 
financial institutions are paying sufficient attention to. And 
the ways that they can do that is the regulators can make a 
pretty good assessment of is there a sufficient risk expertise 
at the board level; and, second, is the CEO adequately involved 
in the process of risk management; and, third, do both the 
board as well as the CEO understand what they're incenting 
their employees to do.
    And I think by having frank discussions between the 
regulators themselves and the board of directors directly, we 
cannot underestimate the power of those kinds of conversations. 
Speaking from personal experience, I know that it is quite 
influential.
    Chairman Reed. Thank you. For the information of the 
panelists, we have a vote scheduled shortly, so I--this could 
go for many, many hours given the expertise that we have 
assembled. But let me ask a final question--that is, pending 
written questions that you should be prepared to accept.
    We have talked about and focused and the last few comments 
have been on enterprise risk, understanding the CEO of all the 
different subsidiaries, et cetera, and that is an issue you 
just addressed. But then there is the larger question for the 
regulators, the systemic risk, and I am just wondering--you 
might comment again, Mr. Blakely, and we will go down the line 
about what we have to do if we get enterprise risk right, I 
think you have commented, to ensure that we get systemic risk. 
Is it about data? Is it about formalized communication between 
regulators? Is it, as Professor Herring suggests, kind of 
making sure that the moral hazard issue has been removed and it 
is the market itself that regulates?
    Mr. Blakely. Well, clearly, I believe that the involvement 
of the Fed in the broader financial markets is a good thing. 
They have a history of dealing with the financial services 
industry in a way that some other regulatory agencies do not. 
They bring a breadth of experience and, frankly, tools to the 
table that other regulatory agencies may not. I think that they 
need to have a greater and deeper understanding of what goes on 
inside of individual institutions so that they can make an 
adequate assessment as to what type of a risk that poses to the 
industry at large. I also believe, too, that the regulators 
should work collectively together to try and identify systemic 
risks such as they are doing right now with regard to the 
credit markets--I mean the credit derivatives market, where 
they are bringing together folks from the industry as well as 
other regulatory agencies to try and understand in advance 
before a disaster happens just what might happen and what are 
the alternative courses of action.
    Chairman Reed. Thank you.
    Professor Herring.
    Mr. Herring. I would certainly agree with Kevin's point. In 
addition, I think one might try to rethink how stress tests are 
devised. Typically, regulators are very reluctant to specify 
particular stress tests because they feel the institution will 
know what is most appropriate for its own conditions. But I 
think there is room for both. I think the regulators, in order 
to tell systemic effects, really ought to have at the same 
point in time returns from all institutions regarding 
particular stress scenarios so that they can anticipate what 
the market-wide consequences might be.
    I think there is another source of systemic risk that has 
sort of crept into the system without anybody paying much 
attention to it, and that is the sheer institutional complexity 
of our larger institutions. One of our institutions, for 
example, has 2,400 majority-owned subsidiaries, and they are in 
more than 90 different countries. It presents an incredible 
obstacle, I think, to the managers of that institution, but 
surely to the outside world to understand what in the world is 
going on. And I think that there is great merit and greater 
simplicity in institutional structure as well as in looking at 
stress tests that will cover all institutions.
    Chairman Reed. Thank you.
    Mr. Bookstaber, please. Can you turn your microphone on, 
please?
    Mr. Bookstaber. I could comment a little bit on those two 
points, the stress test and the complexity. In my book, I 
focused on two components I thought were responsible for a lot 
of what we observe in market crises. One was leverage and the 
other was complexity. And the focus was on the complexity of 
innovative securities and derivatives, but also I had one 
chapter called ``Colossus,'' which used Citigroup as a case 
study. And it is interesting, I wrote that chapter in 2004, but 
the story was the same then as it is now, that when you get an 
organization that is as big as some of the organizations we 
observe, it is hard to get your arms around all of the risks 
and everything that is going on. And the solution is not simply 
to have a risk management structure that is bigger and bigger 
and bigger, because all that tends to do is diffuse the 
information flow. So I think what we need is a flight to 
simplicity, both from the structure of the types of instruments 
that we use and from the nature of the organizations.
    In terms of stress testing, this gets back to a point that 
I made in my oral remarks and in my written testimony that the 
problem is we do not have the data to stress what we need to 
stress. It is one thing to pose a scenario and stress based on 
that scenario; and if you do that, usually the scenario that 
you will choose is something that is based on history or based 
on the normal financial and economic relationships. But when a 
crisis finally occurs, what is driving it is a firm that is 
very leveraged, they are forced to sell, and then they have to 
sell in some other market where they are also big.
    So every time a large institution changes its positions, 
the nature of the risks that potentially can occur will also 
change. So ultimately, to really understand where a crisis 
might emerge and how it will propagate out, you finally need to 
know who is highly leveraged, what do they own, who else is 
leveraged, and what are the relationships between them. And 
those are where the stress tests have to be taking place, and 
the essential data still does not exist for the regulators to 
do this sort of stress test.
    Chairman Reed. And is that something--just a quick follow-
up question. That is something that you think would be 
appropriate for regulators to begin to collect on a systematic 
basis? Is it possible to do that, or is it----
    Mr. Bookstaber. I think it is appropriate. I think you have 
to do it in a way that is very careful to realize the 
proprietary nature of the data, because we are talking about 
leverage and position data where, if other institutions knew 
about it, they could trade against the people and they actually 
would be adverse to liquidity in the market. This is sort of a 
technical point, but with the use of markup languages and so 
on, these types of data, though vast and varied, can be 
standardized in a way that they are relatively easy to collect 
compared to the way they used to be historically. So I do not 
think there is really a technological issue, and the key point, 
as I mentioned earlier, is you have to do it for all risk-
taking organizations.
    Chairman Reed. Well, gentlemen, thank you very much for 
your excellent testimony. My colleagues may have written 
questions which they would submit through the Chair, and I will 
set a June 26th deadline. We would forward them to you, and we 
would ask you to respond within a week or two. But thank you 
very much for excellent testimony, and I have to run off for a 
vote. But we appreciate very much your participation.
    The hearing is adjourned.
    [Whereupon, at 4:18 p.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]




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