    [House Hearing, 111 Congress]
    [From the U.S. Government Publishing Office]

                       EXPERTS' PERSPECTIVES ON SYSTEMIC
                           RISK AND RESOLUTION ISSUES

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

                                    HEARING

                                   BEFORE THE

                        COMMITTEE ON FINANCIAL SERVICES

                         U.S. HOUSE OF REPRESENTATIVES

                         ONE HUNDRED ELEVENTH CONGRESS

                                 FIRST SESSION

                                   __________

                               SEPTEMBER 24, 2009

                                   __________

           Printed for the use of the Committee on Financial Services

                               Serial No. 111-78

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                     HOUSE COMMITTEE ON FINANCIAL SERVICES

                     BARNEY FRANK, Massachusetts, Chairman

    PAUL E. KANJORSKI, Pennsylvania      SPENCER BACHUS, Alabama
    MAXINE WATERS, California            MICHAEL N. CASTLE, Delaware
    CAROLYN B. MALONEY, New York         PETER T. KING, New York
    LUIS V. GUTIERREZ, Illinois          EDWARD R. ROYCE, California
    NYDIA M. VELAZQUEZ, New York         FRANK D. LUCAS, Oklahoma
    MELVIN L. WATT, North Carolina       RON PAUL, Texas
    GARY L. ACKERMAN, New York           DONALD A. MANZULLO, Illinois
    BRAD SHERMAN, California             WALTER B. JONES, Jr., North
    GREGORY W. MEEKS, New York               Carolina
    DENNIS MOORE, Kansas                 JUDY BIGGERT, Illinois
    MICHAEL E. CAPUANO, Massachusetts    GARY G. MILLER, California
    RUBEN HINOJOSA, Texas                SHELLEY MOORE CAPITO, West
    WM. LACY CLAY, Missouri                  Virginia
    CAROLYN McCARTHY, New York           JEB HENSARLING, Texas
    JOE BACA, California                 SCOTT GARRETT, New Jersey
    STEPHEN F. LYNCH, Massachusetts      J. GRESHAM BARRETT, South Carolina
    BRAD MILLER, North Carolina          JIM GERLACH, Pennsylvania
    DAVID SCOTT, Georgia                 RANDY NEUGEBAUER, Texas
    AL GREEN, Texas                      TOM PRICE, Georgia
    EMANUEL CLEAVER, Missouri            PATRICK T. McHENRY, North Carolina
    MELISSA L. BEAN, Illinois            JOHN CAMPBELL, California
    GWEN MOORE, Wisconsin                ADAM PUTNAM, Florida
    PAUL W. HODES, New Hampshire         MICHELE BACHMANN, Minnesota
    KEITH ELLISON, Minnesota             KENNY MARCHANT, Texas
    RON KLEIN, Florida                   THADDEUS G. McCOTTER, Michigan
    CHARLES A. WILSON, Ohio              KEVIN McCARTHY, California
    ED PERLMUTTER, Colorado              BILL POSEY, Florida
    JOE DONNELLY, Indiana                LYNN JENKINS, Kansas
    BILL FOSTER, Illinois                CHRISTOPHER LEE, New York
    ANDRE CARSON, Indiana                ERIK PAULSEN, Minnesota
    JACKIE SPEIER, California            LEONARD LANCE, New Jersey
    TRAVIS CHILDERS, Mississippi
    WALT MINNICK, Idaho
    JOHN ADLER, New Jersey
    MARY JO KILROY, Ohio
    STEVE DRIEHAUS, Ohio
    SUZANNE KOSMAS, Florida
    ALAN GRAYSON, Florida
    JIM HIMES, Connecticut
    GARY PETERS, Michigan
    DAN MAFFEI, New York

            Jeanne M. Roslanowick, Staff Director and Chief Counsel

                                C O N T E N T S

                                  ----------
                                                                       Page
    Hearing held on:
        September 24, 2009...........................................     1
    Appendix:
        September 24, 2009...........................................    55

                                   WITNESSES
                          Thursday, September 24, 2009

    Cochrane, John H., AQR Capital Management Professor of Finance,
      The University of Chicago Booth School of Business.............    41
    Levitt, Hon. Arthur, Jr., former Chairman of the United States
      Securities and Exchange Commission; Senior Advisor, The Carlyle
      Group..........................................................    35
    Miron, Jeffrey A., Senior Lecturer and Director of Undergraduate
      Studies, Department of Economics, Harvard University...........    37
    Volcker, Hon. Paul A., former Chairman of the Board of Governors
      of the Federal Reserve System..................................     6
    Zandi, Mark, Chief Economist and Co-Founder, Moody's Economy.com.    39

                                    APPENDIX

    Prepared statements:
        Bachmann, Hon. Michele.......................................    56
        Cochrane, John H.............................................    57
        Levitt, Hon. Arthur, Jr......................................    62
        Miron, Jeffrey A.............................................    66
        Volcker, Hon. Paul A.........................................    93
        Zandi, Mark..................................................   112

                  Additional Material Submitted for the Record

    Written statement of The Aspen Institute.........................   118

                       EXPERTS' PERSPECTIVES ON SYSTEMIC
                           RISK AND RESOLUTION ISSUES

                                  ----------

                          Thursday, September 24, 2009

                 U.S. House of Representatives,
                       Committee on Financial Services,
                                                       Washington, D.C.
        The committee met, pursuant to notice, at 9:05 a.m., in
    room 2128, Rayburn House Office Building, Hon. Barney Frank
    [chairman of the committee] presiding.
        Members present: Representatives Frank, Kanjorski, Watt,
    Sherman, Meeks, Moore of Kansas, McCarthy of New York, Baca,
    Lynch, Miller of North Carolina, Scott, Green, Cleaver, Bean,
    Klein, Wilson, Perlmutter, Foster, Carson, Minnick, Adler,
    Driehaus, Kosmas, Himes, Maffei; Bachus, Castle, Royce, Lucas,
    Manzullo, Jones, Biggert, Capito, Hensarling, Neugebauer,
    Price, Posey, Jenkins, Lee, Paulsen, and Lance.
        The Chairman. This hearing of the Committee on Financial
    Services will come to order.
        We will be having this hearing today and one tomorrow--
    well, actually, this is the last of the general hearings that
    we will be having on this subject. Tomorrow, we will begin
    legislative hearings because we will have a hearing tomorrow on
    the legislation submitted by our colleague, Mr. Paul of Texas,
    which is a piece of legislation dealing with auditing of the
    Federal Reserve.
        And we are concluding today, and one topic that has been a
    very significant concern is that there is universal dislike of
    the doctrine of ``too-big-to-fail'' and even more, the practice
    of ``too-big-to-fail.'' Unfortunately, there does not appear to
    be a single, simple solution to it. Passing a statute that says
    nobody is ``too-big-to-fail'' doesn't resolve the problem.
        One of our major goals in drafting legislation has been to
    come up with a series of measures that will avoid our facing
    that situation of ``too-big-to-fail.'' We will try to keep
    institutions from being so overleveraged that they are likely
    to fail. We will try to prevent imprudent decisions, for
    instance, that come from 100 percent securitization that come
    from derivatives that are overly leveraged without sufficient
    collateral. We will give some collection of Federal agencies
    the authority to step in when it appears that institutions or
    patterns of activity are being systemically threatening and
    order containment of these activities; and we will have, what I
    guess I am destined to have to continue to refer to as the
    ``resolution authority'' which, in English, is the
    ``dissolution authority,'' the ability of regulators to step in
    and put an institution to death without the kind of tremors
    that occurred or will occur today.
        Now there does appear to be broad agreement, I think, in
    the committee on all sides about those goals. How we do them we
    will differ about. But it was clear yesterday that no one
    thinks that the current choice of straight bankruptcy or
    nothing is workable for the institutions. We have to come up
    with a method of resolving. We have done that, and we shouldn't
    deny ourselves the regular sum successes. Where insured
    depository institutions are involved, we have a system that
    works pretty well.
        Wachovia is a pretty big institution. It failed. This
    didn't cause systemic disruption. It wasn't good for the people
    who were there.
        Other insured depository institutions have failed, and we
    have been able to deal with that. We need to extend that.
        On the other hand, non-depository institutions, Bear
    Stearns, Merrill Lynch, AIG, and Lehman Brothers all failed,
    and all were dealt with--each of these was dealt with in a
    different way and none were satisfactory to anybody, as nearly
    as I can see. A forced takeover of Merrill Lynch by Bank of
    America, the negative consequences of that are still
    reverberating.
        Paying nobody in the case of Lehman Brothers, none of the
    creditors, and causing, according to the Administration
    officials at the time, a terrible shock to the system; paying
    everybody in AIG, which no one, except the people who got paid,
    thinks was a good idea now.
        And Bear Stearns, which was the smallest of them and
    actually was probably handled in the least disruptive way but
    still because it was that hot caused some problems.
        So one of the things we expect people to address today, I
    hope they will address today, is what combination of measures
    we can take to get rid of the doctrine of ``too-big-to-fail.''
        There was one proposal that came from some within the
    Administration that we would have a list of the institutions
    that would be considered ``too-big-to-fail,'' a list of the
    systemically important institutions so that we could deal with
    them, but the general view was that would be considered to be
    the list of those ``too-big-to-fail,'' and what the
    Administration thought would be a scarlet letter, would instead
    be a license to have people invest with you because they would
    think they were protected.
        So as I said, it is a high priority for this committee to
    deal with that and to have as nearly as it is humanly possible,
    a banishment from people's minds.
        I will say this. I am resigned to the fact that cultural
    lag is one of the great constraints on what we do. And I accept
    the fact that until we reach the point where a large
    institution is put to death without there being ``pay
    everybody'' or other inappropriate compensations, people won't
    believe us. We can arm the regulators to do this, we can arm
    people to do it, and I accept the fact that not until it is
    done will people believe it.
        But I will say this: When people are skeptical, listen to
    the members of this committee and our colleagues. We will give
    the regulators the power to step in and make it clear that no
    one is ``too-big-to-fail,'' that failure will eventuate, that
    it will be painful for those involved. There will be no moral
    hazard, no temptation to get that big. Any regulator who failed
    to use that power in the foreseeable future will, I think, feel
    a uniform wrath from this place. So I would hope that people
    would be a little less skeptical.
        We are not going away. The country's anger about this isn't
    going away. So we aren't just setting up the tools; we are
    arming ourselves in a way that I think will be very effective.
        The gentleman from Alabama is now recognized for 5 minutes.
        Mr. Bachus. I thank the chairman, and I agree with him that
    the problem of ``too-big-to-fail'' is one of the most pressing
    and contentious issues of the regulatory reform and debate. And
    how that is resolved I think will go a long way to moving
    regulatory reform ahead.
        Chairman Volcker, we know you as a gentleman and also
    someone whose opinion we respect very much. So we welcome you
    to this committee hearing. And I know you share some of the
    same concerns that the chairman shares and that I share and
    that most of our colleagues share.
        The chairman yesterday in the hearing with Treasury
    Secretary Geithner identified the ``too-big-to-fail'' problem
    as the one that most aggravates people in this country. And I
    agree with you, Chairman Frank, it not only aggravates them, it
    outrages them on many occasions.
        The American taxpayers are tired of paying for Wall
    Street's mistakes, our guaranteeing their obligations. They see
    something manifestly and something wrong with a casino
    environment in which high rollers pocket the profits, often
    measured in millions, if not billions, of dollars while the
    taxpayers pay off the losses.
        The American people are justifiably outraged by a ``heads I
    win, tails you lose'' approach. When we designate 10 or 20 of
    our largest financial institutions as ``too-big-to-fail,'' we
    endorse a financial marketplace in which a handful of enormous
    financial institutions are supported by the promise of
    government-engineered, taxpayer-funded bailouts.
        We also pull people in, assuming they will be saved and
    assuming there is a guarantee.
        The time has come for every member of this body to reject
    once and for all the concept of taxpayer bailouts of these so-
    called ``too-big-to-fail'' institutions. Equally important is
    the fact that in concept and in practice, ``too-big-to-fail''
    necessarily creates a much larger universe of companies and
    businesses which are deemed unworthy and too small to save. To
    establish, as law, such a disparate, inequitable, and
    discriminatory treatment not only should offend our sense of
    fair play and justice, its elitist operation should be rejected
    out of hand as contrary to our democratic principles.
        The Administration wants to codify a permanent bailout
    authority with its proposal to create a resolution authority.
    It really is a permanent TARP administered by government
    bureaucrats with even less accountability than was present in
    the current incarnation of TARP. The beneficiaries of the
    Administration's plan are not the American people or the vast
    majority of small- and medium-sized companies and businesses
    that choose not to engage in the kind of risky financial
    activity that led to the financial market collapse. The more
    responsible individuals of the institutions and inevitably the
    taxpayers will pay for the bailouts but they will not benefit.
        Indeed, just yesterday, in testimony before this committee,
    Treasury Secretary Geithner declined repeated invitations to
    rule out future taxpayer-funded rescues of systemically
    significant firms. In response to my question about taking
    assistance to these firms off the table, Secretary Geithner
    compared such an action as abolishing the fire station, which I
    took to mean he would not agree to stop bailouts. And when
    asked repeatedly by Congressman Brad Sherman, if the Secretary
    would accept even a trillion dollar limit on bailout authority,
    Secretary Geithner said, ``I would not.''
        In conclusion, by contrast, Republicans have offered a
    workable alternative to the bailout status quo. In addition to
    curtailing the Fed's authority to bail out individual firms,
    Republicans support enhanced bankruptcy for failed nonbank
    financial institutions similar to the authorities that the FDIC
    has for banks. By sending a clear, credible signal to the
    marketplace that failed nonbank financial firms will face
    bankruptcy and need to plan accordingly, and the people who do
    business with them, the Republican plan restores market
    discipline, mitigates moral hazard, and protects taxpayers.
        Mr. Chairman, no institution should be ``too-big-to-fail.''
    Institutions can and should fail if their bad decisions render
    them insolvent and they cannot compete in the marketplace. To
    pretend otherwise is to weaken the foundation of our economic
    system.
        The better question is, will we have the courage to do the
    right thing, and reject the Administration's effort to move us
    to a system of gigantic but weak banks kept on--well, that is
    it. And these are real questions.
        I thank the chairman, and I also thank the former Chairman
    of the Fed for being with us today.
        The Chairman. The gentleman from Georgia is recognized for
    3 minutes.
        Mr. Scott. Thank you, Mr. Chairman, and welcome, Mr.
    Volcker.
        We are at a juncture in our dealing with this in terms of
    putting the regulatory reforms to--I think at the same time do
    a little check on our record going forward of how well what we
    have done and is it doing the job?
        The American people are registering some great concerns.
    Poll after poll has indicated that there is a--while Wall
    Street and those at the top appear to be saying that this
    economy is changing, we are bottoming out. That is not so on
    Main Street because we have another set of parameters that are
    working there.
        And I would like to get your opinions on--I have a great
    deal of respect for you and your history and your knowledge.
    But I think as we look at this issue, we need to be concerned
    about any variations of what we would refer to as a double dip
    recession.
        There are people who are still expressing concerns over the
    economy and problems that will loom greater. I am particularly
    concerned, Mr. Volcker, about unemployment. The issue in our
    focus really needs to be on jobs now because if we don't get to
    the bottom of that we gradually begin to lose the faith of the
    American people. The issue needs to be on jobs, the issue needs
    to be on our banks. For some reason, with all of the money we
    have given them, with the bailouts we have given them, with
    many of them going back to their ways of directing bonuses and
    huge salaries, there is a hypocritical nature that is setting
    in because at the same time, these banks are not lending. So if
    you are not lending, especially to small businesses, they are
    going out of business. They are the ones that created the jobs.
        So I think as we go forward with our regulatory reforms we
    have to look at it with a very jaundiced eye and see as we put
    these regulatory reforms in place, what more can we do to prime
    the pump to get money flowing out into the communities.
        The other area of great concern to me--and certainly to my
    folks down in Georgia--is a record number of bank closures. And
    as we look at these regulatory reforms, one size does not fit
    all. What is the future of those small community banks that
    basically do the lending, that are the foundations in many of
    our smaller communities? Those are the banks that are being
    closed left and right. We lead the Nation in Georgia in those
    bank closures, and a part of the reason is they can't get the
    capitalization.
        So I think as we go forward I would be very interested to
    hear some of your concerns on giving us a scorecard, giving us
    a report card. We have been at this now for basically a year.
    This thing happened a year ago. We have been moving at it, and
    I think it is about time to get a little report, and I would be
    interested to hear your comments on that.
        The Chairman. The gentleman from Delaware is recognized for
    1\1/2\ minutes.
        Mr. Castle. Thank you, Mr. Chairman. I actually do not have
    an opening statement. I don't know if the ranking member wanted
    to add to his time.
        The Chairman. I was given a list by the minority. I wasn't
    trying to draft you.
        Mr. Castle. I will yield back my time, maybe in the hopes
    of actually hearing a witness.
        The Chairman. The other two listed aren't here. I have 2
    minutes from Mr. Green, and we can proceed. The gentleman from
    Texas is recognized for 2 minutes.
        Mr. Green. Thank you, Mr. Volcker, for being here.
        Mr. Volcker, sir, you are a sage, and we welcome your
    attendance. I eagerly anticipate what you have to tell us. You
    have shepherded this country in some very difficult times, and
    I think you should be commended for your history of being there
    when your country needed you.
        I want to concur with the ranking member when he talks of
    ``too-big-to-fail'' because quite candidly, I agree. ``Too-big-
    to-fail'' is the right size to regulate, but it is also the
    right size to prevent from becoming ``too-big-to-fail,'' and it
    is the right size to put in a position such that we can wind it
    down without costing the taxpayers any dollars.
        The idea is not to bail out ``too-big-to-fail,'' it is to
    put those that may be ``too-big-to-fail'' in such a position
    that we can wind them down and not allow another AIG to
    prevail. That is what it is really all about.
        We also want to do this. We don't want to put ourselves in
    a position where we are designating by way of a list. We want
    to regulate such that we don't have to designate. As a company,
    AIG starts to become so large that it may fail, we want to
    start the regulatory process such that it won't get there, and
    if indeed it does by some accident, then we want to have a way
    to do what we do with banks in this country, and that is wind
    them down and not cost the taxpayers any dollars.
        Finally, this: There is, I believe, a desire on this side
    to work with persons on the other side to accomplish this
    mission. I am willing to work with the ranking member and
    anyone else who would like to put us in a position such that we
    don't ever have to deal with another ``too-big-to-fail,'' such
    that we will always have that safety net to protect the
    American economy.
        Nobody was bailing out AIG. We bailed out the American
    economy, and in fact we were bailing out the economy on a
    global basis as well.
        I thank you for your sage advice and look forward to
    hearing from you.
        I thank you, Mr. Chairman
        The Chairman. Mr. Volcker, we thank you for joining us. Mr.
    Volcker has a very long list of titles which, under the 5-
    minute rule, I could not finish reading even at my speed. But
    we are very pleased that he came up today, especially to share
    his experiences with us.
        Please, Mr. Volcker.

    STATEMENT OF THE HONORABLE PAUL A. VOLCKER, FORMER CHAIRMAN OF
          THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

        Mr. Volcker. Thank you, Mr. Chairman, and members of the
    committee.
        It has been a long time since I have been in the room. It
    is a familiar room, and I appreciate the opportunity because
    you are dealing with particularly important problems.
        Let me just say in a preliminary way, as you know, the
    President has said--as Mr. Geithner has said, if the market
    betters, the economy steadying, there has been some feeling of
    relaxation about some of these issues and some feeling of maybe
    just return to business as usual, return to making money,
    outside amounts of money, certain resistance to change. And
    from the comments that you have made, I am sure you will not
    respond to that by slowing down, but rather proceeding with all
    deliberate speed to get this right. It is really important.
        It is an incredibly complicated problem, and I want to
    concentrate on mainly the aspect that you have already
    emphasized. But before I do so, let me acknowledge that an
    awful lot of work is going on in various aspects by the
    regulatory agencies. They have taken important initiatives
    dealing with capital and liquidity, and they are working toward
    compensation practices.
        And I would point out it is relevant with the G-20 meeting
    that a lot of what needs to be done really does require a
    certain consistency internationally because these markets are
    global and that just adds another complication. You can't have
    capital requirements, for instance, for American banks that are
    way out of line of capital requirements elsewhere, to take an
    easy example. But that is an additional complication.
        But the central issue that I want to talk about really is
    what you have already said, moral hazard in financial markets.
    You know what that is all about. I don't have to explain it.
    But I would note that this is front and center because the
    active use of long-dormant emergency powers of the Federal
    Reserve together with extraordinary action by the Treasury and
    Congress to support non-bank institutions has extended this
    issue well beyond the world of commercial banking. ``Too-big-
    to-fail'' has been an issue in commercial banking; now it is an
    issue for finance generally.
        I think it raises very important substantive questions. It
    raises some administrative questions that I want to touch upon,
    too. It raise legal questions. And one of those questions is
    the role of the Federal Reserve, which I will return to.
        In dealing with that, I submitted a long statement which
    deals with all of this in more detail. Just to cut to the
    chase, you know, the Administration has set out a possible
    approach, which I feel somewhat resistant to or more than
    somewhat resistant because I think it does suffer from
    conceptual and practical difficulties.
        Now what they suggested is setting out a group of
    particular institutions that, in their judgment, would pose a
    systemic risk in the event of failure.
        I don't know what criteria would be used precisely in
    determining these institutions because the market changes, it
    is not always directly relevant to size. That in itself would
    be a great challenge. But I think it is fair to say that the
    great majority of systemically important institutions are
    today, and likely to be in the future, the mega-commercial
    banks. We are talking about in the center of things, the
    commercial banking problem. That is true here, that is true
    abroad, and in this case we already have an established safety
    net. The commercial banks that are at the heart of the problem
    are already subject to deposit insurance, central bank credit
    facilities, and other means of support.
        I have a little hobby of asking friends and acquaintances
    when they talk to me with experience in financial markets, I
    say, Now, outside of commercial banks, outside of insurance
    companies, which I would say parenthetically I hope better
    regulatory systems will be developed, maybe not as part of this
    legislation but next year. Apart from commercial banks and
    insurance companies, how many genuinely systemically important
    institutions do you think there are in the whole world,
    financial markets. I will tell you the answer I get
    consistently is somewhere between 5 and 25. The universe is not
    huge when you are talking about non-banking, non-insurance
    company, systemically important institutions.
        Now, if you extend this idea of developing a group of
    systemically important institutions for your own banks, then
    the moral hazards problem has obviously increased because the
    connotation is if they are systemically important, officially
    identified, they fall in the same category as banks, and the
    government better be especially alert to dealing with them in
    case of difficulty.
        Now, it does seem to me a better approach would be to
    confine the safety net to where it is, that is to commercial
    banking organizations. And as part of that organization now and
    even more so in the future, the banking supervisors would, I
    think, as a natural part of their responsibility, be especially
    attentive to the risks posed by the largest banking
    organizations.
        So they ought to have the discipline to insist upon best
    practice among those organizations, not just in the United
    States but generally worldwide by agreement. We have to agree
    to more adequate capital, responsible cooperation with other
    supervisory concerns, and leave it as ambiguous as you can as
    to whether government assistance would ever be provided in
    these emergency situations.
        Now that approach recognizes, I think, the reality that the
    commercial banks are the indispensable backbone of the
    financial system. Mr. Scott talked a bit about the importance
    of community banks, regional banks and credit. That is part of
    it. They also act as depository, they take care of the payment
    system, they offer investment advice, they maintain
    international financial flows. These are all essential services
    that justify a special sense of protection.
        Now, when you get to what are called capital market
    activity, a lot of trading, hedge funds, private equity funds,
    a lot of other activity, credit default swaps,CDOs, CDO
    squared, all that stuff, it is a different business. It is an
    impersonal position. It is a trading business, and it is
    useful. We need strong capital markets, but they are not the
    same as customer-related commercial banking functions and they
    do have substantial risks. Banking itself is risky enough. You
    add capital market operations to that, you are just compounding
    the risk. And I would note it is--they present conflicts of
    interest for customer relationships.
        When a bank is rendering advice and maybe investment advice
    to a company, it is rendering underwriting services and then it
    is turning around and creating in those same activities, does
    it bias the customer advice? Does it undercut the customer
    relationship? Is it consistent with the customer relationship?
    Those problems are enormously difficult, and I think
    demonstrably have been a big distraction for bank management
    and led to weaknesses in risk management practices.
        So I would say the logic of this situation is to prohibit
    the banking organizations, and by ``banking organizations,'' I
    am talking about the bank and its holding company and all of
    the related operations. I would prohibit them from sponsoring
    or capitalizing hedge funds, private equity funds, and I would
    have particularly strict supervision enforced by capital and
    collateral requirements toward proprietary trading in
    securities and derivatives.
        Now, how do you approach all of this and deal with the big
    nonbank that might get in trouble?
        That I think is where this resolution authority comes into
    play. Can we have a system, knowledge as to what we have with
    banks, a government authority can take over a failed or failing
    institution, manage that institution, try to find a merger
    partner if that is reasonable, force the end of the equity if
    there is no equity really left in the company, ask debt
    holders, negotiate with debt holders to exchange dept for
    equity to make the company solvent again, if that is possible.
    If none of that is possible, arrange an orderly liquidation.
    And none of that necessarily involves the injection of
    government money and taxpayer money but it provides an
    organized procedure for letting down what I hope is a very rare
    occurrence of the failure of a systemically important nonbank
    institution.
        Now who has all of this authority and how are the general
    regulatory and supervisory arrangements rejiggered, if at all,
    and I do think they do need some rejiggering. I would mention
    one aspect of that. The Treasury itself has correctly
    identified the need for what I call an overseer. Somebody, some
    organization that is responsible not just for individual
    institutions but responsible for surveying the whole financial
    system, identifying points of weakness, which may or may not
    lie in an individual institution. It may lie in new trading
    developments. But take two obvious examples.
        Who was alert to the rise of the subprime mortgage a few
    years ago? It may not have appeared to have presented a risk at
    the time for an individual institution, but it sure in its
    speed of increase and its weakness presented a risk to the
    whole system. Somebody should have been alerted to that. Who
    has been looking at credit default swaps and wondering whether
    they reach the point of creating a threat to the system? And
    the answer is basically nobody and not very well. And somebody
    should have that responsibility.
        The Treasury has been very eloquent on that point. They
    have suggested a kind of council or regulatory agency headed by
    the Treasury. I frankly don't think that is a very effective
    way to do it because getting a bunch of agencies together and
    getting to agreement on anything, and they all have their
    particular responsibilities, their particular constituencies
    are a very tough business. So if you do it that way you have to
    be a Treasury. You have to build up a new staff in the
    Treasury.
        The alternative is the Federal Reserve. I spent a lot of
    time in the Treasury so I am not particularly prejudiced of the
    Federal Reserve, I would argue, but I think this is a natural
    function for the Federal Reserve. I think consciously or
    unconsciously we have looked to the Federal Reserve. Whether
    the responsibility has been discharged effectively or not,
    there is a sense that the Federal Reserve is the agency, the
    major agency to be concerned with the whole financial market,
    and there is no doubt when you get in trouble, when anybody in
    the financial markets gets in real trouble they run to the
    Federal Reserve.
        The Federal Reserve has the authority, the money. It
    presumably has the experience and capabilities, and I think
    that simple fact ought to be recognized. It is a very important
    institution. It seems to be logical that they ought to be kind
    of assigned explicitly what I always thought they had
    implicitly, a kind of surveillance of a whole system.
        [The prepared statement of Mr. Volcker can be found on page
    93 of the appendix.]
        The Chairman. Obviously, this has been very helpful on a
    broad range.
        I want to talk about one issue that you care a lot about
    and in which your experience really gives you a great deal of
    authority. It hasn't gotten much attention, and that is the
    concern you have about the problems raised by proprietary
    trading within the banks, the bank holding companies. You have
    some fairly strong views about restricting that. You mentioned
    it, but I would ask you to elaborate on that because I think
    that is, as I look at it, is one of the important topics. It
    hasn't gotten discussed much. I know it was raised by some
    others, there is Mr. Levitt, Ms. Donaldson who had that in
    their--I think in their investors' list of concerns.
        So is it feasible to just ban it, or how would you deal
    with the question of proprietary trading by the institutions?
        Mr. Volcker. When I comment that I think banks should be
    restricted in their, what I think of as truly capital market
    impersonal activity, it is pretty easy to talk about hedge
    funds and equity funds because they are identifiable
    institutions. Proprietary trading is not an identifiable
    institution in the same way, although many financial
    institutions will have a proprietary trading desk. That is the
    way they label it themselves.
        The Chairman. That is the way they have labeled it, before
    you get through. That is the way it has traditionally been
    labeled by some, but by the time you are through testifying,
    they will probably have a new name for it.
        Mr. Volcker. However it is labeled, I think conceptually
    there is a difference and can't be denied that a company, a
    bank, or whatever it is, is trading actively in the market, the
    securities that bear no customer relationship, no continuing
    interest. They are interested in making a profit on a
    particular trade or making a speculative profit. And that
    activity, in some institutions anyway, has become increasingly
    important and it is inherently risky, it inherently presents a
    conflict of interest. It inherently is hard to manage. Some
    people are good at it, some people are not so good at it. It
    takes a lot of concentration.
        How do you deal with it because there is some perfectly
    legitimate trading that goes on in a bank or financial
    institution, and it is an outgrowth of their customer interest.
    If they are underwriting securities and lending securities for
    a particular customer, they may want to trade in those
    securities that they have underwritten, to take a simple
    example. And if they are going to do some trading, they have to
    maintain a certain liquidity, a certain staff that is able do
    that. How do you distinguish between a kind of routine, low-
    level trading activity and proprietary trading as an active
    part of the money making business of the firm?
        It is partly a matter of judgment and partly a matter of
    volume, but I think what you have to rely upon is supervisory
    discretion. You tell the supervisor that part of the concern of
    banking regulation should be cutting down on this kind of
    speculative activity, trading activity. And the supervisor
    certainly has the authority to arrange capital requirements
    that could be increasingly severe as the trading activity
    increased, and they could take other supervisory steps to
    assure that trading activity is in reasonable alignment with
    the customer orientation of the banks.
        The Chairman. Thank you. So in essence, this is something
    that could be handled by underlining the supervisory authority,
    not by some kind of statutory bar but in the statute make it
    very explicit the grants of authority.
        Mr. Volcker. I don't think you can write a bright line law
    to say what is proprietary and what isn't.
        The Chairman. Just to be clear, because in the legislation
    we have been contemplating, that is already clearly identified
    as one of the tools that could be used in an institution which
    is being treated as a systemic risk. But your point is that it
    ought to be a generic authority and that it is not a matter of
    the systemic risk but is a conflict in other ways.
        On the question of the death panels, which is otherwise
    called the resolving authority--``death panel'' has such a
    wonderful ring to it. Just because it is entirely inaccurate in
    one area, it doesn't mean it should pass from the debate. I
    think we ought to--we will save the phrase and use it where it
    makes some sense, and that is the resolving authority.
        On the question about whether or not they should--I am out
    of time. So let me pose the question and you can elaborate on
    it.
        There is obviously a big debate about whether or not public
    funds ought ever to be available in resolving the mess left
    behind by one of these institutions. If you could answer it
    briefly now and elaborate in writing, I would appreciate that.
        Mr. Volcker. In terms of the resolution authority, which
    would give extraordinary authority to whatever agency is
    designated to control the institution, I do not think it is
    desirable to provide in that same arrangement authority to lend
    money or to provide money because that will encourage the
    ``too-big-to-fail'' kind of syndrome.
        So if you give it strong enough authority to control the
    institution and to manage such things as forcing, negotiating
    or forcing, whatever word you want use, let us say a conversion
    of debt into equity, hopefully you would avoid the need for
    injecting money and the stockholder would lose, the creditor
    might lose, and the creditor should be concerned about whether
    he is going to lose.
        Now, I would also say--I guess I didn't mention in this
    preliminary statement--that if the overseer, for instance,
    identified an institution or several institutions as being so
    large and so extended as to present a real risk, there would be
    some residual authority to place capital requirements on that
    institution, leverage requirements, maybe liquidity
    requirements. But that doesn't involve government money.
        The Chairman. I appreciate it.
        The gentleman from Alabama.
        Mr. Bachus. I thank the chairman.
        Chairman Volcker, Secretary Geithner declined to rule out
    any more government bailouts of troubled institutions. And I
    think what we usually assume by that, we are not talking about
    the FDIC's traditional power to resolve depository
    institutions. He declined to do so.
        Do you think that is a mistake?
        Mr. Volcker. I would answer that question this way: I think
    you have the emergency power of the Federal Reserve, section
    133. I am not proposing that be abolished. I have mixed
    feelings about that because I squirm when it is used, frankly.
    We spent a lot of time trying to avoid its use because we knew
    if it ever got used it would become a precedent for the future,
    and if we used it for New York, people will say we should use
    it for Chicago or the State of California. And we didn't use it
    for Chrysler 20 years ago, whenever it was. Well, demands arose
    because we didn't want to set the precedent of using it.
        Well, our precedent has been set now in very strange
    circumstances, very radical circumstances. So understandably,
    it has been set.
        But I think we want to develop attitudes and policies that
    say this is extremely extraordinary. It is part of the
    apparatus of the bank safety net, although it could be extended
    beyond that. I don't think I would promote that, but I wouldn't
    take it away.
        Mr. Bachus. We have sort of scrambled the egg. We have the
    commercial banks and the investment banks. Last September, some
    of the investment banks came under the safety net--
        Mr. Volcker. Right.
        Mr. Bachus. --I think you have indicated, and I think many
    of us realize there is a difference in what was a commercial
    bank, a lending facility, and an investment or trading bank. In
    fact, if you look at the two investment banks, the two largest
    ones, their last report showed substantial profits from
    trading, which indicates a trade that they are still
    basically--their profits are being derived from trading
    derivatives and some of the things that you described.
        Do we go back to that system?
        Mr. Volcker. Well, we can have investment banks again. I
    guess there is only one big investment--well, two, one very
    active in trading, the other less active in trading. But I
    don't want those investment banks brought under the general
    safety net. There ought to be a distinction. And if they want
    to go out and do a lot of trading and that is a legitimate
    function, if they want to do whatever they want to do in the
    financial world, okay, but don't bring them under the safety
    net.
        Mr. Bachus. And if they fail, they go into an enhanced--
        Mr. Volcker. If they fail, you use the resolution that is
    already as necessary.
        Mr. Bachus. Let me ask you another question, and I really
    have two.
        One is I just want to acknowledge something and see--we did
    have--some of our failures were a result of the derivative
    trading and instruments that didn't exist 20 years ago. And you
    have talked about that.
        You had another problem and that is depository institutions
    that went out and bought subprime affiliates that were not
    regulated at all. And I think that was a tremendous threat to
    the system.
        Mr. Volcker. Absolutely.
        Mr. Bachus. Would you comment on that? You could go down
    the list of banks.
        Mr. Volcker. The subprime phenomena is interesting because,
    you know, I am not in the middle of the markets these days, and
    I wasn't conscious of the speed in which they were increasing.
    They were a phenomena of practically a standing start to a
    trillion, trillion and a half dollar business in the space of 3
    or 4 years that arose very rapidly, and apparently there was no
    clear sense in the regulatory community of the potential threat
    that this posed; and it probably, because they were obscured by
    the same thing that obscured bank managements and others, that
    we had some fancy financial engineering here that somehow
    presto magic, the risks go away if we put it in a big package
    and get a good credit rating, which is what they were getting.
        But I think that was a failure in risk management, a
    failure of the credit rating agencies, but it also was a
    failure of the regulators that weren't on top of this. And this
    arose not in the traditional banks. They may have participated,
    and they did participate in the end, but it arose in kind of
    fringe operations, but nobody sat there and said look, this is
    a potential threat if it increases at this rate of speed to the
    financial system. Nobody that I know of. Somebody should have
    been raising that question.
        And in my view, you know, as the Federal Reserve was
    already given clearance to do it, they are in the best position
    to do it.
        Mr. Bachus. There were loans that banks couldn't make. They
    wouldn't make it under their own underwriting standards. They
    wouldn't originate them in the banks so they went out and
    bought an unregulated subprime lender to make loans that they
    would never make.
        The Chairman. The Federal Reserve was given that authority
    in 1994 because that is exactly the authority that Mr. Bernanke
    invoked in 2007 when he did finally promulgate rules, but that
    was unchanged from the authority that existed from 1994.
        The gentleman from North Carolina.
        Mr. Watt. Thank you, Mr. Chairman.
        Chairman Volcker, thank you for being here. I have been on
    this committee now for 17 years and there seem to be two
    acknowledged gurus in the financial services industry. Alan
    Greenspan was one. When he spoke, I never understood a darn
    thing that he ever said but he seemed very eloquent in his
    positions. And you are the second one, and I have heard you
    speak 3 times now.
        I understand, I think, what you are saying, but it seems to
    me that your testimony this morning and the other times that I
    have heard you address the systemic risk issue leads us back
    exactly to where we are right now.
        If we didn't do anything on systemic risk, we already have
    regulation of--we have all of the banks who are currently under
    regulations, and I am just trying to understand how--what you
    are proposing with respect to systemic risk differs from what
    we have now. That is the one question.
        And I am going to put both of them out there and then I
    will shut up and listen to you talk.
        The second question is, you have done a lot of work. I have
    read your report on the international monetary situation, and
    you led a group or participated in an international group that
    looked at this from an international perspective. And I didn't
    hear you address any of that this morning. I know we are here
    to deal with our domestic situation, but how do you see this
    being intertwined in the systemic issue being addressed on a
    worldwide basis unless we address it somehow more aggressively
    than you have proposed on the domestic side?
        Mr. Volcker. Two relevant questions.
        On the first question, I am not recommending anything
    particularly different so far as banks are concerned that
    already have lender of last resort, they already have deposit
    insurance, and we have some history of intervening with Federal
    Reserve money or government money in the case of failure of
    very large banking institutions. So that I take is a given. And
    that is common around the world. There isn't a developed
    country that doesn't have a similar system to protect banks
    because banks are, I think, the backbone of the system.
        Now it is also true in the United States the relevant
    importance of banks has declined in terms of giving credit
    because more of the credit creation has been going into
    securities, which is the province of the capital market.
        What is different is the situation has changed where some
    of the benefits anyway, the safety net, has been extended
    outside the banking system. That is what I want to change.
        But you can't change it just by saying it is not going to
    happen because you are going to have problems. You have to
    develop some other possibilities and arrangements to minimize
    the chances of a crisis. So that is what we are proposing.
        Mr. Watt. So basically what you are proposing is taking
    some of the people who are now covered under the FDIC, have
    some kind of implicit backing and separating them out and
    making it clear that they don't have any kind of implicit
    backing. They are just going to be allowed to fail.
        But I don't understand how that squares with your position
    that you retain, that the Fed retain emergency authority. Why
    wouldn't they still then in emergency situations continue, now
    that the precedent has been set, to use that emergency
    authority rather than whatever implicit authority?
        Mr. Volcker. That is a legitimate question. Do you want to
    take the emergency authority away from the Federal Reserve and
    give it to nobody? I am not quite that radical at this point,
    given what we have been through. But it is a reasonable
    question. You are quite right, what I am trying to do is
    diminish the sense that it is there and available for nonbanks.
        Now on the international side, if what you say is true, I
    deal a little bit with it in my long statement I have issued to
    the committee. And there are some issues where international
    cooperation will be clearly necessary and, in fact, it has a
    pretty good history so far and that is in the area of capital
    requirements.
        There already is a high degree of uniformity in capital
    requirements. They are going to have to be reviewed, they are
    being reviewed nationally, they are being reviewed here and
    they are being reviewed in the U.K., but there is a body at the
    BIS, separate from the BIS, but a joint body of regulatory
    authorities to consider that issue. And they also have now
    extended their authority, encouraged by heads of state, to
    consider other matters of banking supervision and regulation
    where international consistency is important. And there are
    quite a few of those areas, and they have done quite a lot in
    trying to regularize practice. It is a big challenge, but it is
    important.
        On some of these other things, it is equally important. I
    think you already have a framework where practically all big
    banks or big countries with relevant banking systems already
    have a safety net. That is different in detail but it is a
    common factor.
        Now we have to deal with how all of these countries deal
    with their nonbanks. And I think some consistency there is
    important.
        The other really big financial center, as you well know, is
    London. And these matters are under intense consideration by
    the regulatory authorities in London. And at the end of the
    day, I think it is important that there be some consistency
    between what we do here and what they do in the U.K., just as a
    start. And I think that is quite possible. It won't be perfect,
    but that is the way we started actually with capital
    requirements. We got an agreement between the U.K. and the
    United States, and then it got extended around the world. So
    maybe we can duplicate that.
        The Chairman. Now I am going to try again. The gentleman
    from Delaware.
        Mr. Castle. Thank you, Mr. Chairman.
        Mr. Volcker, like probably everybody else on this
    committee, I have a tremendous amount of respect for your
    comments on the economy and this particular problem of banking
    in general. I want to thank you for being here. I have some
    questions concerning the Federal Reserve itself.
        Let me throw a couple of things out and you can respond to
    them.
        As we all know, the Federal Reserve has great
    responsibilities in the economy today--you know that better
    than any of us--all the way from monetary policy to interest
    rates, the emergency powers that you have discussed here today,
    and consumer protection.
        The consumer protection may, in accord with whatever we do
    here in Congress, change and go over to be handled otherwise.
    But other than that, the remaining powers would be there.
        You have suggested strongly that it is the best agency. You
    have suggested in your writing--I am not sure if you spoke it
    or not--appointing someone else who would have this
    responsibility confirmed by the Senate, etc., with respect to
    the systemic risk, etc., and I understand that.
        But my question is, is the Federal Reserve taking on too
    much responsibility with respect to the monetary circumstances
    of this country and its policy, one, and then the second
    question is should there be or have you recommended someplace--
    I haven't seen it--some sort of a council that would meet with
    whomever the appointment of the Federal Reserve person would be
    to help guide this? And I am thinking about the other banking
    regulators who seem to have a great deal of knowledge and
    input. Would they serve on some sort of group that would advise
    or would all that be informal, or would they be formally
    members?
        I would be interested in your comments about the Federal
    Reserve's ability to manage this kind of emergency at this
    point.
        Mr. Volcker. Well, obviously, a very relevant question, is
    the Federal Reserve proposing or are other people proposing as
    things exist? Does the Federal Reserve take on too much? I
    don't think so. These are big responsibilities. But as I see
    it, there is a close relationship between banking and financial
    supervision and monetary policy.
        I don't think monetary policy should be a matter of domain
    of a few economists sitting in a room deciding on the basis of
    various theories which are probably controversial, and what
    interest rates should be precisely where, and so forth. That is
    part of it. But I think that process ought to be leavened by
    knowledge and close contact with what is going on in financial
    markets.
        Now, we have an example of that recently. The Federal
    Reserve was counting on monetary policy, but that got thrown
    off course and the economy got thrown off course completely by
    what was happening in the financial system outside the realm of
    monetary policy. Now, I think the regulators should have been
    on top of that a little better, although they are never going
    to be perfect. But we want to--I think we need a cross kind of
    fertilization between monetary policy and supervisory policy,
    myself.
        It is an old concern--go back and you read the history of
    the Federal Reserve. Marriner Eccles in the 1930's, who was
    then the Chairman, complained bitterly about the fact that the
    Federal Reserve didn't have enough control over supervisory
    policy because in the middle of the Depression, he thought
    those other banking supervisors were being way too tough on
    banks and inhibiting bank lending. And he thought they were too
    easy earlier, when the economy was doing well.
        Now, is the Federal Reserve going to do a better job? I
    don't know. I don't think they should be the only regulator.
    But I do think they are the logical ones to have this oversight
    responsibility.
        And I also think, as you mentioned, if the Federal Reserve
    is going to remain in the regulatory supervisory business, I
    think the Congress should reinforce their responsibility by
    doing such things as having a particular Vice Chairman of the
    Board who is responsible for supervisory policy, and he knows
    that is his statutory function. There is nobody in that
    position now. The staff is going to have to be strengthened and
    enlarged and various other measures made.
        Now, should there be a council? I have no problem with a
    council, and I think it would be useful, so long as there is
    somebody who is driving the process and is, in the end,
    responsible.
        And the Treasury, as I read it, they don't quite say it
    this way, but I think what it amounts to, at the end of the
    day, the way the Treasury would do it is have the Treasury in
    that position. And I guess the way I would do it is I would
    have the Federal Reserve in that position, because I think it
    is a part of a natural central banking function.
        It is interesting, this is in controversy all over the
    world, frankly, but in the U.K., which has gotten a lot of
    attention, supervisory authority was taken away from the Bank
    of England 10 years ago, more or less. And then when the crisis
    arose, they were kind of at sixes and sevens as to who was
    responsible and how the crisis arose; how did the regulatory
    agency--how was that too insensitive and why didn't the Bank of
    England know what was going on? And they had trouble
    coordinating the effort. And the Treasury got involved, too, as
    it naturally would, but at one point that was considered best
    practice: Take the regulation out of the Federal Reserve.
        I don't think that is a strong opinion internationally
    anymore, after seeing the primary exponent, the U.K.--I can't
    say it fell on its face, but it didn't do very well when push
    came to shove, because the locus of responsibility was not
    clear.
        The Chairman. Mr. Volcker, thank you. There is a lot of
    interest, so we are going to have to move on.
        The gentleman from New York, Mr. Meeks.
        Mr. Meeks. Thank you, Mr. Chairman. Good to see you Mr.
    Volcker. We have been debating something within my office. I am
    going to make a quick statement and then just ask you if, in
    fact, you can give me your opinion on it; that we when we
    consider the issue of ``too-big-to-fail'' and moral hazard, we
    are basically trying to get firms and their investors to
    internalize the cost of negative externalities that they may
    present to the system as a whole. In other words, we want the
    capital costs and the capital structure and the appetite for
    the risk to reflect all the costs of the institution, both
    internally and externally.
        And I think Larry Summers, when he was speaking before this
    committee earlier, said that if a firm is too big to resolve in
    an orderly manner, it is undoubtedly too big to run in a
    professional manner. In other words, if the senior management
    of a financial institution cannot present a plan that will
    convince the public and its regulators that it can disentangle
    and wind down its operations in an orderly manner, there is no
    reason to believe that this same management team can run the
    institution on a daily basis, because they themselves don't
    fully understand their own company.
        And for this reason, I believe that a properly structured,
    comprehensive resolution authority is, in fact, the most
    critical pillar to managing the moral hazard of the ``too-big-
    to-fail'' and systemic risk going forward. And the reason for
    that is different than what has been commonly discussed. It
    seems to me that the strength of the resolution authority is
    that it makes debt capital markets work in concert with
    regulators, and debt presents multiples of equity on financial
    institutions' balance sheet and debt holders have the power of
    covenants to manage what they perceive as risk or threats to
    their privileges as debt holders.
        With effective, credible resolution authority, bondholders
    will know that they can no longer rely on the government as an
    informal insurance policy on their debt. It is this expectation
    in the past that has allowed firms to become ``too-big-to-
    fail'' as debt markets and every incentive to provide nearly
    unlimited financing to the largest institutions, knowing that
    the larger it got, the more likely it was that the investment
    would be backed by the government in case of institution
    failure.
        So I think that is the crucial area we are looking at, and
    I would like just to get an idea of what you think in that
    regard, because I think that is absolutely key as we move
    forward with reform, with regulation reform in this particular
    instance. I would love to get your opinion on that.
        Mr. Volcker. I agree with the thrust of what you are
    saying. That is the burden of my testimony here this morning is
    that we do need such a resolution authority, for the reasons
    you described. Some of the approaches that the Administration
    has surrounded that with, I don't agree with. But the basic
    idea that you need that kind of authority is, I think, central.
        Mr. Meeks. Do you believe that, as a consequence of capital
    more accurately reflecting the full risk of investing in an
    institution, that it will increase with that the institution
    size and the level of global risk?
        Mr. Volcker. Well, I hope we can get a realization of that;
    that the institution will be more careful and less risk-prone
    and less--and the financial system and the economy will be less
    subject to their failure.
        Mr. Meeks. Thank you. I yield back.
        The Chairman. The gentleman from New York, Mr. Lee, I
    believe, would be next.
        Mr. Lee. Thank you, Mr. Volcker. It is a pleasure to have
    been listening to you this morning. I appreciate many of your
    thoughts. You touched on a lot of areas and I, like you in many
    cases, feel that you have to be very careful in how much
    farther we go along with expanding the Federal regulation. I
    think we need to have the right type of regulation in place
    with the right type of authority to those--in this case, the
    Federal Reserve. In many cases, I agreed with what you said.
        You touched briefly on the issue when you have banking
    institutions getting in more riskier-type trades. And in your
    mind, how do you--is there a way to decouple that and ensure we
    provide solvency to this industry?
        Mr. Volcker. Couple that with--
        Mr. Lee. With the banking institutions right now. How do we
    decouple where they are getting into riskier trading type
    activities--do you have a solution on how we would be able to
    separate these in a logical manner?
        Mr. Volcker. Well, I think some of the activities that I am
    concerned about are clearly enough defined so you can just, in
    effect, either put it in law or have clear that the supervisory
    authority will prohibit it.
        The tricky area is I think trading, which we discussed a
    little bit earlier, because there is a kind of legitimate area
    of trading that a large bank anyway is going to engage in that
    is, in fact, considerably in the area of customer service. If a
    customer comes in and wants to sell some securities, they ought
    to be able to sell through a bank. And if a bank is going to
    handle that, it is going to have to have some kind of a trading
    operation, a foreign exchange operation.
        But I think there is a--the borderline is fuzzy, but there
    is a clear distinction between customer-related trading
    activity and pure proprietary trading, which some of the big
    institutions label it that way. They have a proprietary trading
    desk, separately operated, sitting someplace else, as in the
    case of--
        The Chairman. Mr. Volcker, could you speak into the
    microphone? You have to sacrifice politeness for audibility. So
    we need you to speak directly into the microphone. It is less
    important to be polite than to be audible, so don't look at who
    you are talking to.
        Mr. Volcker. AIG is a good example of what I am worried
    about. It is not a bank, but it should be regulated, I think,
    naturally. But they had this trading operation, a little
    trading operation that made a lot of money for a while, and it
    got out of hand, mostly credit default swaps. Nobody was much
    looking at it. No regulator was looking at it.
        It is an activity that if, better informed now, if a
    supervisor was looking at it and AIG was supervised--and they
    should be supervised--somebody should have raised a question.
    That is an activity that had nothing to do with your insurance
    business directly, or out there on a trading operation to make
    a lot of money, and similarly to profit-making but not to the
    insurance business. Stop it. I mean, that was a clear enough
    case that you--
        Mr. Lee. I am just bringing up AIG. With the knowledge that
    you have now, in retrospect, going back a year ago, how would
    you have handled this situation with AIG?
        Mr. Volcker. It is a complicated situation. They had to
    make a very quick decision about an area that nobody could
    understand the full implications of. The regulators I am sure
    were not on top of this operation in London or Connecticut, or
    wherever it was being operated. And everybody got in over their
    heads, and they did what was necessary in a very disturbed
    situation to provide money. And it has become now, as you know,
    $150 billion, $180 billion, whatever it is; it is, you know,
    outrageous. But I understand how they got there. That is what
    we want to avoid.
        And I might say, while it is not on the agenda today, and
    the Treasury didn't put it on the agenda, I would hope this
    committee would look at the question of national charters for
    insurance companies and bring them under--at least the big
    ones--under a framework so that something like AIG with similar
    problems can't arise in the future. I think a lot of the big
    insurance companies would welcome a national charter and the
    consistency that would provide, because--I don't want to commit
    them into the safety net, but I do think that they ought to be
    regulated in a consistent way.
        Mr. Lee. Thank you.
        The Chairman. Thank you, Mr. Volcker.
        Let me just say, for your information, the question of an
    optional Federal charter for the insurance, particularly life
    insurance, is on the committee's agenda for probably next year.
    It just would be more weight than I think this issue could
    carry.
        There will be a proposal made by some for a national
    insurance office to do some monitoring. But the question of an
    optional charter is a very important one. It is a request we
    get from the international community. There is a lot of
    resistance to it at the State Insurance Commission level here.
    But I did want to assure you--
        Mr. Volcker. I know there is something short of a charter.
    I hope you would go further than what has been proposed.
        The Chairman. Well, right now--that, right now, is much
    short of a charter. For next year, on this committee's agenda
    next year, will be the question of a charter, of an optional
    charter.
        The gentlewoman from Illinois, for instance, has been very
    much interested in that, along with the gentleman from
    California, Mr. Royce. And I have assured them they will get a
    full hearing.
        But it just, with the agenda this year, complicated by
    needing to deal with the issues from last year--but it is on
    the agenda.
        Mr. Volcker. I am unaware of any other AIGs out there, so
    maybe you are all right at the moment.
        The Chairman. Well, of course, AIG's regulator was the
    fearsome Office of Thrift Supervision, and we will be
    addressing that issue.
        The gentleman from Kansas.
        Mr. Moore of Kansas. Thank you, Mr. Chairman. And, Chairman
    Frank, I ask unanimous consent that the resolution authority
    proposal by Tom Hoenig, president of the Federal Reserve Bank
    of Kansas City, and his colleagues, as well as two of his
    recent speeches, be entered into the record.
        The Chairman. Without objection, it is so ordered.
        And, without objection, there will be general leave for any
    of the members or the witnesses to introduce into the record
    any material they would wish to insert.
        Mr. Moore of Kansas. Thank you, Mr. Chairman.
        Chairman Volcker, how do we end ``too-big-to-fail?'' I
    don't know if you have seen the recent proposal offered by
    Kansas City Fed President Hoenig and his colleagues. Their
    proposal on resolution authority lays out more explicit rules
    than the Administration's proposal of how a large financial
    institution Like Lehman Brothers or AIG could be resolved so
    the debt holders, shareholders, and management would be held
    accountable before taxpayers are asked to step in. If you
    haven't seen the Kansas City Fed proposal, I would like to
    provide to you a copy and I would appreciate your written
    comments, if you would please. Others suggest that we require
    the largest financial firms to undergo a regular stress test
    that would have aggregate information publicly released, even
    in good times. I know some have argued the list of these firms
    should remain confidential. But doesn't the market already know
    who these firms are, based on the last round of stress tests?
    How do you propose we create the right incentives for firms to
    maintain reasonable leverage ratios and strongly discourage
    ``too-big-to-fail?''
        Mr. Volcker. Well, I might say I become aware yesterday
    that a Kansas City bank had made such a proposal, but I haven't
    read it so I can't comment on it in detail.
        Mr. Moore of Kansas. I will forward this to you, sir.
        Mr. Volcker. I am sure these are all directed toward the
    same problem that we have been discussing; in fact, all these
    questions this morning. How do you reduce the moral hazard
    problem? How do you--
        Mr. Moore of Kansas. Sir, excuse me. Could you pull the
    microphone just a little closer? I am having a little
    difficulty hearing you.
        Mr. Volcker. I said, we have discussed in a number of these
    questions, and my opening statement, how we deal with this
    moral hazard problem. And in all these cases, I think, I
    believe in the Kansas City proposal, this idea of a resolution
    authority looms very large.
        Just how you do that, you are going to find not the easiest
    drafting problem in the world, because it raises a lot of
    technical issues and legal issues, even constitutional issues,
    which have to be carefully thought through. But I do think it
    is possible.
        There is clear precedent or clear analogous arrangements
    for the banking world. And so what needs to be done is
    extending that to the nonbanking world, without the implicit
    promise--and of course this is key--without the implicit
    assumption that Federal money will be provided in the case of
    the failing institution.
        Mr. Moore of Kansas. Chairman Volcker, as we consider
    monitoring for systemic risks, it seems to me that it would be
    helpful to ensure our inspectors general, the various financial
    agencies be also asked to help identify weaknesses in the
    regulatory structure and propose solutions.
        Would you support formally connecting these IGs to create a
    financial watchdog council, where they would meet on a
    quarterly basis and be required to provide Congress an annual
    high-risk assessment report on the greatest risks and gaps in
    our financial regulatory system that need to be addressed?
    Would you support a proposal like that, sir?
        Mr. Volcker. I think I would have to look at that before I
    have any comment. When I respond on the Kansas City thing, I
    will respond on that point.
        Mr. Moore of Kansas. Thank you, sir, very, very much. I
    yield back, Mr. Chairman.
        The Chairman. The gentlewoman from West Virginia, Mrs.
    Capito.
        Mrs. Capito. Thank you, Mr. Chairman. I think I am out of
    sync here. Sorry.
        The Chairman. Yes. Well, I take--
        Mrs. Capito. Well, I am in sync.
        The Chairman. Well, on this issue I take instructions from
    the Minority, so Mr. Lance is next.
        Mrs. Capito. Thank you, sir.
        Mr. Lance. Thank you very much, Mr. Chairman. Good morning
    to you, Mr. Volcker.
        Regarding the whole issue of ``too-big-to-fail''--and this
    is obviously of great concern to all of us--and regarding the
    issue of moral hazard, yesterday the Secretary of the Treasury
    indicated that in identifying tier one candidates, there would
    not be a list but the market would know who they were, based
    upon the criteria.
        Is there any real way to resolve this situation? It seems
    to me that Wall Street will know who they are and that there
    will inevitably be moral risk, more hazard, as a result of the
    identification of tier one entities.
        Mr. Volcker. I don't think--Put it positive. I think it is
    extremely difficult to designate in advance who is systemically
    important and who isn't, because you may even find some fairly
    small institutions, not mega-institutions anyway, that are
    playing a particular role in the market at a particular time
    and have had a lot of interconnections with other institutions
    that create a big problem. They create a clog in the resolution
    of credit default swaps or something. Arranging all this in
    advance, I don't know whether the Treasury would intend to
    announce it or not announce it or set out criteria or what.
        Mr. Lance. Not as I understand it, sir. There would not be
    an announcement as to which entities actually are on the list,
    and the list would not be public; but that based upon the
    criteria, that Wall Street could figure out who they are.
        Mr. Volcker. Yes, well, I would think that is true. Wall
    Street would figure it out, so you would have to probably
    announce it in the end. And then you have the problem, is a
    particular institution in, or is a particular institution out?
    And I think we will find in calm circumstances, the
    institutions that are in would hate it, because they would have
    particularly tough capital requirements and feel uncompetitive.
    But as soon as a problem arose, the institutions who were out
    would complain that we are vulnerable and they are not.
        Mr. Lance. Yes. I perceive a situation where, at one stage
    in the economic cycle, people would lobby not to be in it, and
    then later they would lobby to be in it.
        Mr. Volcker. I think it is not the happiest thing in the
    world, but I think you properly have to leave some ambiguity in
    this situation.
        Mr. Lance. Thank you, sir. This is a continuing issue on
    this committee, on both sides of the aisle, and it is not
    easily resolved. And I appreciate your thoughts on that.
        I yield back the balance of my time. Thank you.
        The Chairman. The gentlewoman from New York.
        Mrs. McCarthy of New York. Thank you, Mr. Chairman. And it
    is good to see you again.
        I guess my line of questioning is, being that we are
    seeing, you know, the banks starting to come back and starting
    to loan--not as much as what they should--we are seeing the
    market coming back up a little bit. We see on TV that the banks
    and the financial institutions are spending millions of dollars
    with very nice fluffy ads to get customers to come back.
        And I guess the question is: With all that we are going to
    be trying to do, how long is it going to be before they start
    taking more risk again?
        And that is one of the concerns I have. You know, it used
    to be that all these corporations, they ran their business
    because of trust, trust of the American people. They have
    ruined that trust. We can stand here and sit here and try and
    make it better, but millions of people have lost their IRAs,
    they have lost their retirement funds. Many have had to stop
    their thoughts of even retiring. We can't make that up.
        But one of the things that I am afraid of, and I am already
    starting to see it, is the financial system is prone to more
    systemic risks today than I think ever before. I think it would
    be a tribute to the creation of complex investments products
    such as credit defaults. I mean, they are already starting on
    coming out with new products. And yet, you know, I think
    everybody was sleeping at the wheel.
        You talk about the Federal Reserve. No one did anything to
    really bring the attention to the authorities on the way they
    were supposed to. So how do we make that better? How do we get
    the industry, I guess, to have a moral backbone? That is the
    main point, and we can't legislate for that.
        Mr. Volcker. Well, I agree with your concerns, and we have
    lost the sense of fiduciary responsibility that should
    inherently--
        The Chairman. Into the microphone, please, Mr. Volcker.
        Mr. Volcker. I am going to have to eat it.
        The Chairman. Bring it closer to you. It will move, you
    don't have to bend. Move the whole thing closer to you.
        Mr. Volcker. I have a lot of sympathy with what the
    Representative from New York is saying about the loss of a
    sense of fiduciary responsibility. And I would like to restore
    that to the banks as much as possible, because they should have
    it. I think it is kind of hopeless in terms of--just in
    personal capital market operators. A tremendous amount of
    money, as you well know, was made in the financial system. So
    the incentive to get back to the situation as normal, or what
    was considered normal before, is pretty strong by the people
    who were participating. But, of course, it is that system that
    led us over the cliff, and with all the adverse consequences
    that were mentioned. And that is what we want to avoid in the
    future.
        And you talk about the capacity to make up more and more
    new products, get around more and more regulation. It occurs to
    me, as I heard you speaking, that maybe the best reform we
    could make is have a big tax on financial engineers so that
    they can't make up all these new things quite so rapidly;
    because it is this highly complex, opaque financial engineering
    which gave a false sense of confidence, which broke down.
        But you have outlined the challenge, and Treasury has tried
    to address it. The Administration has tried to address it. Many
    other people have made suggestions. I am making a few
    suggestions this morning. And you are going to have to decide.
    But you can't let it go without some important action.
        Mrs. McCarthy of New York. No, I agree with you. And I
    think important action is certainly where we are trying to go.
    And we are trying to find the right balance. Again, you know,
    we have a younger generation that we have been trying to
    convince that they should start saving. Saving in this Nation
    was at a zero rate before all this started.
        Mr. Volcker. That is part of how we got in this problem.
        Mrs. McCarthy of New York. Exactly. And with that being
    said, though, always try to look for something good. People are
    cutting back on some of their extraordinary expenses. They are
    cutting back on using their credit cards. And I think it is a
    lesson that everybody has made. But with that lesson, I think
    the punishment was too much. And I hope that we do find the
    right balance, especially for the consumers. We have to start
    taking care of the consumers this time around. Thank you.
        The Chairman. The gentlewoman from Kansas.
        Ms. Jenkins. Thank you, Mr. Chairman.
        Mr. Chairman, the Administration has said that one of the
    goals of its resolution authority is to inflict the cost of
    failure upon shareholders and bondholders. At the same time,
    Mr. Geithner has been unable to say that further bailouts of
    creditors will be off the table. In a world where the mantra
    has become ``no more Lehmans,'' is the promise that haircuts
    will be inflicted upon creditors the least bit credible? And if
    it is not credible, doesn't that mean that the next crisis will
    be still bigger?
        Mr. Volcker. The danger is that the spread of implicitly a
    moral hazard could make the next crisis bigger. It is not going
    to be next year. It is not going to be probably 4 or 5 years.
    But memories are dim. And we want to make a system such that we
    don't have a still bigger crisis 10 years from now. And if we
    do nothing and let moral hazard become even more accepted, I am
    afraid there is a real danger.
        So you want this resolution system to do such things as
    creditors taking a haircut if they have to; or convert into
    stocks, and the stockholder will probably lose and lose
    completely. In many cases, there will be a forced merger or
    other actions that will not require the injection of government
    money that can stabilize the situation.
        Now, that is more forceful than what happened in the midst
    of the great crisis a year ago when, by and large, with the
    exception of Lehman, the bondholders were pretty much protected
    in the financial world. They weren't protected in General
    Motors and Chrysler, but they were protected in the financial.
    And even some of the stockholders were protected.
        Now, they did not lose as much as you might have thought
    they should have lost. We want to minimize that kind of result
    to the extent possible so that the lesson gets through: You
    creditors are taking a risk and you ought to understand that.
    And the government isn't going to come to your aid if this
    institution fails.
        And this is the game. I hate to call it a game, but this
    is, I think, the approach that we are trying to instill, and
    make sure there is what is appropriate uncertainty, or maybe
    certainty, that if these nonbank institutions are going to
    fail, the creditors are at risk and the stockholders are at
    risk. And we do the best we can to do that without destroying
    the system.
        Ms. Jenkins. Thank you. I appreciate your input. I yield
    back the balance of my time.
        The Chairman. The gentleman from Massachusetts. This time,
    I saw you.
        Mr. Lynch. Mr. Volcker, thank you for your attendance and
    for helping the committee with its work. I was listening to
    your testimony outside and I was wondering, this whole
    framework that we are considering here--given the complexity of
    some of this, some of the instruments that are being traded
    now, the derivatives that we are now going to put on exchanges,
    and some that are not but necessarily require oversight, where
    we are entering new territory here which we hope will bring
    more effective regulation to the entire financial services
    industry. The question for us in part will be how to pay for
    that, how to pay for that structure.
        And I know that the last time we had a great disruption
    here, the Great Depression, Congress and the financial services
    industry sat down and they derived a system that--I think it
    was one three-hundreth of 1 percent of every share traded on
    the exchanges would go in to pay for the SEC, for example. That
    number has been reduced over time because of the volume of
    trades.
        But would you favor some type of--when we have to grapple
    with how to pay for all this, would you favor some type of
    system, some transaction fee, for example, that would help fund
    all of this? We have many, many of our constituents who don't
    have any--they don't have an IRA, they don't have money in the
    stock market. And yet if we use the general taxation authority,
    they too will be paying for this system that they don't
    necessarily benefit directly from.
        And I was wondering if we could have your thoughts on how
    we might as a Congress pay for some of the regulation that we
    are about to implement.
        Mr. Volcker. Well, just a general question has arisen from
    time to time in the past. It rose quite poignantly 20 or 30
    years ago with respect to foreign exchange crises or foreign
    exchange operations, as to whether a little tax wouldn't do
    some good, both in raising revenues and in discouraging
    speculative activity. I think the conclusion of people who
    looked into that in the past was kind of twofold. First of all,
    it is very hard to do it for one country in any significant
    amount, because you force then, competitively, the market to
    another country that doesn't charge. So that is the number one
    problem. You have to get some consistency internationally.
        The more general problem, I think, is if the fee is low
    enough not to be disruptive of markets, it is not going to
    raise much revenue. If it is high enough to raise some revenue,
    it will be disruptive. So you are kind of caught; and is there
    any middle ground?
        But I think it might be interesting if the Congress
    suggested somebody look at this and see whether there is
    anything to the idea at all. You probably are aware that the
    head of the British Supervisory Authority has proposed--and I
    think he says he doesn't think it is going to happen--but he
    says just what you say: Maybe a little tax on the financial
    transactions would be a good thing.
        It is very interesting. He says maybe the financial world,
    financial system, got too big in the U.K., it got too dominant.
    It made a lot of money, but it really didn't contribute to the
    national wealth of the United Kingdom. And he has raised some
    very interesting questions, including, I don't know how
    seriously, the question of this tax. But he has a point.
        You are probably familiar with the fact that the world of
    finance at one point, in terms of its total profits, came to
    almost 40 percent of all the profits in the United States. And
    that doesn't even count all the bonuses. That is after the
    bonuses.
        And you know, some people raised the question, I raised a
    question of whether the value, really, of the world of finance
    is 40 percent of the United States and things haven't gotten a
    little out of bounds here, which is what you are struggling
    with in a general sense. How is this great industry of finance,
    harnessed to do the job it is going to do, an absolutely
    indispensable job, without taking risks that for a while were
    very profitable, and then it turned very sour. How do you get
    the job done, done in a way that--of course, smart men can make
    reasonable returns without placing the whole economy at risk.
        The Chairman. The time has expired. Mr. Volcker can stay
    until 11:30. There are 10 members present who haven't asked
    questions. I will announce on the Democratic side that I will
    give priority to the people who were here. That should
    accommodate everybody who was here. If no new members come on
    either side, everybody who sat through it can do it. The
    Minority can make its decisions. But with Mr. Volcker's
    agreement, that will give us 10 people an hour. We will hold
    people strictly to 5 minutes. And in fairness to the people who
    were here, that is the way we will go.
        So now it is up to Mrs. Capito.
        Mrs. Capito. Thank you, Mr. Chairman. Thank you, Mr.
    Chairman, for being here.
        I would like to go to the resolution authority that the
    Administration has proposed. Those of us--we put together a
    Republican plan to deal with re-regulation and new regulation.
    And one of the ideas that we put forward was an enhanced
    bankruptcy rather than a resolution authority by the Reserve.
    And I think in doing that, I think we were--we feel that it
    creates more transparency, accountability; it can go into the
    bankruptcy court, with the accompanying experts in that
    bankruptcy court that would understand the complexity of what
    is going on. And also, it would remove, I think, any kind of
    appearance of a bailout or another implicit or implied
    government backstop.
        Do you have an opinion on an enhanced bankruptcy as opposed
    to the resolution before you?
        Mr. Volcker. I haven't seen your proposal so I can't
    comment in detail. But I think the problem that we are all
    dealing with is when the emergency comes, you don't have much
    time. And it looks efficient anyway, to say okay, the
    government had to take action immediately. We are going to put
    somebody in there to run this organization, and it can do what
    it can do in terms of, for instance, doing the kind of thing
    with the creditors that a bankruptcy court might eventually do.
    But you don't have a month to work it out. You don't have 2
    months to work it out. You don't have a week to work it out.
    You don't have days to work it out. You have to do it right
    away, or at least plan it right away.
        So that is, I think, the problem that we are dealing with,
    the ordinary bankruptcy-type negotiated settlements which work
    okay when you don't have a systemic risk. That is a day-by-day
    affair. You have to deal with it immediately. And that is, of
    course, the problem we ran into a year ago.
        So within that constraint, if you have a better way of
    doing it, good; but I think it has to recognize that
    constraint.
        Mrs. Capito. All right, thank you.
        My last question is, so many of these matters--I mean you
    have dealt with these matters your entire life and done such a
    wonderful job. They are so darn complicated for the man on the
    street who is listening to this hearing.
        Or any time I go to my district and try to talk about the
    need for new regulation in the financial markets, people's eyes
    start to glass over. And I know you have made many speeches and
    many--is there any way, in a concise way, besides, you know,
    this is going to protect you from losing your retirement in the
    future--is there any way that you find is most effective to
    convey the message to the man on the street that this is an
    issue that really does impact them every day in their life?
        Mr. Volcker. Well, it would be no comfort to you that I
    find it too damn complicated myself, so it is very complicated.
    But I think the message that you have to give them is, the
    whole object of this exercise is to prevent a repeat of what
    has happened. And it is not just a loss of finance, which is
    obviously important, particularly the loss of retirement funds
    and all that kind of thing. That is serious enough. But it has
    also affected the operation of the economy. So people lost
    jobs, and we are left with a big recession, we are left with a
    situation where it is going to be a tough recovery.
        So we are dealing with a big problem--you are dealing with.
    And I wish it was simpler, but it is not very simple because
    the finance system itself has gotten so complicated. I think
    that is part of the problem, frankly. I mean, I think I have
    made remarks about financial engineers. I am more than half
    serious about that, because it has gotten so complicated. I am
    sure the management of most financial institutions don't
    understand what people are doing down in the bowels of the
    institution, in some very fancy bit of financial engineering.
    And they get told, as I am sure in the case of the subprime
    mortgage, we have it all figured out. These are lousy mortgages
    but we have them all put together in a way that is perfectly
    safe and they are triple A. So you can buy them and you can
    pay.
        And I don't think the managements in most cases, you know,
    were able to see through that, understandably, because it is
    very complicated. Now I think the cloud before the eyes has
    been removed, and we ought to take advantage of that and try to
    make sure it doesn't return.
        Mrs. Capito. Thank you. I yield back.
        The Chairman. The gentleman from North Carolina, Mr.
    Miller.
        Mr. Miller of North Carolina. Thank you, Mr. Volcker. Last
    fall when Lehman collapsed and AIG was rescued, I felt like I
    was not a sufficiently conscientious member of this committee,
    because I so little understood credit default swaps which had
    played such a huge role in all that. And then I came to realize
    that no one understood them, which made me feel a little better
    about my own level of conscientiousness, but maybe feel worse
    for the economy of the country and of the world.
        In your testimony, you identified credit default swaps as
    something that had exacerbated the risks that our entire
    economy faced, the Nation's economy and the world's economy.
    The usual justification is risk management. They are like
    insurance. But the great, great bulk of credit default swaps
    and other derivatives are between parties, none of whom have
    any risk to manage. They have no interest in the underlying
    whatever it is.
        You, in your testimony, said some kinds of risky behavior
    should not be allowed of institutions that are systemically
    important. Do you think credit default swaps, for instance,
    where nobody in the contract has any interest in the underlying
    security, should be allowed of systemically important
    institutions?
        Mr. Volcker. Well, let me just make a general kind of
    philosophic question, and then credit default swaps. My general
    position is you make a distinction between banks and others.
    Banks are going to be protected. They are protected in other
    countries. They have been protected here for a century. That is
    not going to change, shouldn't change, I don't think. But let's
    not extend that protection to the whole world.
        Now we get the credit default swaps which are out there in
    the market and arguably serve a legitimate function in a
    trading operation of protecting the holding of a bond against
    the default on the bond. But it became a big kind of
    speculative market, trading market, so you had many more credit
    default swaps outstanding than there were credits, which raises
    some questions about the functioning of the market, and how the
    basic purpose it was serving was underlying and had a purpose.
    But the market was developed in a way that it was vulnerable to
    collapse--if that is the right word--if it came under great
    strain. And it came under great strain because AIG was so
    central to the market. Now, that had been of concern, frankly,
    before. Some people understood this before the crisis, and, on
    a voluntary basis, began introducing measures--
        Mr. Miller of North Carolina. You do need to eat your
    microphone. I am having a really hard time hearing you. Sorry.
        Mr. Volcker. I said people had begun working on the credit
    default swap problem in terms of the clearance and settlement
    procedures, even before the crisis, on a voluntary basis, with
    some success and some great effort. Now the crisis has exposed
    it and the government stepped in and made proposals. I don't
    know how many of them require legislation. At some point, it
    will require some legislation.
        But now there is a lot of progress in forcing this trading
    into clearinghouses or organized exchanges with the whole
    panoply of rules that implies, collateral requirements,
    protection against default and so forth. So that is a big step
    forward.
        You might not have had the AIG problem which has loomed so
    large, had all those arrangements been in place before, because
    there were no agreed--well, there was an appropriate basis in
    that respect, some agreed conventions, but AIG did not
    sufficiently collateralize and protect against risk, given what
    happened. They thought they had no risk because they were so
    big and strong. Well, when they weren't so big and strong, you
    had a problem. That is a big problem, and it is one of the
    areas in which I am sure that big progress is going to be made
    and is being made.
        Mr. Miller of North Carolina. Do you think that the margin
    requirements to the collateral requirement is sufficient with
    respect to--
        Mr. Volcker. Well, somebody ought to be in a position to
    make sure that it is sufficient. I am not an expert. I can't
    judge whether they are sufficient or insufficient. Somebody
    ought to be deciding that.
        Mr. Miller of North Carolina. Are there any collateral
    default swaps, credit default swaps, other derivatives, that
    should require an insurable interest by somebody in the
    transaction? Should there be a requirement with respect to any
    credit default swaps of an insurable interest?
        Mr. Volcker. I think this whole market needs to be brought
    under surveillance, and you ought to provide the authority that
    somebody can have adequate authority to satisfy themselves the
    market is sanitized.
        Mr. Miller of North Carolina. My time has expired. Thank
    you.
        The Chairman. The gentleman from Texas.
        Mr. Neugebauer. Thank you, Mr. Chairman. Thank you,
    Chairman Volcker, for being here.
        Looking back at your experience at the Federal Reserve, one
    of the things that is out there today is that the Federal
    Reserve would designate these tier one companies in financial
    institutions. And a lot of people believe that when you say
    that company is tier one, that they are in fact ``too-big-to-
    fail.'' And so there is an implicit guarantee there that these
    are entities that we are not going to let fail.
        The question I have for you is: Is that good for the
    marketplace, and is that good policy?
        Mr. Volcker. No, I don't like that idea. That is part of
    what I am saying here. Trying to identify these institutions in
    advance as a special interest, whether they say it or not, then
    carries the connotation in the market that they are ``too-big-
    to-fail.'' And I think that adds to the moral hazard problem.
    Most of what we have been discussing this morning is how to
    corral moral hazard. And I don't think that is--that is not the
    way to do it. It doesn't corral it, it extends it.
        Mr. Neugebauer. I have heard you say--and I think this is
    something that you and I agree on--that capital could have
    cured a lot of the ills that we faced in the country over the
    last year if these companies had actually been capitalized to a
    level sufficient and commensurate with the risks and exposure
    that they were taking.
        Is it a better strategy, in your opinion, for the
    regulatory agencies, the regulators, that when these entities
    are very diverse, involved in a lot of different activities,
    that they actually do a better job of breaking down the
    businesses that each one of these entities is in, and assigning
    capital requirements for those activities; and so then, if that
    entity wants to continue that business activity, it understands
    that it will have to have a certain amount of capital to do
    that, and the marketplace then, in effect, begins to analyze
    those businesses and ascertain whether they want to furnish the
    capital to those institutions? And so don't you have a check
    and balance from the marketplace as well as the regulatory
    structure?
        Mr. Volcker. I think capital requirements and amount of
    capital are obviously important. But if you try to fine-tune it
    too far--the banking regulators have struggled with this--how
    much capital in each particular kind of risk basket? It is very
    hard to define different risks very precisely.
        And they went from a system, or trying to go from a system
    that was very crude, back when I was Chairman of the Federal
    Reserve--which we had installed--to say it is not sophisticated
    enough, it doesn't have all those baskets that you are talking
    about. But boy, they have run into more difficulty. They have
    spent 10 years trying to define this and they put a lot of
    weight on credit rating agencies. Now, that no longer looks so
    great. But that is illustrative of the kind of problem you run
    into.
        So I am kind of on the side of, yes, adequate capital. Yes,
    make sure capital is big enough, but recognize it has to be
    pretty crude, and don't try to be too sophisticated about it.
        I do think, and you may be getting at this, when you get
    into nonbanks, bank capital is already--whether it is adequate
    or not, no doubt it is a matter of a supervisory concern. When
    you get outside of the banking system, then I think there ought
    to be some residual authority for those few institutions that
    get so big they really look dangerous from the standpoint of
    financial stability, somebody has the authority to say, look,
    you are too leveraged. You have to provide some more capital,
    or you have to cut down on your assets; or you cut down on your
    activities and you have to hold more liquidity. I think the
    need for that will be rare.
        I do believe in registration of hedge funds, I do believe
    there ought to be some reporting of hedge funds. But I think
    there are very few hedge funds that present a systemic risk.
    They are a different kind of operation, a different kind of
    financing. We have seen failures of hedge funds that were
    successfully absorbed without much difficulty. Interestingly
    enough, where that was not true was the hedge funds owned by
    Bear Stearns. What sent Bear Stearns in the beginning of its
    downward slide was the failure of or losses in its own hedge
    funds, which is illustrative of why I don't want commercial
    banks to be holding hedge funds, because that would be a point
    of vulnerability.
        Mr. Neugebauer. Thank you, Mr. Chairman.
        The Chairman. Thank you. We have votes, unfortunately. We
    can't hold Mr. Volcker after this. We will have time for two
    more questions for people who have been here, and then we will
    break. We will resume, and we will start with those who were
    here and didn't get to ask.
        The gentleman from Georgia.
        Mr. Scott. Thank you, Mr. Chairman.
        Mr. Volcker, let me ask you to comment on the whole issue
    of ``too-big-to-fail,'' because I think that we have not paid
    attention to what happens as a result of that. The consequence
    becomes what do we do; do we have a strategy; does that
    strategy lead to another strategy called too-small-to-save? And
    I think that is where we are.
        Historically, if we looked at the Depression that we went
    through, it was these smaller banks, banks went under, they
    never came back. Eventually, smaller banks began to serve a
    niche. I am very concerned about the future of our smaller
    banks, our community and regional banks. And are we at the
    point, as a result of this rush to save these large banks,
    holding companies, there isn't that much attention that we are
    faced with in terms of these smaller banks. Bank after bank
    after bank has gone under across this country. They haven't
    been the Bank of Americas or the SunTrusts or the national
    banks, the big banks. They have been these community banks that
    actually provide the monies for these communities.
        One of the big problems we had, for example, with the
    automobile dealers was the fact that once the automobile
    manufacturers had a problem, the automobile dealers had a
    problem, but it wasn't--their problem was the inability to get
    money.
        So the problem here becomes, I think, we are glossing over
    a deeper problem here of getting down to the grass roots in
    these communities. Unemployment is not going to bounce back
    until we get these small businesses thriving. The small
    businesses are getting their monies from the smaller community
    regional banks. And yet because of this overemphasis on this
    ``too-big-to-fail'' strategy, we are losing the bigger picture,
    it seems to me; and as a result, we are left with too-little-
    to-save.
        Could you comment on this particular predicament we are in?
        Mr. Volcker. Well, I am not sure how helpful I can be. I
    think there is a problem. Obviously you are seeing a lot of
    failing of small banks, and they are kind of easy to take care
    of in terms of the capacity of the FDIC, and disturbance or
    lack thereof, and the failure of a particular small bank. But I
    do think that it takes judgment. But in a particular case of a
    small bank, to what extent is the problem one of accounting
    practice maybe, and I think bank accounting needs some review.
    I am not sure how important that is to these smaller banks.
        Are their cases where--bad word, but I will use it--that
    forbearance would have been justified, and the benefit of the
    doubt in some sense given to the small bank to see whether it
    can hold together for a while without forcing it into either a
    merger or liquidation? I don't know. That takes a very
    sophisticated and understanding regulatory regime, which may be
    beyond us.
        Mr. Scott. Do you see a future for the small community
    regional banks?
        Mr. Volcker. Look, I am old-fashioned. I see a future for
    small- and medium-sized community banks because they have some
    inherent advantages in dealing with local communities and the
    small borrowers and the individuals that are concerned. I think
    they can be quite competitive. And they are not a danger to the
    country. Quite the contrary. What I think we ought to do is we
    ought to be conscious that we are not unconsciously
    undercutting them. But I don't have any magic answers to that.
        Mr. Scott. All right. Well, thank you very much.
        Let me just ask you one other question here. I have a few
    more minutes. Over the past 6 months, loans and leases have
    declined at a record annual rate of 8 percent with no hint of
    an upturn, despite the Fed's massive effort to get credit
    flowing. Credit is still not flowing sufficiently to assure a
    strong and sustainable economy.
        Do you believe this to be a two-sided problem? One, reduced
    willingness of banks to lend amid the record loan
    delinquencies; and, two, the subdued desire to borrow.
        Mr. Volcker. Well, bank lending, I guess, is declining.
    This is an area of the market that is still clogged up. It is a
    matter of confidence in part, in large part. And a lot of them
    are in financial difficulty. And I think it is going to take
    time for that to unlock. The big market has opened up
    considerably, but the small bank market has not, although there
    are some signs it is beginning to change. So I hope that we can
    see evidence of that before too long.
        Mr. Scott. Thank you, Mr. Volcker.
        Mr. Miller of North Carolina. [presiding] Thank you. Mr.
    Hensarling.
        Mr. Hensarling. Thank you, Mr. Chairman. And, Chairman
    Volcker, over here. The good news is I appear to be your last
    questioner of the morning. Thank you for your time, sir.
        I want to follow up on a line of questioning from my
    colleague from Texas, Mr. Neugebauer, and try to put a very
    fine point on it, perhaps a theoretical point. He was inquiring
    about, in retrospect, could the regulators, had they had I
    suppose more perfect knowledge in being able to assess risk,
    could they not have applied the proper capital and liquidity
    standards, be it to our insured institutions or our investment
    banks? At least, theoretically, had they known, could you have
    applied proper capital and liquidity standards to perhaps have
    prevented the economic turmoil that we saw?
        Mr. Volcker. I think the answer is, theoretically, yes. But
    the answer may also be, practically, no. I don't mean to be
    that negative. But the problem with banking supervision, the
    chronic problem is when things are going well, nobody wants to
    hear from the supervisor, including Congress, doesn't want to
    hear about restrictions. And you will get complaints from your
    constituencies: ``What are those big bad regulators doing
    demanding higher capital requirements and preventing me from
    doing this or that?'' ``I never failed,'' the argument will be,
    ``and I am doing fine. Leave me alone.'' And then, of course,
    when things happen, where were they?
        Mr. Hensarling. But I guess for a historical perspective--
    and I guess I would ask if you agree or disagree--at least with
    respect to our insured institutions, the prudential regulators
    had the ability to take prompt and correct action.
        Mr. Volcker. I think there was some failure in banking
    supervision.
        Mr. Hensarling. Perhaps they lacked the expertise, perhaps
    they lacked the courage, forethought, but they didn't really
    didn't lack the regulatory authority to have imposed a capital
    or liquidity standard that would have been commensurate with
    the risk.
        Mr. Volcker. I think there are two things in particular
    that I would say directed toward that. First of all, I do think
    that the idea of having an overall overseer to kind of look at
    things, whether capital standards generally are adequate,
    whether the liquidity standards are adequate, whether some
    trading operations are developing that are destabilizing. We
    haven't had anybody overtly and specifically charged with that
    kind of responsibility. We have individual agencies looking at
    individual banks, yes, and they are worried about capital. But
    they don't take a fully systemic view, by nature of their
    responsibilities.
        I also think, so far as the Federal Reserve specifically is
    concerned, if they are going to carry heavy supervisory
    responsibility, I think there does need to be some internal
    reorganization in the Federal Reserve to make sure that the
    Board itself, the Chairman and the Board itself, are
    sufficiently invested with the responsibility for regulation
    and supervision. And explicitly I have suggested, other people
    have suggested, that there be created a position of Vice
    Chairman of the Board for Regulatory and Supervisory Practice,
    so that there is no doubt on your part as a Congressman as to
    who in the Federal Reserve is supposed to be on top of that.
        Mr. Hensarling. Chairman Volcker, let me turn to the
    question of resolution authority. And clearly, there are
    differences within this body on how best to do that, be that
    through some type of greater expert enhanced bankruptcy process
    versus perhaps the Federal Reserve undertaking this particular
    duty.
        I believe I heard Chairman Frank, yesterday, say that
    whatever the resolution authority--and I know he is not in the
    Chair at the moment--what I believe I heard he said, at least
    from his perspective, is that resolution authority essentially
    ought to be a death sentence, which I believe I interpreted to
    mean that he would favor receivership over conservatorship.
        We presently have Fannie Mae and Freddie Mac and AIG in
    forms of conservatorship, with massive transfusions of taxpayer
    money, with no exit strategy, no end in sight for the taxpayer.
        Whatever resolution authority may come out of the United
    States Congress, could you speak to us about your opinion on
    whether or not it should have the ability to place these into
    conservatorship versus receivership and the pros and cons
    associated with that?
        Mr. Volcker. I think there ought to be authority for both.
    Conservatorship, implying this is an institution that has
    enough viability to be reorganized and be merged and
    revitalized; and receivership, liquidator.
        Mr. Hensarling. Would you put AIG in the category of a firm
    that--
        Mr. Volcker. I am not the regulator of AIG. I don't have
    any knowledge of all of AIG. I know it is very, very
    complicated, complicated enough that I haven't wanted to get
    involved.
        Mr. Hensarling. We are out of time. Thank you, Mr.
    Chairman.
        Mr. Green. [presiding] Thank you.
        Mr. Volcker, because time is of the essence, I am going to
    move rather quickly to my questions, and there are only two.
    The first has to do with the notion that, metaphorically
    speaking, this economy had a toothache. And many times when you
    have a toothache, you will do anything to get rid of it. But
    once you are rid of it, you don't have the same memory of the
    pain that you had at the time you had the toothache.
        And the reason I use this metaphor is because I want you to
    tell me just how bad it was. You spoke in terms of the economy
    going off a cliff. Tell me how bad was it when we interceded?
    How bad was it?
        Mr. Volcker. Bad. Very bad.
        Mr. Green. Compared to the Great Depression, let's call the
    Great Depression a 10. If it was a 10, how bad was this
    situation, Mr. Volcker?
        Mr. Volcker. Well, the disturbance was very large, but of
    course, extremely forceful action was taken to curb the
    deterioration. But as you know, for a couple of quarters, the
    economy went down very rapidly, and part of the problem was it
    was not only in the United States. It became a worldwide
    phenomenon, a worldwide--I shouldn't say worldwide. It became a
    phenomenon among almost all well-developed countries.
        So you had a situation that could feed upon itself, there
    was no strong point of growth in the world economy. So it was
    bad.
        It is impossible to tell what would have happened without
    the massive government support. But you knew at that point and
    even now, the financial system was based upon government
    support. And that is not the kind of financial system we want
    to have. It is not what we talk about as a free enterprise
    system.
        Mr. Green. When you use the term ``going off a cliff,''
    sir, give me a little bit more of what that means, ``going off
    a cliff.''
        Mr. Volcker. It meant that, the falling-off-the-cliff
    analogy applied to the rapid decline in the economic activity
    for 6 months or so, which found its expression, cause, the
    rapidity of it, in that the supply of credit dried up. Banks
    were not lending. Banks could not lend. The open market was
    constipated. So there was no availability of credit, and that
    led to, obviously, difficulties in carrying on economic
    activity.
        Mr. Green. I am going to ask one final question, and
    because my friend and I have different views on this, I am
    going to stay and give him an opportunity, because he may want
    to have a follow-up on this question. I think it is only fair
    to do so.
        Mr. Volcker, was the CRA the cause of this crisis that you
    and I just finished discussing?
        Mr. Volcker. What was the cause?
        Mr. Green. Was the CRA, the Community Reinvestment Act, the
    cause?
        Mr. Volcker. Was the Community Reinvestment Act the cause?
        Mr. Green. I don't mean to insult your intelligence, but it
    is important that I get this on the record. Was the Community
    Reinvestment Act the cause?
        Mr. Volcker. A cause?
        Mr. Green. The cause.
        Mr. Volcker. I don't believe that it was a significant
    factor in this situation.
        Mr. Green. Now, because we are short on time, sir, could
    you--
        Mr. Royce. I will be very brief.
        And, by the way, we go through a routine where we ask if
    the Government-Sponsored Enterprises, Fannie Mae and Freddie
    Mac, were one of the causes, the lack of regulation over them,
    and then that gets translated, but that is not what I am
    interested in today.
        Mr. Volcker. I am willing to inject a comment here.
        Mr. Royce. Yes?
        Mr. Volcker. Please do not recreate Fannie Mae and Freddie
    Mac in the form of these hybrid institutions, half private,
    half public.
        Mr. Royce. So you think that the GSEs were one of the
    causes?
        Mr. Volcker. I think they were a factor, yes.
        Mr. Royce. Okay, then, let me ask you a question. The
    Richmond Fed economist, back in 1999, said 27 percent of all of
    the liabilities of firms in the U.S. financial sector were
    explicitly guaranteed by the Federal Government; another 18
    percent enjoyed some implicit support. That would be 45
    percent. Now that is back 10 years ago.
        Now we look at March of 2008 when the New York Fed stepped
    in and assumed the risk of about $30 billion in the portfolio
    of the investment bank Bear Stearns. So we have seen this rapid
    expansion of both the perceived and the actual financial safety
    net, the explicit financial safety net. Do you think the
    expansion of this safety net has exacerbated the ``too-big-to-
    fail'' problem?
        Mr. Volcker. Yes, and I think the whole--90 percent of the
    discussion we have been having here is trying to figure out
    some way of pulling that back.
        Mr. Cleaver. I am going to have to ask Mr. Volcker to give
    the rest of his response in writing. We have exceeded our time
    and are to zero on our voting--
        Mr. Royce. Sure enough.
        Mr. Cleaver. If I may say so, Mr. Volcker, we thank you for
    being here, and I do this on behalf of our Chair, and we thank
    all of the other panelists for being here. We are coming back
    after this vote.
        Mr. Volcker, you are excused, and it is with great pleasure
    that we have had you here today.
        Thank you, sir.
        Mr. Volcker. Thank you for having me.
        [recess]
        Mr. Cleaver. [presiding] I think we will go ahead and begin
    with our testimony. We appreciate all of you donating your
    valuable time and intelligence to this committee today.
        We are going to begin with the Honorable Arthur Levitt,
    Jr., the former Chairman of the SEC and Senior Advisor to the
    Carlyle Group.
        Mr. Levitt.

    STATEMENT OF THE HONORABLE ARTHUR LEVITT, JR., FORMER CHAIRMAN
    OF THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION; SENIOR
                       ADVISOR, THE CARLYLE GROUP

        Mr. Levitt. Thank you for the opportunity of appearing
    before the committee to discuss the critical issues of
    establishing a systemic risk regulator and a resolution
    authority. I will summarize my prepared statement, which I have
    submitted to the record.
        As a former Chair of the SEC and currently as an advisor to
    Getco, The Carlyle Group, and Goldman Sachs, I hope I can share
    with you important considerations to inform your efforts.
        Though the appetite for reform appears to move in inverse
    relationship to market performance, financial markets are no
    less risky and regulatory gaps remain. I am concerned that
    public investors may well be convinced because of the relative
    market calm of the last few months that all is well in our
    regulatory system, but all is not well and I am glad you are
    showing leadership in addressing these issues.
        Your success will be determined by how well you affirm the
    principles of effective financial regulations, principles
    relating to transparency and regulatory independence, the
    proper oversight of leverage and risk taking, the nurturing of
    strong enforcement, early intervention, and the imposition of
    market discipline.
        One of the key questions before this committee is how to
    authorize and hold accountable a systemic risk regulator and
    who should provide this function. I would like to suggest that
    the more critical question is whether any regulator or groups
    of regulators can have the same impact as well as a resolution
    authority. Such an authority would be created explicitly to
    impose discipline on those with the most power to influence the
    level of risk taking, the holders of both equity and debt in
    institutions which may be ``too-big-to-fail.''
        A systemic risk regulator will not be effective unless you
    also create a resolution authority with the power to send these
    failing institutions to their demise and thus impact the
    holders of both their debt and equity.
        To give a simple analogy, it doesn't matter who serves as
    the cop on the beat if there are no courts of law to send law
    breakers to jail.
        I strongly believe that a systemic risk regulator must
    serve as an early warning system with the power to direct
    appropriate regulatory agencies to implement actions. I am
    agnostic about who should lead such an agency and perform this
    function, and I would caution against making the Federal
    Reserve the systemic risk regulator in its present structure.
        The Fed's responsibilities to defend the safety and
    soundness of financial institutions and to manage monetary
    policy creates inevitable and compromising conflicts with the
    kind of vigilance and independent oversight a systemic risk
    regulator requires. If, however, the Fed is deemed to be the
    best available place for this role, I would urge Congress to
    remove from the Fed some of its responsibilities, conflicting
    responsibilities, especially those of bank oversight.
        In many respects, the surest way to cause investors,
    lenders, and management to focus on risk is not to warn them
    about risk but to give them every conceivable way to discover
    risk and tell them what will happen to them if they don't pay
    attention.
        We can deal with this by establishing a resolution
    authority charged with closing out failed institutions which
    pose systemwide risk. Such an authority would have the power to
    do just about anything to put a failing bank in order or close
    it down in an orderly way without, if possible, further
    government assistance. It could terminate contracts, it could
    sell assets, cancel debt, cancel equity, and refer management
    for civil penalties for taking excessive risk even after
    multiple warnings.
        I would expect that managers, customers, creditors, and
    investors would become a good deal more careful, having
    foreknowledge of their potential rights and responsibilities
    should such a resolution authority be activated. They would see
    the advantage of greater transparency and developing more
    knowledge of individual institutions, and this market discovery
    may well do the work of many outside systemic risk regulators.
        Of course, your goal is to incentivise market discovery.
    You will also want to establish the value of transparency with
    respect to market information. I want to emphasize in
    particular the importance of fair value accounting for major
    financial institutions engaging in significant amounts of risk
    taking and leverage. Such accounting gives investors a true
    sense of the value of an asset in all market conditions, not
    just those conditions favored by asset holders.
        Greater transparency would make it possible for market
    participants to price risks appropriately and for a systemic
    risk regulator to demand fresh infusions of liquidity or higher
    margin requirements if needed.
        I would much prefer that a systemic risk regulator be so
    effective that a resolution authority would be unnecessary. But
    sadly, we know that always preventing failure is absolutely
    impossible. I think it is, therefore, in my opinion, your job
    to make failure possible.
        Thanks again for your attention to these issues, and I urge
    you to continue to accelerate your efforts.
        [The prepared statement of Mr. Levitt can be found on page
    62 of the appendix.]
        Mr. Cleaver. Thank you, Mr. Chairman. The next witness, Mr.
    Jeffrey Miron, is a senior lecturer and director of
    undergraduate studies in the Department of Economics at Harvard
    University.
        Let me ask the three remaining witnesses, because of the
    possibility of another vote in maybe 25 or 30 minutes, I am
    going to ask if you can still push out the most significant
    parts of your testimony. But perhaps at the end if you could
    summarize them so we can make sure that all of you are able to
    complete your testimony before any vote call.
        Thank you.

    STATEMENT OF JEFFREY A. MIRON, SENIOR LECTURER AND DIRECTOR OF
        UNDERGRADUATE STUDIES, DEPARTMENT OF ECONOMICS, HARVARD
                               UNIVERSITY

        Mr. Miron. Thank you, Mr. Chairman, Ranking Member
    Neugebauer, and committee members. Let me begin by expressing
    my thanks for the opportunity to present my views on this
    matter. The question I will address is whether Congress should
    adopt Title XII of the proposed Resolution Authority for Large
    Interconnected Financial Companies Act of 2009. This Act would
    grant the FDIC powers for resolving insolvent financial
    institutions similar to those that it currently possesses for
    revolving banks. My answer to this question is an emphatic,
    unequivocal ``no.''
        Let me explain. The problem that resolution systems
    attempts to address is that when our financial system fails,
    the value of the claims on that institution's assets exceed the
    value of the assets themselves. Thus, someone must decide who
    gets what, and it is impossible, by virtue of the assumption
    that we are dealing with a failed institution, to make everyone
    whole. The size of the pie owned by the failing institution has
    shrunk so those who are expecting a slice of that pie
    collectively face the necessity of going somewhat or
    substantially hungry. The resolution authority decides who gets
    what, but the reality is that someone has to go wanting.
        It is in society's broad interest to have clear, simple,
    and enforceable procedures for resolving failed institutions,
    principally to ensure that investors are willing to commit
    their funds in the first place. If the rules about resolution
    were arbitrary and ever-changing, investors would be loathe to
    invest and economic investment productivity and growth would
    suffer.
        A well-functioning resolution process is part of a system
    for defining and enforcing property rights, which economists
    agree is essential to a smoothly functioning capital system.
        The crucial thing to remember here is that someone has to
    lose. Just as importantly, it is valuable to society as a
    whole, although not to the directly-harmed parties, that those
    invested in the failed institutions suffer economic losses.
    This releases resources to better uses, provides signals about
    good and bad investments and rewards those who have made smart
    decisions.
        The flip side of the fact that standard resolution systems,
    like bankruptcy, impose an institution's losses on that
    institution's stakeholders, is the fact that a standard of
    resolution authority, such as the courts, puts none of its own
    resources into that institution. The resolution authority is
    resolving claims and dividing the pie but is not adding any
    more pie.
        Under the bill being considered, however, the FDIC would
    have the power to make loans to the financial institutions to
    purchase its debt obligations and other assets, to assume or
    guarantee obligations and so on. This means the FDIC would be
    putting its own, that is, taxpayers' skin in the game, a
    radical departure from standard bankruptcy and an approach that
    mimics closely the actions that Treasury took under TARP. Thus,
    this bill institutionalizes TARP for bank holding companies.
        A crucial implication of this departure from standard
    bankruptcy is the taxpayer funds foot the bill for the loans,
    asset purchases, guarantees, and other support that FDIC would
    provide to prevent failing institutions from going under. These
    infusions of taxpayer funds come with little meaningful
    accountability, and it would be hard to know when they have
    been paid back and often that will not occur. The proposed new
    authority for the FDIC also generates the impression that
    society can avoid the losses that failure implies, but that is
    false. The proposed FDIC actions would merely shift those
    losses to taxpayers. The new approach is institutionalized
    bailouts, plain and simple.
        Thus, under the expansion of FDIC authority to cover
    nonbank financial institutions, bank holding companies will
    forever more regard themselves as explicitly, not just
    implicitly, backstopped by the full faith and credit of the
    U.S. Treasury. That is moral hazard in the extreme and it will
    be disastrous for keeping the lid on inappropriate risk taking.
        The right alternative to expanding FDIC authority is good
    old-fashioned bankruptcy. It has become accepted wisdom that
    bankruptcies by financial institutions cause great harm, and it
    is asserted in particular that letting Lehman Brothers fail was
    the crucial misstep last fall. In fact, nothing could be
    further from the truth.
        As I explain in more detail in my written testimony, the
    ultimate causes of the financial crisis were two misguided
    Federal policies; namely, the enormous subsidies and pressure
    provided for mortgage lending to non-creditworthy borrowers and
    the implicit guarantees provided by both Federal Reserve
    actions and the U.S. history of protecting financial
    institution creditors. These forces generated an enormous
    misallocation of investment capital, away from plant and
    equipment towards housing, created the bubble, and established
    a setting where numerous financial institutions had to fail
    because their assets were grossly overvalued relative to
    fundamentals. Lehman's failure was one part of this adjustment,
    and it was a necessary part. If anything, too few financial
    institutions failed since the massive interventions in credit
    housing markets that have occurred in the past year have
    artificially propped up housing prices, delaying the
    adjustments.
        Thus, the better way to resolve nonbank financial
    institutions is bankruptcy, not bailout. That is not to say
    existing bankruptcy law is perfect. One can imagine ways it
    might be faster and more transparent, which would be
    beneficial, nor should one assume that had bankruptcy been
    allowed to operate fully in the fall of 2008, the economy would
    have escaped without any pain. A significant economic downturn,
    in particular, was both inevitable and necessary given the
    fundamental misallocation of capital that occurred in the years
    before the panic, but nothing in the data, historical data or
    recent experience, suggests these bankruptcies would have
    caused anything worse than what we experienced and broader
    bankruptcies would have helped eliminate more hazards going
    forward.
        In light of these assessments, I urge the members of this
    committee to vote against this bill since it codifies an
    approach to the resolution that is fundamentally misguided. We
    need to learn from our mistakes and trust bankruptcies, not
    bailouts, going forward as we should have done in the recent
    past.
        [The prepared statement of Mr. Miron can be found on page
    66 of the appendix.]
        Mr. Cleaver. Our next witness is Mr. Mark Zandi, the chief
    economist and co-founder of Moody's Economy.com.

    MARK ZANDI, CHIEF ECONOMIST AND CO-FOUNDER, MOODY'S ECONOMY.COM

        Mr. Zandi. Thank you to the members of the committee for
    the opportunity to testify today. My remarks are my personal
    views and not those of the Moody's Corporation, my employer.
        The Obama Administration's proposed financial regulatory
    reforms will, if largely enacted, result in a more stable and
    well-functioning financial system. I will list five of the most
    important elements of the reform, and I will make a few
    suggestions on how to make them more effective.
        First, reform must establish a more orderly resolution
    process for large, systemically important financial firms.
    Regulators' uncertainty and delay in addressing the problems at
    Lehman Brothers and AIG, in my view, contributed significantly
    to the panic that hit the financial system last September.
        Financial institutions need a single, well-articulated, and
    transparent resolution mechanism outside the bankruptcy
    process. The new resolution mechanism should preserve the
    system of stability while encouraging market discipline by
    imposing losses on shareholders and other creditors and
    replacing senior management. Charging the FDIC with this
    responsibility is appropriate given the efficient job it does
    handling failed depository institutions.
        I think it would also be important to require that
    financial firms maintain an acceptable resolution plan to guide
    regulators in the event of their failure. As part of this plan,
    institutions should be required to conduct annual stress tests
    based on different economic scenarios similar to the tests that
    large banks engaged in this last spring. Such an exercise, I
    think, would be very therapeutic and would reveal how well
    institutions have prepared themselves for a badly-performing
    economy.
        Second, reform must address the ``too-big-to-fail''
    problem, which has become even bigger in the financial crisis.
    The desire to break up large institutions is understandable,
    but I don't think there is any going back to the era of Glass-
    Steagall. Taxpayers are providing a substantial benefit to the
    shareholders and creditors of institutions considered ``too-
    big-to-fail,'' and these institutions should meet higher
    standards for safety and soundness. As financial firms grow
    larger, they should be subject to greater disclosure
    requirements, required to hold more capital, satisfy stiffer
    liquidity standards, and pay deposit and other insurance
    premiums commensurate with their size and the risks they pose.
    Capital buffers and insurance premiums should increase in the
    good times and decline in the bad times.
        Third, reform should make financial markets more
    transparent. Opaque structured-finance markets facilitated the
    origination of trillions of dollars in badly underwritten loans
    which ignited the panic when those loans and the securities
    they supported started to go bad.
        The key to better functioning financial markets is
    increased transparency. Requiring over-the-counter derivative
    trading takes place on central clearing platforms make sense;
    so does requiring that issuers of structured financed
    securities provide markets with the information necessary to
    evaluate the creditworthiness of the loans underlying the
    securities. Issuers of corporate equity and debt must provide
    extensive information to investors, but this is not the case
    for mortgage and asset-backed securities. Having an independent
    party also vet the data to ensure its accuracy and timeliness
    would also go a long way to ensure better lending and
    reestablishing confidence in these markets.
        Fourth, reform should establish the Federal Reserve as a
    systemic risk regulator. The Fed is uniquely suited for this
    task given its position in the global financial system, its
    significant financial and intellectual resources, and its
    history of political independence.
        The principal worry in making the Fed the systemic risk
    regulator is that its conduct of monetary policy may come under
    onerous oversight. Arguably one of the most important strengths
    of the financial system is the Fed's independence in setting
    monetary policy. It would be very counterproductive if
    regulatory reform were to diminish even the appearance of that
    independence. To this end it would be helpful if oversight of
    the Fed's regulatory functions were separated from the
    oversight of its monetary policy responsibilities. One
    suggestion would be to establish semi-annual reporting to the
    Congress on its regulatory activities much like its current
    reporting to Congress on monetary policy.
        Fifth, and finally, reform should establish a new Consumer
    Financial Protection Agency to protect consumers of financial
    products. The CFPA should have rulemaking, supervision, and
    enforcement authority. As is clear from the recent financial
    crisis, households have limited understanding of their
    obligations as borrowers or the risks they take as investors.
        It is also clear that the current fractured regulatory
    framework overseeing consumer financial protection is wholly
    inadequate. Much of the most egregious mortgage lending during
    the housing bubble earlier in the decade was done by financial
    firms whose corporate structures were designed specifically to
    fall between the regulatory cracks. There is no way to end the
    regulatory arbitrage in the regulatory framework. The framework
    itself must be fundamentally changed.
        The idea of a new agency has come under substantial
    criticism from financial institutions that fear it will stifle
    their ability to create new products and raise the cost of
    existing ones. This is not an unreasonable concern but it can
    be adequately addressed. The suggestion that the CFPA should
    require institutions to offer so-called plain vanilla financial
    products to households should be dropped. Such a requirement
    would create substantial disincentives for institutions to add
    useful features in existing products.
        Finally, let me just say I think the Administration's
    proposed regulatory reform is much-needed and reasonably well-
    designed. Reform will provide a framework that would not have
    prevented the last crisis, but it would have made it measurably
    less severe and it certainly will reduce the odds and severity
    of future calamities.
        [The prepared statement of Dr. Zandi can be found on page
    112 of the appendix.]
        Mr. Cleaver. Our final witness is John H. Cochrane, AQR
    capital management professor of finance at the University of
    Chicago Booth School of business.

    STATEMENT OF JOHN H. COCHRANE, AQR CAPITAL MANAGEMENT PROFESSOR
     OF FINANCE, THE UNIVERSITY OF CHICAGO BOOTH SCHOOL OF BUSINESS

        Mr. Cochrane. Thank you for giving me the opportunity to
    talk to you today.
        This wasn't an isolated event. We are in a cycle of ever-
    larger risk taking punctuated by ever-larger failures and ever-
    larger bailouts, and this cycle can't go on. We can't afford
    it. This crisis strained our government's borrowing ability,
    there remains the worry of flight from the dollar and
    government default through inflation. The next and larger
    crisis will lead to that calamity.
        Moreover, the bailout cycle is making the financial system
    much more fragile. Financial market participants expect what
    they have seen and what they have been told, that no large
    institution will be allowed to fail. They are reacting
    predictably. Banks are becoming bigger, more global, more
    integrated, more systemic, and more opaque. They want
    regulators to fear bankruptcy as much as possible.
        We need the exact opposite. We and Wall Street need to
    reconstruct the financial system so as much of it as possible
    can fail without government help, with pain to the interested
    parties but not to the system.
        There are two competing visions of policy to get to this
    goal. In the first, large integrated instructions will be
    allowed to continue and to grow with the implicit or explicit
    guarantee of government help in the event of trouble, But with
    the hope that more aggressive supervision will contain the
    obvious incentive to take more risks.
        In the second, we think carefully about the minimal set of
    activities that can't be allowed to fail and must be
    guaranteed. Then we commit not to bail out the rest. Private
    parties have to prepare for their failure. We name, we
    diagnose, and we fix whatever problems with bankruptcy law
    caused systemic fears.
        Clearly, I think the second approach is much more likely to
    work. The financial and legal engineering used to avoid
    regulation and capital controls last time were child's play.
    ``Too-big-to-fail'' must become ``too-big-to-exist.''
        A resolution authority offers some advantages in this
    effort. It allows the government to impose some of the economic
    effects of failure, shareholders and debt holders lose money,
    without legal bankruptcy. But alas, nothing comes without a
    price.
        Regulators fear--their main systemic fear is often exactly
    the counterparties will lose money, so it is not obvious they
    will use this most important provision and instead bail out the
    counterparties.
        I think the FDIC, as often mentioned, is a useful model. It
    is useful for its limitations as well as for its rights. These
    constrain moral hazard and keep it from becoming a huge
    piggybank for Wall Street losses.
        The FDIC applies only to banks. Resolution authority must
    come with a similar statement of who is and who is not subject
    to its authority. Deposit insurance and FDIC resolution come
    with a serious restriction of activities. An FDIC-insured bank
    can't run a hedge fund. Protection, resolution, and government
    resources must similarly be limited to systemic activities and
    the minimum that has to accompany them.
        Deposit insurance in FDIC resolution address a clearly
    defined systemic problem, bank runs. A resolution authority
    must also be aimed at a specific defined and understood
    systemic problem, and the FDIC can only interfere with clear
    triggers.
        The Administration's proposal needs improvement, especially
    in the last two items. It only requires that the Secretary and
    the President announce their fear of serious adverse effects.
    That is an invitation to panic, frantic lobbying, and
    gamesmanship to make one's failure as costly as possible.
        It is useful to step back and ask, what problem is it we
    are trying to fix anyway? Regulators say they fear the systemic
    effects of bankruptcy. But what are these?
        If you ask exactly what is wrong with bankruptcy, you find
    fixable, technical problems. The runs on Lehman and Bear
    Stearns brokerages, collateral stuck in foreign bankruptcy
    courts, even the run on money market funds, these can all be
    fixed with changes to legal and accounting rules. And
    resolution doesn't avoid these questions. Somebody has to
    decide who gets what. If Citi is too complex for us to figure
    that out now, how is the poor Secretary of the Treasury going
    to figure it out at 2 o'clock in the morning on a Sunday night?
        The most pervasive argument for systemic effective
    bankruptcy, I think, is not technical; it is psychological.
    Markets expected the government to bail everybody out. Lehman's
    failure made them reconsider whether the government was going
    to bail out Citigroup. But the right answer to that problem is
    to limit and clearly define the presumption that everyone will
    be bailed out--not to expand it and leave it vague.
        Here I have to disagree with Mr. Volcker's testimony. He
    said we should always leave people guessing, but that means
    people will always be guessing what the government is going to
    do, leading to panic when it does something else. And let me
    applaud Chairman Frank's statement earlier that no one will
    believe us until we let one happen. I look forward to, not
    necessarily to that day, but to the clearer statement--clearer
    understanding by markets and the government of what the rules
    are going to be the day afterwards.
        [The prepared statement of Professor Cochrane can be found
    on page 57 of the appendix.]
        Mr. Cleaver. We are going to begin the conversation with
    the gentleman from Texas, Mr. Neugebauer, who has an
    appointment that he needs to keep and so we will begin with
    him, and then we will move to the other side.
        Mr. Neugebauer.
        Mr. Neugebauer. I thank the gentleman for accommodating me.
    One of the things that I hope that we all agree on, and I think
    I hear, is that there are no more bailouts. That is bad for
    market discipline, that companies that make bad decisions have
    to suffer the consequences of that. And one of the elements of
    the Republican alternative is that we believe there are ways to
    do that. One is making sure that entities are adequately
    capitalized. But secondly, not having someone choose which
    companies are systemically risky to the marketplace and thereby
    giving them a free pass on their market activities.
        But I want to go to the resolution issue because I think it
    is probably as equally important in restoring market
    discipline.
        One of the things that I am very concerned about in the
    current bill is that it is a wheel of fortune, as I call it,
    when you get to the bankruptcy or to the dissolution of that
    entity. Because if someone is arbitrarily going to just choose
    which people get made whole and which aren't and which people
    get a certain percentage and not follow some orderly discharge
    of those obligations, how am I going to estimate what my risk
    is when I am either buying equity or I am buying security or
    buying debt or I am buying subordinated debt or taking an
    unsecured position or secured position if somebody else is
    going to determine what my position is?
        So the Republican plan quite honestly has designed about,
    as I think Mr. Cochrane was talking about, is that if there
    are--we actually set up a special chapter in the Bankruptcy
    Code, and if there are special powers or additional expertise
    that are needed to make that discharge, but that way everybody
    that is making an investment in an organization knows that if
    this investment does go south, they understand what their
    position is and not relying on the wheel of fortune in some
    cases where if the wheel turns in my direction, I went from an
    unsecured to a more preferential position.
        Your comments, Mr. Cochrane? I will start with you and kind
    of just go down the line there.
        Mr. Cochrane. Yes. I would agree with you. One thing that
    worries me about great power and no rules is precisely that
    means not only is it a wheel of fortune, it is a wheel of
    fortune that answers your phone calls. So there will be a lot
    of lobbying.
        It also means that the game of buying debt becomes not one
    of guessing what is the value of the assets, it is one of
    guessing what am I going to get out of the new resolution
    authority.
        And finally, we are acting as if it is simple. The whole
    reason we are worried about this is that the web of
    counterparties which are systemic, which aren't systemic, who
    should get money, who not, too complicated to think about.
    Well, goodness gracious, it is going to be even more
    complicated to think about it at 2 o'clock on a Sunday morning.
        Mr. Zandi. I agree with many of the things that you said.
    The one thing I worry about and am concerned about is putting
    these institutions into bankruptcy. That has its own set of
    uncertainties as any firm going into bankruptcy and creditors
    know. And the problem is that the uncertainty can drag on for
    quite some time, because of the nature of these financial
    institutions. We don't have the time. So I think we need a
    resolution mechanism that is independent of the bankruptcy
    system. I don't think the system can be fixed to a sufficient
    degree to address those issues, and to take our chances in
    using bankruptcy, of course, for this process would in fact
    create greater uncertainty and cost taxpayers more in the long
    run.
        Mr. Neugebauer. As a follow-up to what you are saying, I
    think what we envision is a separate actually--possibly
    judicially, have special courts to do that, to have the
    expertise to make those decisions relatively quickly so that if
    there is a continuation possibility in that entity that there
    is the ability for someone to make those decisions at that
    particular point in time. It is not much different than the
    resolution concept except that we are going to have an orderly
    disposition in the event of a liquidation and settling that
    everybody understands.
        Mr. Miron?
        Mr. Miron. I would emphasize two aspects of your comments.
    One is I personally think there should be no more bailouts.
    Whatever the resolution system is, whether it is a bankruptcy
    court, a new kind of bankruptcy that no taxpayer money goes
    into it.
        Then the second point is, can we design a bankruptcy
    system, even for nonfinancial firms, that is smoother and
    faster than the current one. The answer is probably, but
    certainly it might be appealing to try to design something
    which is very fast and very smooth, say a default off the shelf
    and last will and testament that you have to create when you
    are incorporated.
        But I also think finally that the risks of the financial
    firm bankruptcies have been exaggerated. I don't say they were
    zero by any means, but I think there was a lot of claiming that
    the sky was going to fall in, which was not based on evidence
    in the historical records. Particularly before 1914, we had
    many, many financial panics. The vast majority were not
    associated with major changes in the economy. They were short.
    They were limited to a few firms and a few cities and the
    economy recovered very quickly.
        Mr. Levitt. You know, it is so hard to be formulaic about
    these issues and to try to define what is in the public mind
    and what isn't.
        When you are going through a panic, and we went through a
    panic, it is scary, very, very frightening. And I wouldn't take
    the position that there will be no more bailouts. We don't know
    what there is going to be or how great the threat is going to
    be. But if the resolution authority is so established where the
    onus is put on both creditors and shareholders they will be, in
    my judgment, in a much better position to evaluate the
    condition of given institutions than any regulator might be. I
    think holding their feet to the fire in that fashion will go a
    long way toward avoiding the kind of calamity that you speak
    of.
        As to the need for a systemic risk overseer in terms of a
    council that would serve as an early warning system, I think
    that makes a good deal of sense. It would be a hands-on group
    that would be led by a presidential employee. As an
    alternative, if the Fed were to get rid of its conflicts--and I
    think they have very profound conflicts which make them a less
    than ideal systemic risk regulator--I think the combination of
    these two could do a great deal to restore public confidence.
        If the public loses total confidence in the system, all of
    our pronouncements about ``too-big-to-fail'' and we can't
    afford the bailout, or what have you, go up in smoke. It is a
    power that should not be underestimated.
        Mr. Cleaver. Thank you. We are going to have votes in maybe
    15 or 20 minutes. I do think we can get all members in if the
    members will use the Reader's Digest version of your questions
    and if you will give the Cliff Notes version of the answer, I
    think we can get through all of these.
        We will begin with the gentlelady from Illinois, Ms. Bean.
        Ms. Bean. Thank you, Mr. Chairman, and to the witnesses for
    sharing your expertise today.
        Many of us have advocated for countercyclical capital
    requirements to avoid the kind of depth and width of the
    downfall that we recently experienced, specifically to
    discourage the type of leverage that we saw. And as Mr. Zandi
    said in his own testimony, if I understood it properly,
    suggesting that when we see a bubble in formation, obviously
    increasing capital requirements will maybe minimize how big
    that bubble gets. In a precipitous downfall we would ease up
    capital requirements as well, which we didn't do, so it doesn't
    get so wide as institutions divest themselves, even in this
    case non-subprime related assets.
        Given that history suggests that regulators, though they
    have the authority to impose those changes, tend not to want to
    be the buzzkill when the party is going, will regulators follow
    guidance from the Feds or does Congress really need to be more
    proscriptive in that regard and require those type of changes
    relative to capital requirements?
        I am asking Mr. Zandi specifically.
        Mr. Zandi. I think it is a reasonable concern based on
    historical experience. Regulators don't step in when they need
    to. It is very difficult to do that. And in tough times, they
    put more pressure on institutions, and it can be
    counterproductive.
        I don't think it should be resolved legislatively. I think,
    though, it can be addressed through the various accounting
    rules that are adopted to try to effectuate a countercyclical
    effort to raise capital standards, various kinds of insurance.
    So I think if you can codify it in the accounting rules, I
    think that would be a more effective way of doing it.
        Once you start legislating it, then it becomes so binding
    that--we don't really know what is going to work well. Part of
    it is going to be experimentation, and it is hard to change
    legislation easily. So I think if you can make sure that the
    accounting rules are set in a way that this is done to your
    satisfaction, then that would be the more appropriate thing.
        Mr. Levitt. I think that is an important point. Accounting
    is really at the heart of much of the problem. We don't really
    know what many of these institutions hold in their portfolios.
    I really believe that we need fair market accounting on the
    part of financial institutions, and I think that a lot of this
    depends upon whether you are a deposit-taking institution that
    engages in transactions involving risk or whether you are not a
    deposit-taking institution.
        I think fair value accounting conveying a clear picture to
    investors of precisely what risk they may be taking is terribly
    important.
        Ms. Bean. Thank you, and I yield back.
        Mr. Cleaver. The gentleman from California, Mr. Sherman.
        Mr. Sherman. Mr. Levitt, you say we shouldn't adopt the
    standard of no more bailouts. The Executive Branch believes not
    only that there should be a capacity for future bailouts but
    that it ought to be orderly. And by orderly, what they mean is
    no further congressional involvement, that if the Executive
    Branch wants to tie up $1 trillion, $2 trillion, and they think
    it is necessary, God, they are good people, they should be able
    to make that decision without the disorderliness that we saw
    last fall where Congress added a bunch of provisions,
    oversight, and even voted it down the first time.
        Do you believe that we ought to give the Executive Branch
    the authority to commit over $1 trillion to bail out
    systemically important firms in a time of crisis without
    further congressional approval?
        Mr. Levitt. I would rather not be specific about that issue
    because again, it is so difficult to be in the eye of the storm
    and find yourself bound by formulaic restrictions.
        Mr. Sherman. Sir, you are an American. Do you believe in
    the Constitution or not? Is your loyalty to Wall Street greater
    than your loyalty to the Constitution?
        Mr. Levitt. I don't think anything in my public life would
    lead anyone to that conclusion, Mr. Sherman.
        Mr. Sherman. Doesn't the Constitution say that
    appropriations are supposed to be made by Congress and that
    Congress doesn't just give the Executive Branch the right to,
    in some future instance, spend $1 trillion, $2 trillion, $3
    trillion of taxpayer money without any congressional
    involvement? Doesn't it bother you as an American?
        Mr. Levitt. I think Congress is intimately involved and has
    been intimately involved in this whole process or we wouldn't
    be sitting here right now.
        Mr. Sherman. Briefing a few congressional leaders is
    constitutionally irrelevant. The Constitution calls for votes
    on the Floor of Congress where even bald guys from California
    get to vote. For you to say that the principles of the
    Constitution are achieved because a few congressional leaders
    are briefed--
        Mr. Levitt. You are putting words in my mouth, Mr. Sherman.
    That is not what I said.
        Mr. Sherman. Perhaps you should speak for yourself.
        Mr. Levitt. You are misinterpreting what I have said. And I
    don't know that this is the appropriate forum to argue about
    constitutional support or constitutional values.
        Of course, I believe in the power of the Congress and the
    power of the people.
        Mr. Sherman. Let me move on.
        There is an argument that the only way we can have
    institutions that are ``too-big-to-fail'' is to have a system
    for bailing them out if they do fail and of course higher
    capital requirements in the hope that they won't. The other
    approach is ``too-big-to-fail'' is too big to exist.
        We could have a rule that said no company can enter into
    contracts which caused them to be liable to American persons in
    excess of 1 percent of the U.S. GDP. This could be binding on
    foreign and domestic firms and so if a firm approached that
    limit, they might choose to break up, otherwise they cannot
    enter into new contracts which obligated them.
        Mr. Cochrane, is it better to have a system of larger and
    larger and larger tier 1 financial institutions where people
    know that if you are one of the top five you have a 50 percent
    chance at least of being bailed out if you get into trouble, or
    is it better to say ``too-big-to-fail'' is ``too-big-to-
    exist?''
        Mr. Cochrane. ``Too-big-to-fail'' is ``too-big-to-exist.''
        Mr. Sherman. Mr. Zandi?
        Mr. Zandi. I am a little nervous about answering, to tell
    you the truth, I think given what happened before.
        My sense is that in theory it would be nice to say that if
    you are ``too-big-to-fail,'' you are ``too-big-to-exist.'' But
    in reality, in practice, that is not going to happen. That
    won't happen. I don't think it is efficient. Our institutions
    won't be competitive globally.
        Mr. Sherman. If we impose on all institutions worldwide the
    same standard; that is, do not have liabilities to U.S. persons
    in excess of 1 percent of the U.S. GDP, that would allow all
    firms, no matter where headquartered, to have the same systemic
    risk to the U.S. economy.
        Mr. Zandi. Two points. One is, why 1 percent? The second
    is, we live in a global financial system. We are not an island
    unto ourselves.
        Mr. Cleaver. Mr. Manzullo, the gentleman from Illinois.
        Mr. Manzullo. Sometimes the hearing that has the fewest
    members turns out to be one of the most unusual. I always enjoy
    somebody who teaches at Harvard and is a senior fellow at the
    Cato Institute. That is interesting. I have big problems with
    the message that we are going to set up the safety net for your
    guys who screw up on Wall Street. I mean, that is how I look at
    this legislation. It has created an America that is looking for
    a bailout for everything. And people are smart enough to
    realize that there is no bailout, that the people who are
    actually either the--probably the water in the buckets are the
    taxpayers who have to take care of this load.
        Why have a piece of legislation, Mr. Miron, that, for
    example, you say in the very last line on page 3 of your
    testimony, ``thus this bill institutionalizes TARP for bank
    holding companies.'' Tell us what is wrong. Just go into depth
    on your statement.
        Mr. Miron. The crucial thing is that under this bill, it is
    not just that we have given the FDIC power to resolve, to
    settle the competing claims, which is similar to what a
    bankruptcy judge does, but we very explicitly said that the
    FDIC can borrow money from Treasury--that is explicitly in the
    bill--can use that money from Treasury to buy the debts of the
    failing institutions, to take equity stakes, to guarantee its
    obligations and all sorts of things.
        Now, there are provisions in the bill where allegedly the
    FDIC is going to recoup that money later on. The way it recoups
    it is truly bizarre. It recoups it by levying fees on all the
    remaining tier 1 financial institutions. So it is kind of like
    the deposit insurance system except it is ex post, not ex anti.
        So the incentive it sets up is for every one of those
    firms, take as much risk as you can, sometimes you will make a
    lot of profit. If you fail and you disappear, then the people
    who pay for that are all of the remaining firms in the
    industry. So of course every firm is going to be thinking that
    way, so they are all going to be simultaneously trying to
    outrisk each other. It is just an unmitigated recipe for
    disaster.
        Mr. Manzullo. There is a new form of capitalism called
    joint and several liability.
        Mr. Cochrane. It also gives them an incentive to make your
    failure as systemically fearful as possible, not just to make
    you get the bailout, but you want to hold a gun to everybody's
    head that you are as dangerous to the financial system as
    possible so that you can get the bailout.
        Mr. Manzullo. Does it bother you that institutions beyond
    financial institutions could be impacted by this legislation?
        Mr. Miron. In what manner?
        Mr. Manzullo. The broad swoop that could bring in a
    nonbank.
        Mr. Miron. Absolutely. First of all, the definition of what
    is an institution covered by this ends up being extremely
    malleable. So GMAC is probably going to come in, and if GMAC is
    in, then somehow General Motors gets in. You are going to have
    people who make toaster ovens who buy a small brokerage service
    firm, put it on their books, and they are covered and they are
    ``too-big-to-fail'' and have access to all of these Treasury
    funds, yes. It is just incredible--it is a blank check.
        Mr. Manzullo. Do you fellows feel that it would have been
    better if these banks and obviously the car companies had just
    filed straight Chapter 11 liquidation? Not Chapter 11, Chapter
    7 or Chapter 11, that would be reorganization and Chapter 7 is
    straight bankruptcy. Use regular bankruptcy laws.
        Mr. Miron. Absolutely. Now, people correctly point to the
    fact that there are all of these counterparty claims that banks
    have and so if one fails it is likely to spill over into other
    institutions. That is exactly right, but that is only half the
    story.
        The other half of the story is it happens a few times and
    all of these banks and nonbank financial institutions are going
    to start taking on fewer counterparty risks. They are going to
    start to hedge better, they are going to take less risks, and
    they are going to start to adjust their behavior so that then
    the spillovers when one fails will not be nearly as extreme.
    And it is going to be painful to get to that point where people
    do business in a different way. But as Chairman Frank said at
    the very beginning, it is not going to start happening until we
    actually stick it to somebody.
        Mr. Levitt. I think the resolution authority is more
    effective than the bankruptcy law in terms of doing the job you
    want done. It is fairer.
        Mr. Miron. It is fairer?
        Mr. Cleaver. I am going to call on the gentleman from
    Colorado, Mr. Perlmutter.
        Mr. Perlmutter. Thank you, Mr. Chairman. Let us sort of get
    back to that last topic. That is the last thing that I need to
    understand.
        Chairman Levitt, how do we resolve broker-dealers?
        Mr. Levitt. How do we resolve?
        Mr. Perlmutter. Broker-dealers.
        We have a court proceeding through a liquidation. How do we
    resolve banks and credit unions? Mr. Miron, how do we liquidate
    banks and credit unions?
        Mr. Miron. The way we liquidate them now in is through the
    FDIC. In the vast majority of cases until recently--
        Mr. Perlmutter. We liquidate them. We liquidate them and
    sell and then we offload whatever are the bad debt and we tried
    to sell them, parcel them out, do something with them.
        Mr. Cochrane, how do we liquidate or how do we resolve
    insurance companies?
        Mr. Cochrane. The key component--
        Mr. Perlmutter. How do we resolve insurance companies? Do
    you know? We liquidate them through the insurance commissioner.
        Now, guys, I am a Chapter 11 lawyer. I did it for 25 years.
    So if the Republicans want to have more Chapter 11, God bless
    them. I just don't see when you are dealing--when you have
    assets that are fairly liquid, whether they are stock
    certificates that you are holding or insurance policies you are
    holding or cash that you are holding, a Chapter 11 doesn't work
    very well because now you are dissipating potentially during
    the course of the reorganization assets that really belong to
    somebody else.
        Now, you know, I have done--I can't tell you how many
    Chapter 11's I have done. And you can see that by taking GM,
    Chrysler, they were able to go through Chapter 11, but they did
    a lot of work proceeding that to do the Chapter 11.
        So, in my opinion, if we have a holding company that may--
    part of the problem is, I think, that we have institutions that
    are just too big and they also have too many products. They are
    stockbrokers, they are insurance companies and they are banks,
    all at the same time. And so now how do we deal with them in an
    orderly way? Everybody is using resolution authority. I call it
    something where we need to have an orderly liquidation. Now, do
    you think we can do that in a Chapter 11, really, Mr. Miron?
        Mr. Miron. Yes. I agree that you are going to end up in
    many cases just liquidating. In some cases, depending on the
    nature of the different things that have been put together,
    some pieces are easily sold off and can operate; some pieces
    were perfectly solvent and profit-making.
        Mr. Perlmutter. So how do you manage those really liquid
    assets that might be a depositor's asset, or it is a bond or it
    is a stock certificate or something? See, the problem is, we
    have--
        Mr. Miron. I don't understand why we don't just sell it to
    the highest bidder. I am confused. Why doesn't it just get sold
    to the highest bidder?
        Mr. Perlmutter. Well, that would be a liquidation. That
    would be a Chapter 7. And I don't mean to--you guys use
    bankruptcy as if it is some general term. You do things
    differently in bankruptcy court.
        Mr. Zandi. Can I make a point? We had a case study of a
    firm that went into bankruptcy, and we saw how well it went.
    Lehman Brothers is a case in point that went into bankruptcy.
    It was a complete mess. It would have been a complete fiasco if
    the government had not stepped in, in response to that.
        I think we saw pretty clearly what bankruptcy does. It does
    not work in the case of these large, very complicated
    institutions, which have very liquid assets that can go out the
    door immediately. It just didn't work and I don't think you can
    fix it to make it work.
        Mr. Perlmutter. I really would like to think that it could,
    okay? Now, I guess maybe I have done too many of them to
    recognize how long some of these things take and how
    complicated they get and how you fight about a particular
    subject in the court when these are the kinds of things that
    require resolution promptly, quickly, for the certainty that
    you are seeking, Mr. Miron and Mr. Cochran, the certainty that
    you are seeking for the marketplace?
        Mr. Levitt. Or the certainty that resolution brings to the
    process by putting the creditors on notice that they, too, can
    lose everything before it happens.
        Mr. Perlmutter. Right. See, I don't want any more bailouts.
    I am with you guys. And I subscribe to the ``too-big-to-fail''
    is ``too-big-to-exist.'' Great. Those are nice goals and
    platitudes. But when you are in an emergency, you are in an
    emergency, and all rules seem to go by the wayside because you
    just have to get the job done and keep the system going. I want
    to separate stockbrokers from the bankers.
        Thank you, Mr. Chairman. I appreciate the time.
        Mr. Cleaver. [presiding] Thank you. Mr. Foster from
    Illinois.
        Mr. Foster. Thank you. First, I would like to second my
    endorsement of Dr. Zandi's endorsement of periodic stress tests
    for potentially systemically important firms. So, for example,
    if specifically, all firms that have balance sheets that exceed
    1 percent of GDP would be required to report in appropriate
    detail what their situation would be like under conditions of
    mild, moderate, or depression-like economic downturn. I think
    this would be a tremendous benefit. If you have comments on
    that, I would be interested in hearing them.
        The second thing I would be interested in hearing your
    comments on is the concept of requiring large firms to maintain
    a living will, essentially a pre-negotiated private sector
    bailout. A variation of this are these reverse convertible
    debentures, if I am pronouncing that correctly, where you
    essentially have things that convert to equity, and requiring
    firms that are approaching ``too-big-to-fail'' to hold a
    significant amount of debt in that form, so that when the
    trigger gets pulled, they automatically have a pre-negotiated,
    as I say, private sector bailout.
        And I think forcing institutions to confront the
    possibility of their demise, having the board of directors vote
    on, yes, this is the plan for dissolving ourselves if we fail,
    could have a tremendously positive cultural impact on Wall
    Street. So I would be interested.
        And finally, the last question is whether any of you are
    aware of anything that is understood about the efficiency of
    our economy as a function of the maximum allowable bank size.
    Like what is the hit in economic growth that we would take if
    we limited banks to certain sizes. If there is anything that is
    known about that academically, I would be very interested in
    hearing about it.
        Mr. Zandi. Well, let me say I think the idea of requiring
    institutions to have a living will as part of that process,
    also engaging in regular stress testing, would be very
    therapeutic. I think it would provide a lot of information to
    the marketplace, and I think it would be very therapeutic for
    the banks. It was actually surprising to me in the stress tests
    that were conducted back in the spring that it was such a chore
    for the institutions; you would think that they would have the
    mechanism for doing things like this. But in fact, they really
    did not.
        I think just going through that process was very
    enlightening for them, for the regulators and for, obviously,
    market participants, and it was very key to turning confidence
    around at a very important point in the crisis. I think it was
    very important and therapeutic. So I think that is vital.
        That is an interesting question about bank size and
    economic efficiency. I don't know of any academic literature,
    but that would be an interesting thing to explore.
        Mr. Foster. It certainly gets mentioned qualitatively.
    Every time we talk about limiting bank size, they say, oh no,
    this would be a disaster for economic efficiency. I would like
    to see the curve of economic efficiency versus bank size
    limits.
        Mr. Cochrane. It is a hard question, and I can't tell you
    the answer, but I can tell you the question. Which is, are
    banks so large because that is the natural--they are more
    efficient by being more large, or are banks more large because
    this gets them better access to bailouts and government
    protection? I have suspicions it is in the other direction, but
    I wish I had better evidence.
        Mr. Foster. Any other comments on this? Then I yield back.
        Mr. Cleaver. Thank you. The gentleman from Texas, Mr.
    Green, is recognized for 3 minutes.
        Mr. Green. Thank you, Mr. Chairman. But, Mr. Chairman, out
    of fairness, I am not sure that this young man has had--
        Mr. Himes. No, no. Go ahead.
        Mr. Green. Thank you. And I will be as terse and laconic as
    possible. Permit me to say that I don't have the time to lay
    the proper predicate, but, Mr. Levitt and Mr. Miron--Mr. Miron,
    following your logic, we would not use the FDIC for banks. We
    would use bankruptcy, following your logic.
        Now, with that aside, I would like to talk about this issue
    of pain that you use rather cavalierly. Pain needs to be
    defined, because pain can mean more than just a loss of money.
    It can also have something to do with the worth of money.
        Mr. Levitt, if you would, the pain of allowing AIG to go
    into bankruptcy, the pain of allowing Bear Stearns to go into
    bankruptcy, the pain of allowing Lehman to go into bankruptcy,
    the pain of allowing the auto industry--Chrysler and GM--to go
    into bankruptcy, what would that pain translate into locally,
    meaning within the United States and globally?
        Mr. Levitt. That pain has a danger that reverberates not
    just throughout the United States, but throughout the world,
    because what you are talking about is the pain of public
    confidence. And that loss of public confidence could lead to
    catastrophic results. So it is very hard to quantify the
    implications of job loss, of the cratering of institutional
    creations that were looked upon as symbols of stability, and it
    just shakes the confidence of the people to its very roots. So
    that is a very, very severe penalty.
        Mr. Green. My final comment would be this--and I will yield
    back. My concern is this; is that we are not paying enough
    attention to each other. My belief is that we all want a
    resolution authority, without spending tax dollars. But for
    some reason, we are saying such that it appears as though the
    other doesn't want it, when I think the folk on the other side
    desire it, and the folks on this side desire it.
        But I do think that there has to be some credence given to
    what Mr. Levitt has said. You can never say never in a world
    that is dynamic. It is not static. I remember Ronald Reagan
    saying that he would never sign a certain piece of legislation.
    He said that his feet--he was sealed in cement. And when he
    signed it, he said what you hear is that cement cracking right
    now.
        My point is, I am with all of you. We should not bail out.
    Never bail out again as long as we live. Don't want to do it,
    shouldn't have done it this time. Never. God forbid, if we have
    to, how do we do it?
        Thank you, Mr. Chairman. I yield back.
        Mr. Cleaver. Thank you. One of the questions that plagues
    me is the whole concept of ``too-big-to-fail,'' which may be
    also ``too-interconnected-to-fail.'' And I don't know if those
    are synonymous, ``too-big-to-fail'' and ``too-interconnected-
    to-fail.'' How do you read those, Dr. Zandi?
        Mr. Zandi. I think they are synonymous. I think you can be
    large, and if your connections are limited, and you are not
    going to affect other institutions, then I think you can be
    resolved in the normal course of affairs. I don't think that is
    significant. But generally, I mean, if you are large and big,
    that means you are interconnected. You can't become large and
    big unless you are. You have all these different relationships
    and moving parts and, therefore, big generally is synonymous
    with--
        Mr. Cleaver. So should we restrict the connectedness?
        Mr. Zandi. I don't think you can.
        Mr. Cleaver. I mean, that prevents the snowball from
    rolling down the hill.
        Mr. Zandi. I don't think you can, because these
    institutions need to have relationships all over the globe in
    different markets, you know; they are providing different kinds
    of products and services to the economy. So I don't think there
    is any logical way of doing that, no.
        Mr. Cochrane. I do think, sir, that you are asking an
    extremely important question that I hope you will ask more and
    more. Too-what-to-fail? Through last year I have heard lots of
    oh, there will be--the world will end. There will be systemic
    risk. And nobody says exactly what is the systemic risk that is
    going to cause the great calamity. Is it too big? Too
    interconnected? What exactly is the problem? Keep asking that
    question, please.
        Mr. Zandi. Well, I could give an answer. Just go back to
    last September and October. It came to such a point that the--
    because of the failure of Lehman, because of the near failure
    of AIG, because of other various events, the Nation's
    nonfinancial commercial paper market was frozen, literally. So
    blue chip companies that make everyday products were on the
    verge of shutting their businesses down. And I know this
    firsthand, because I was getting calls from senior management
    of major retailers saying, ``I am not going to get delivery of
    product to put onto my store shelf because this company can't
    get credit.''
        So that was because of the interconnectedness of the
    financial system, and it bled right to the nonfinancial world,
    literally within a few days.
        Mr. Cochrane. It wasn't just because of Lehman Brothers
    failing.
        Mr. Cleaver. Okay. Under normal circumstances I would like
    to keep going on this, because I am very concerned about it.
    And if I had time, I would like to juxtapose what the Swedish
    Government did with what we did. They separated the troubled
    assets and created--we kind of flirted with this for a moment
    about the bad bank, which is a bad term. But since we don't
    have time, and since I don't want to miss the vote, I
    appreciate very much you sharing with us, and your time and
    your intellect. This has been very, very helpful and
    informative.
        There are some things I am supposed to say. So whatever I
    don't say that I am supposed to say, it is said. The committee
    is adjourned.
        [Whereupon, at 12:35 p.m., the hearing was adjourned.]

                                A P P E N D I X

                               September 24, 2009

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