[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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