[Senate Hearing 111-614]
[From the U.S. Government Publishing Office]
S. Hrg. 111-614
FINANCIAL REGULATION
=======================================================================
HEARINGS
before the
COMMITTEE ON
HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
of the
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
----------
JANUARY 21, 2009
WHERE WERE THE WATCHDOGS? THE FINANCIAL CRISIS AND THE BREAKDOWN OF
FINANCIAL GOVERNANCE
MARCH 4, 2009
WHERE WERE THE WATCHDOGS? SYSTEMIC RISK AND THE BREAKDOWN OF FINANCIAL
GOVERANCE
MAY 21, 2009
WHERE WERE THE WATCHDOGS? FINANCIAL REGULATORY LESSONS FROM ABROAD
----------
Available via http://www.gpoaccess.gov/congress/index.html
Printed for the use of the
Committee on Homeland Security and Governmental Affairs
S. Hrg. 111-614
FINANCIAL REGULATION
=======================================================================
HEARINGS
before the
COMMITTEE ON
HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
of the
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
__________
JANUARY 21, 2009
WHERE WERE THE WATCHDOGS? THE FINANCIAL CRISIS AND THE BREAKDOWN OF
FINANCIAL GOVERNANCE
MARCH 4, 2009
WHERE WERE THE WATCHDOGS? SYSTEMIC RISK AND THE BREAKDOWN OF FINANCIAL
GOVERANCE
MAY 21, 2009
WHERE WERE THE WATCHDOGS? FINANCIAL REGULATORY LESSONS FROM ABROAD
__________
Available via http://www.gpoaccess.gov/congress/index.html
Printed for the use of the
Committee on Homeland Security and Governmental Affairs
U.S. GOVERNMENT PRINTING OFFICE
49-488 PDF WASHINGTON : 2010
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COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan SUSAN M. COLLINS, Maine
DANIEL K. AKAKA, Hawaii TOM COBURN, Oklahoma
THOMAS R. CARPER, Delaware JOHN McCAIN, Arizona
MARK L. PRYOR, Arkansas GEORGE V. VOINOVICH, Ohio
MARY L. LANDRIEU, Louisiana JOHN ENSIGN, Nevada
CLAIRE McCASKILL, Missouri LINDSEY GRAHAM, South Carolina
JON TESTER, Montana
ROLAND W. BURRIS, Illinois
MICHAEL F. BENNET, Colorado
Michael L. Alexander, Staff Director
Beth M. Grossman, Senior Counsel
Jonathan M. Kraden, Counsel
Ryan P. McCormick, Legislative Assistant, Office of Senator Joseph I.
Lieberman
Brandon L. Milhorn, Minority Staff Director and Chief Counsel
Asha A. Mathew, Minority Senior Counsel
Mark B. LeDuc, Minority Legislative Counsel
Clark T. Irwin, Minority Professional Staff Member
Trina Driessnack Tyrer, Chief Clerk
Patricia R. Hogan, Publications Clerk and GPO Detailee
Laura W. Kilbride, Hearing Clerk
C O N T E N T S
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Opening statements:
Page
Senator Lieberman........................................ 1, 39, 73
Senator Collins.......................................... 3, 40, 74
Senator Levin................................................ 5
Senator Tester.............................................. 27, 58
Senator Burris.............................................. 30, 63
Senator McCaskill............................................ 93
Prepared statements:
Senator Lieberman.................................... 344, 357, 361
Senator Collins...................................... 346, 359, 364
Senator Levin with an attachment............................. 349
WITNESSES
Wednesday, January 21, 2009
Eugene L. Dodaro, Acting Comptroller General of the United
States, U.S. Government Accountability Office, accompanied by
Richard J. Hillman, Managing Director, Financial Markets and
Community Investment, U.S. Government Accountability Office,
and Thomas McCool, Director, Center for Economics, Applied
Research and Methods, U.S. Government Accountability Office.... 8
Howell E. Jackson, James S. Reid Jr. Professor of Law, Harvard
Law School..................................................... 11
Steven M. Davidoff, Professor of Law, University of Connecticut
School of Law.................................................. 16
Wednesday, March 4, 2009
Robert E. Litan, Ph.D., Vice President for Research and Policy,
Ewing Marion Kauffman Foundation............................... 42
Damon A. Silvers, Deputy Chair, Congressional Oversight Panel,
and Associate General Counsel, AFL-CIO......................... 47
Robert C. Pozen, Chairman, MFS Investment Management............. 51
Thursday, May 21, 2009
David W. Green, Former Head of International Policy, Financial
Services Authority, United Kingdom............................. 76
Jeffrey Carmichael, Ph.D., Chief Executive Officer, Promontory
Financial Group Australasia.................................... 78
W. Edmund Clark, Ph.D., President and Chief Executive Officer, TD
Bank Financial Group........................................... 81
David G. Nason, Managing Director, Promontory Financial Group,
LLC............................................................ 84
Alphabetical List of Witnesses
Carmichael, Jeffrey, Ph.D.:
Testimony.................................................... 78
Prepared statement........................................... 318
Clark, W. Edmund, Ph.D.:
Testimony.................................................... 81
Prepared statement........................................... 326
Davidoff, Steven M.:
Testimony.................................................... 16
Prepared statement........................................... 143
Dodaro, Eugene L.:
Testimony.................................................... 8
Prepared statement........................................... 105
Green, David W.:
Testimony.................................................... 76
Prepared statement........................................... 311
Jackson, Howell E.:
Testimony.................................................... 11
Prepared statement........................................... 133
Litan, Robert E., Ph.D.:
Testimony.................................................... 42
Prepared statement........................................... 158
Nason, David G.:
Testimony.................................................... 84
Prepared statement........................................... 334
Pozen, Robert C.:
Testimony.................................................... 51
Prepared statement........................................... 304
Silvers, Damon A.:
Testimony.................................................... 47
Prepared statement with attachments.......................... 178
APPENDIX
Congressional Oversight Panel, ``Special Report on Regulatory
Reform,'' January 2009, submitted by Mr. Silvers............... 190
Responses to post-hearing questions for the Record from:
Mr. Dodaro................................................... 341
GAO Report titled ``Financial Regulation--A Framework for
Crafting and Assessing Proposals to Modernize the Outdated U.S.
Financial Regulatory System,'' January 2009, submitted by Mr.
Dodaro......................................................... 366
WHERE WERE THE WATCHDOGS? THE
FINANCIAL CRISIS AND THE BREAKDOWN
OF FINANCIAL GOVERNANCE
----------
WEDNESDAY, JANUARY 21, 2009
U.S. Senate,
Committee on Homeland Security
and Governmental Affairs,
Washington, DC.
The Committee met, pursuant to notice, at 2:07 p.m., in
room SD-342, Dirksen Senate Office Building, Hon. Joseph I.
Lieberman, Chairman of the Committee, presiding.
Present: Senators Lieberman, Levin, Tester, Burris, and
Collins.
OPENING STATEMENT OF CHAIRMAN LIEBERMAN
Chairman Lieberman. The hearing will come to order. Good
afternoon and welcome. As our Nation begins work under our
brand-new President to recover from the worst financial crisis
since the Great Depression, we must ask how and why it
happened. Is the existing U.S. financial regulatory system
adequately equipped to protect consumers, investors, and our
economy?
A new report \1\ by the Government Accountability Office
(GAO) that is the focus of today's hearing lays out a very
persuasive case that the answer to that question is ``no.''
Over time, as the financial services sector has grown, moved in
new directions, or suffered from scandals or crises, Congress
has usually responded in a piecemeal fashion, grafting new
regulatory agencies on top of one another. As a result,
responsibilities for overseeing the financial services industry
are today shared by over 200 different regulatory agencies at
the Federal and State level, not to mention numerous self-
regulatory organizations, such as the stock exchanges.
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\1\ The GAO Report referenced by Chairman Lieberman appears in the
Appendix on page 366.
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GAO's report concludes that our current regulatory
structure is outdated and unable to meet today's challenges and
highlights several key changes in financial markets that have
exposed significant gaps and limitations in our ability to
protect the public interest. Some of GAO's observations are
familiar to Members of this Committee. We have heard over the
years about the careless lending practices that led to the
current subprime mortgage crisis, the increasing number of
overleveraged financial institutions that need to be bailed out
by the government, the failures of credit-reporting agencies to
provide credible ratings for increasingly complex financial
products, and the inability of regulators to uncover or in some
sense respond to the world's largest ever Ponzi scheme.
It gives this Committee no satisfaction to note that some
of these shortcomings were highlighted over 6 years ago in our
investigation both by the full Committee and the Permanent
Subcommittee on Investigations following the collapse of Enron.
And there we noted the inadequacies of the credit-rating
agencies and the failures of regulators to notice the red flags
that warned of massive financial fraud. Rather than
contributing to the stability of financial markets, our
fractured regulatory system seems to encourage financial
institutions to play regulators against one another. New and
complex financial products have been created that bypass these
antiquated regulatory regimes. In some derivatives markets, the
regulation is absent altogether.
All in all, these problems surely contributed to the build-
up of systemic risks and the eventual breakdown in credit and
financial markets in the last year that has put millions of
people out of work, destroyed so much of the savings and home
values of the American people, and broken our economic
confidence in the future.
We have called this hearing today to take a government-wide
look at our existing structure of regulation of financial
services. We have asked today's witnesses--Gene Dodaro, Acting
Comptroller General of the United States, Professor Howell
Jackson of the Harvard Law School, and Professor Steven
Davidoff of the University of Connecticut School of Law--to
tell us if the current regulatory system adequately protects
consumers, preserves the integrity of our markets, and protects
the safety and soundness of our financial institutions.
Given the scope of the crisis we face today on top of the
crises that we have gone through over recent years, including--
and I go back a little further here--the savings and loan
scandals, the dot-com bubble, and the Enron accounting mess
that I mentioned, we think that now is the time to think, not
just about regulatory reform, but about regulatory
reorganization. Personally, I have not concluded if the way to
fix our current system is to establish a single overarching
super-regulatory agency, like that which exists in other
developed countries, if it would be wiser simply to improve the
ability of the existing regulatory bodies, or if the answer is
somewhere in between.
However, what I have concluded is that there are serious
deficiencies in our current patchwork regulatory system, and
before Congress can fix them wisely--and in a way that will not
just respond to the last economic crisis or scandal but prevent
the next one--I think we have to step back and carefully
scrutinize how the pieces would best fit together. And that, I
believe, is what our Committee is well suited to do.
President Obama has declared that reforming the current
financial regulatory structure will be one of his top
priorities in this first year of his presidency, and I think we
all welcome that. Such legislation will come out of the Senate
Banking Committee, although it does touch on agencies that are
regulated by other committees, such as the Finance Committee,
the Agriculture Committee, and the Commerce Committee. However,
I believe that this Committee's unique authority concerning
governmental organization and oversight, as well as the special
investigative power of our Permanent Subcommittee on
Investigations, requires us to get involved in this review and
will enable us to help the Senate reach the right conclusions
about how we restructure our system of financial governance to
prevent future financial crises that can cause terrible
economic pain.
You may ask, how are we going to do this if the bill is not
coming out of our Committee? Well, we certainly can do this
first with a series of hearings and investigations; then
depending on the interest and will of Committee Members, to
express our conclusions in a report, which we will forward to
the Banking Committee; and perhaps, if we are so moved, to
offer amendments on the floor later this year when the fiscal
regulation reform proposal reaches the floor.
In any case, this is a matter of importance and urgency to
our country, and I do believe that we have something to
contribute to the Senate discussion and legislation.
Senator Levin. Senator Burris is here, and I would like to
welcome him, since it is his first hearing.
Chairman Lieberman. Senator Levin notes that Senator Burris
is here. I have to get over a bad habit where I refer to him as
``General Burris'' because we were both Attorneys General, and
we love that title. But, Senator Burris, I really welcome you.
I know of your work, and although you came here, shall we say,
in uncertain circumstances, I know you well enough to know that
you are very well qualified to be an outstanding Member of the
Senate and will contribute greatly to the work of this
Committee. So I am delighted that you have chosen to be on the
Committee, and we welcome you here today.
Senator Burris. Thank you, Mr. Chairman.
Chairman Lieberman. A pleasure. Senator Collins.
OPENING STATEMENT OF SENATOR COLLINS
Senator Collins. Thank you, Mr. Chairman. Let me also add
my words of welcome to our newest Committee Member. I would
also inform the Members of this Committee that we will be
adding Members on the Republican side. I am very pleased that
Senators McCain, Ensign, and Graham will be joining the
Committee as well. So, once again, we will have a great
complement of Members with which to do our work.
Chairman Lieberman. And with that group, I might add,
lively hearings and deliberations.
Senator Collins. This is true, Mr. Chairman.
Mr. Chairman, let me start by thanking you for holding this
hearing today. I spent 5 years in State government overseeing
financial regulation, so I have a great deal of interest in
this area.
The spiraling financial crisis has harmed virtually every
American family. December's job losses were the worst monthly
decline since 1945 and drove the unemployment rate above 7
percent. Individual retirement accounts and college savings
accounts, as well as university endowments and public and
private pension funds, have suffered huge losses. Consumer
credit and mortgage availability have become more restricted.
In the past year, more than one million homes have been
foreclosed upon, and foreclosure proceedings are targeting two
million more. Home prices are still falling, and at least 14
million households owe more on their mortgages than their homes
are worth. The current crisis has its roots in the financial
system, where a combination of low interest rates, reckless
lending, complex new instruments, securitization of assets,
poor disclosure and understanding of risks, excessive leverage,
and inadequate regulation poisoned the normal flows of credit
and commerce.
The financial system itself has not escaped this carnage. A
year ago, American capital markets were dominated by five large
investment firms: Bear Stearns, Lehman Brothers, Merrill Lynch,
Morgan Stanley, and Goldman Sachs. Now they have either failed,
been sold to banks, or have converted to bank holding
companies.
Tens of thousands of banking and investment jobs have
disappeared. A year ago, we thought a ``tarp'' was for covering
your roof after a hurricane. Now the Troubled Asset Relief
Program (TARP), originally touted as a means for the Treasury
Department to buy troubled assets from banks, has morphed into
a mechanism for buying hundreds of billions of dollars in bank
preferred stock and warrants in order to inject capital into
those financial institutions. It is not sufficient for Congress
to continue to infuse new money into the TARP, or simply to
pass an economic stimulus package. We must also ask how to
repair our system of financial regulation to minimize the risk
that another crisis such as this might build up undetected and
unchallenged.
As we consider the options for reform, the GAO's new report
on financial regulation will be a valuable guidebook. It
describes the structure of the current system, explains the
system's inability to cope with shifting circumstances, and
proposes criteria for judging reforms. GAO sums up our
challenge: ``As the Nation finds itself in the midst of one of
the worst financial crises ever, it has become apparent that
the regulatory system is ill-suited to meet the Nation's needs
in the 21st Century.'' That judgment confirms what this
Committee has found in our hearings on commodity speculation
and derivatives trading; that is, there are too many gaps
between jurisdictions, too many financial entities and
instruments that can create huge risks but are largely free
from regulatory requirements, and too little attention paid to
systemic risk.
We now understand that everyday activities by mortgage
brokers, hedge funds, over-the-counter traders, investment
banks, Freddie Mac and Fannie Mae, and others dealing in
mortgage-backed securities, credit default swaps, and other
instruments can create a crisis that affects virtually every
home and business in America. Yet, of the dozen Federal
agencies and hundreds of State agencies that are involved in
financial regulation, it appears that not one is tasked with
detecting and assessing systemic risks. We have seen the
consequences of that flaw. The proliferation of unregulated and
unreported credit default swaps created spider webs of
commitments so that a few failures rippled into the destruction
of major investment banks.
By accident or by design, there are many key players in the
modern regulatory system who are unregulated or lightly
regulated, including mortgage brokers, self-regulating
exchanges and credit-rating agencies, hedge funds, and non-bank
lenders. Without additional transparency into their operations,
a new systemic risk monitor would find its mission difficult to
achieve. These difficulties have become so obvious that it is
now common to hear government and industry officials, as well
as academic experts, calling for a new systemic risk agency or
monitor and for a restructuring of regulatory agencies.
In November, I introduced a bill to correct two other
glaring gaps in our regulatory system: The lack of explicit
regulatory authority over investment bank holding companies,
and the lack of transparency for credit default swaps.
Regulatory reform is absolutely essential to restoring public
confidence in our financial markets. I am convinced we could
continue to invest billions of dollars in banks, but that if we
do not put in place a new, strong regulatory system, the
public's confidence, which is essential to the operation of our
markets, will not be restored. America's consumers, workers,
savers, and investors deserve the protection of a new
regulatory system that modernizes regulatory agencies, sets
safety and soundness requirements for financial institutions to
prevent excessive risk taking, and improves oversight,
accountability, and transparency.
Mr. Chairman, I am going to ask unanimous consent that the
remainder of my statement be introduced into the record since I
realize we have only limited time this afternoon, and I could
go on forever on what is one my favorite issues.\1\ Thank you.
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\1\ The prepared statement of Senator Collins appears in the
Appendix on page 346.
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Chairman Lieberman. Needless to say, I would be interested
in having you go on forever, but without objection, we will
enter the statement in the record.
Senator Levin is the Chairman of the Permanent Subcommittee
on Investigations. He has some thoughts and plans with regard
to the topic of our inquiry today, and therefore, I would like
to call on him on this occasion as well for an opening
statement.
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Well, thank you, Mr. Chairman. Again, I
would be happy to have this time deducted from my question
period.
Chairman Lieberman. Not at all.
Senator Levin. Mr. Chairman, I thank you and the Ranking
Member for holding this hearing. History has proven time and
again that markets are not self-policing. The Pecora hearings
before a Senate committee in the 1930s pulled back the curtain
on the abuses that gave rise to the Great Depression. Hearings
since then have documented a litany of abuses by financial
firms trying to take advantage of investors and markets for
private gain.
In recent years, for example, Congressional hearings--
including by the Permanent Subcommittee on Investigations
(PSI), which I chair--showed how Enron cooked its books,
deliberately distorted energy prices, and cheated on its taxes,
becoming the seventh largest corporation in the country before
its collapse. Our Subcommittee hearings also showed how leading
U.S. financial institutions such as Citigroup, JPMorgan, and
Merrill Lynch willingly participated in deceptive transactions
to help Enron inflate its earnings. Some of our other hearings
of PSI have disclosed that U.S. corporations engaged in
misleading accounting, offshore tax abuses, excessive stock
option payments, and other disturbing practices.
Our hearings in 2007 showed how a single hedge fund named
Amaranth made massive commodity purchases on both regulated and
unregulated energy markets to profit from distorted energy
prices that they helped generate, causing U.S. consumers to pay
more. Subcommittee hearings last year showed how Lehman
Brothers, Morgan Stanley, and others helped offshore hedge
funds dodge payment of U.S. taxes on U.S. stock dividends by
facilitating complex swap agreements and stock loan
transactions. Other congressional hearings have shown how
Countrywide and others sold abusive mortgages, overcharged
borrowers, and offloaded defective mortgage-based securities
onto the market.
Part of the explanation for these recent abuses is a
history of actions that have gradually weakened our financial
regulatory system. Here is a chart, which I guess our audience
can see, but we cannot, so I will quickly read what is on
it.\1\ The chart lists just a few of those actions over the
last 10 years. Some of these actions are the following:
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\1\ The chart referenced by Senator Levin appears in the Appendix
on page 356.
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Back in October 1998, at the request of the Securities and
Exchange Commission (SEC), the Treasury Department, and the
Federal Reserve, Congress blocked funding for the Commodity
Futures Trading Commission (CFTC) regulation of over-the-
counter derivatives.
In 1999, the Gramm-Leach-Bliley Act repealed the Glass-
Steagall Act of 1933, which separated banks, broker-dealers,
and insurers.
In December 2000, the Commodity Futures Modernization Act
prohibited swaps regulation, and opened the Enron loophole
allowing unregulated energy markets for large traders.
In August 2003, the SEC delayed requiring auditors of
private broker-dealers to register with Public Company
Accounting Oversight Board rules.
In June 2004, the SEC weakened the net capital rule for
securities firms.
In June 2006, the Court of Appeals invalidated the SEC
regulation requiring hedge fund registration. We needed the SEC
to come back to us and to ask for legislation. That did not
happen.
In December 2007, the SEC allowed foreign companies trading
on U.S. exchanges to use international financial reporting
standards without a reconciliation to U.S. generally accepted
accounting principles.
And these are just a few of the actions which have been
taken.
It hasn't been all one way, although it has mostly been one
way. After the Enron scandal, we were able to enact the
Sarbanes-Oxley Act that strengthened oversight of the
accounting profession, required stronger financial controls,
and made a number of other improvements. Last year, we
successfully closed the Enron loophole which barred government
oversight of electronic energy markets for large traders. There
is still more reform in that area needed. But, overall,
stronger market regulation has been the exception, not the
rule, and had to be won despite naysayers claiming that markets
work best with minimal regulation. The current crisis shows
that minimal regulation is a recipe for disaster, an overhaul
of Wall Street regulation is long overdue, and Congress needs
to act now to fix a broken system.
As Congress and the new Administration begin the work of
financial restructuring and our Committee begins to examine
these issues, I just want to briefly offer a few observations
about needed financial reforms. The first is that Congress
needs to put a cop on the beat in every financial market with
authority to police every type of market participant and
financial instrument to stop the abuses. We need to eliminate
the statutory barriers, for example, that prohibit Federal
regulation of credit default swaps, hedge funds, and derivative
traders. We need to enact new limits on high-risk activities
including preventing banks from running their own hedge funds
and requiring the end of abusive offshore activities. Congress
also needs to reduce the concentration of risk to the taxpayer
by preventing any one bank from holding more than 10 percent of
U.S. financial deposits, and to institute new protections to
stop financial institutions from profiting from practices that
abuse investors and consumers. I believe that we need to act on
the substance of these abuses and to fill these gaps.
Finally, Mr. Chairman, let me just add one other thought.
The Chairman and Ranking Member are undertaking a very
important mission, which is to look at the structure of the
regulations because that is within the jurisdiction of this
Committee. And I do not want to, in any way, minimize the
importance of that effort. But we also need to make sure that
this effort puts additional pressure on the committees that
have the substantive jurisdiction to take the steps necessary
to close the gaps that have been created in this system, the
regulatory gaps so big that some of the greediest members of
our society have been able to very easily walk through the
gaps, making billions of dollars for themselves.
And so, again, I want to commend you, Mr. Chairman. This is
the more difficult part of the effort, the structuring part,
and it is important to try to reach conclusions as to which
agency is the proper agency to do the regulation. That is the
who. But I believe the more urgent item, which I hope this
effort will help support, is not so much the who, as important
as that is; it is the whether--whether we are going to get a
cop back on the beat. And this effort of our Chairman and our
Ranking Member is, I know, aimed at supporting that goal
because both of them have expressed and through their actions
on this Committee have indicated the importance of the
substantive reforms that need to be made to fill the gaps that
have been created and the holes that have been gone through by
too many greedy folks. And I want to commend you, Mr. Chairman,
and our Ranking Member, Senator Collins, for your effort.
But, again, I just think we have to make sure that our
effort in some way supports the critical substantive changes
which both of you have spoken about, introduced legislation on,
and fully support. I thank you.
Chairman Lieberman. Thanks, Senator Levin. Your statement
means a lot to me. I appreciate what you have said. That is
exactly what we hope to do. Your support obviously will help us
to do that. I think we can, through these hearings, both learn
and educate others, and then reach conclusions which can help
us to be advocates for the most effective regulation of the
financial sectors of our economy that we are capable of doing.
I like what Senator Levin says, and if I may again go back
to our earlier days as attorneys general, Senator Burris, there
is a role within the chamber for advocacy among our colleagues
for the most comprehensive and toughest regulation in this
particular area because so much suffering has resulted from the
lack of such.
Thanks, Senator Levin.
Let us go right to our witnesses now. First we are going to
hear from Gene Dodaro, who, as I mentioned, is Acting
Comptroller General. I will say for the record that Mr. Dodaro
is accompanied by Richard Hillman, Managing Director of the
Financial Markets and Community Investment Section of GAO; and
Thomas McCool, Director of the Center for Economics, Applied
Research, and Methods within GAO.
Thanks for being here. Thanks for an excellent foundational
report, which we ask you to testify on now.
TESTIMONY OF EUGENE L. DODARO,\1\ ACTING COMPTROLLER GENERAL OF
THE UNITED STATES, U.S. GOVERNMENT ACCOUNTABILITY OFFICE,
ACCOMPANIED BY RICHARD J. HILLMAN, MANAGING DIRECTOR, FINANCIAL
MARKETS AND COMMUNITY INVESTMENT, U.S. GOVERNMENT
ACCOUNTABILITY OFFICE, AND THOMAS MCCOOL, DIRECTOR, CENTER FOR
ECONOMICS, APPLIED RESEARCH AND METHODS, U.S. GOVERNMENT
ACCOUNTABILITY OFFICE
Mr. Dodaro. Thank you very much, Mr. Chairman. Good
afternoon to you, Ranking Member Senator Collins, and other
Members of the Committee. We are very pleased to be here today
to assist your deliberations on the financial regulatory
system.
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\1\ The prepared statement of Mr. Dodaro appears in the Appendix on
page 105.
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As was mentioned, our report was intended to provide a
foundation for how the system has evolved over the last 150
years, what changes have occurred in the markets that have
challenged that regulatory system and caused some of the
fissures that we have seen, and to put forth a framework for
helping the Congress craft and evaluate proposals in order to
modernize the system. Our basic conclusion is the system is
outdated, it is fragmented, and it is ill suited to meet the
21st Century challenges.
Now, there are many reasons why we come to that conclusion
in the report, but I will highlight three main points right
now.
First is that regulators have struggled and often failed to
address the systemic risk of large financial conglomerates or
to adequately ensure that those entities manage their own
risks. Now, over the last two decades, financial conglomerates
have developed through mergers and acquisitions, and they have
developed and gotten into banking, securities, insurance, and a
wide variety of services. And while this has occurred,
basically our financial regulatory structure has remained
relatively the same, set up on a functional basis. This has
caused tremendous coordination problems, which are documented
in some of our reports, and raises questions about the
authorities and the tools available to regulators in order to
address these concerns.
A vivid example is the difficulty and the ultimate failure
of the SEC's consolidated supervision program, which failed to
address the holding company risk of many of the investment
banks over this period of time. Our reports have also
documented some of the challenges that the Office of Thrift
Supervision had in managing such--or regulating holding
companies activities of the type that AIG had conducted.
The second major trend is the fact that the financial
regulators have had to deal with now some of the problems that
have been created by entities that have been less regulated.
These include the non-bank mortgage lenders, the hedge funds,
and the credit-rating agencies.
For example, just to give you some significance of the size
of this, in 2006, for the mortgage origination loans for
subprime and non-prime entities, of those 25 institutions that
made those loans, which made up about 90 percent of all loans--
it is about $543 billion in loans. Of the 25 entities, only
four were not non-bank lenders. So you had a lot of activity
going on that was growing over this period of time that was not
subject to the same type of regulation that commercial banks
were experiencing during this period of time.
The third trend was the emergence of a wide variety of
complex financial products, as has been referenced here in the
opening statements: Collateralized debt obligations, credit
default swaps, over-the-counter derivatives, and mortgage
products that were innovative and did not have the type of
disclosures that were needed. All this confused investors and
others and complicated attempts to have a complete picture of
this.
The other conclusion that we come to is there is no one
central entity that is basically charged with looking at risk
across the system, and this is a major deficiency in the
current structure that needs attention.
Our view is that reform is urgently needed, and unless it
is approached and dealt with soon, the vulnerabilities that we
have all talked about this morning are going to continue to
remain in the system. And that just can't be as we go forward
as a country and try to stabilize the system and move forward
in economic development.
Our framework is intended, though, to say a couple things.
One, the reform needs to be approached in a comprehensive
manner so that we do not react as a country, again, in a
fragmented approach. And our nine characteristics that we set
out are intended to help in that regard to make sure that all
critical elements are addressed.
Those nine characteristics deal with a couple of very
important topics. I will just highlight a few quickly.
First, we believe there need to be a clear articulation of
the goals of the regulatory system set in statute. That would
provide consistency over time and also enable Congress to hold
the regulators accountable for achieving those results.
It has to be appropriately comprehensive, another
characteristic. We need to close the gaps with some of the
large entities that are posing risk and many of the products.
We have to move to both cover the entities as well as the
complexity of these financial products.
It has to be systemwide. Somebody needs to be in charge of
monitoring the system and focusing on the development of risk
going forward. We all know where the risks are now, but they
are likely to change over a period of time. So we need to close
the gaps and put a process in place to monitor this on an
ongoing basis.
It needs to be flexible and adaptable. We need innovation
to allow for capital formation, but somebody has to make
determinations on what the level of risk is that is acceptable
with those innovations and make some early decisions and not
wait until the consequences have become so dire over time.
We need to have an efficient system. There is a lot of
overlap right now. The overlap can be dealt with as part of the
reform.
There need to be strong consumer protections. It is clear
from our work and the work of others, as referenced in Senator
Levin's comments and the opening statements both by the
Chairman and Ranking Member, disclosures have not been
adequate.
There also needs to be greater attention to financial
literacy efforts. We have looked at the entity that has been
put in place in the Federal Government to provide that, but it
has not been resourced properly, and not enough attention has
been given to that particular area.
We have to make sure that the regulators are independent,
resourced properly to preserve that independence, and given the
necessary authority to move forward.
And, finally, we need to protect the taxpayers. Any risks
that occur in the future should be borne by the entities being
regulated and not by the taxpayer. That needs to be our goal,
and we need to minimize taxpayer exposure so we do not go
through again what we are currently going through across the
country.
This is a very important initiative. GAO is pleased to
assist this Committee and stands ready to help this Committee
and the Congress deal with these very important issues and
decisions going forward. And my colleagues and I would be happy
to answer any of your questions at the appropriate time this
afternoon.
So thank you very much.
Chairman Lieberman. Thanks very much, Mr. Dodaro. That is a
very good beginning for us.
We are grateful that Professor Howell Jackson from Harvard
is here, and we are also grateful that President Obama and the
new Administration are not taking everybody from the Harvard
Law School faculty. [Laughter.]
In fact, if I am correct, the President's nomination of
Dean Elena Kagan to be Solicitor General has moved you now to
be the Acting Dean of the Law School. Is that right?
Mr. Jackson. That is true.
Chairman Lieberman. If so, I congratulate you and wish you
well. Thanks for your testimony. We will hear it now.
TESTIMONY OF HOWELL E. JACKSON,\1\ JAMES S. REID JR. PROFESSOR
OF LAW, HARVARD LAW SCHOOL
Mr. Jackson. Thank you very much. It is a pleasure to be
here, Senator Lieberman and Senator Collins. I am delighted to
have a chance to participate in this hearing and begin the
process, I hope, of genuine and serious regulatory reform in
this country, which is long overdue.
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\1\ The prepared statement of Mr. Jackson appears in the Appendix
on page 133.
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Let me begin by just commending Government Accountability
Office for its fine report. I think it does an excellent job
both pulling together its prior work on the subject and also
laying out the major weaknesses in our regulatory structure.
And I agree with almost everything that is in the report. The
regulatory gaps that exist have created serious problems for
our economy. There is a serious mismatch between our regulatory
structure and the 21st Century financial services industry,
particularly to the extent that financial conglomerates
dominate and are able to play off different regulatory agencies
against each other and find this unregulated space to expand
products.
I think that one of the things the report highlights in
passing that is important to recognize is the world has really
moved ahead of us in the area of regulatory reform. If you go
around the major countries and look at the legislation that
they have been adopting over the past 5 to 10 years, it has all
been a movement towards consolidated supervision that puts us
at a serious disadvantage.
We have the anomalous situation in this country of having
the world's most expensive regulatory structure in both
absolute terms and relative terms, but one that has failed to
provide us the kind of protections that we need. So this
Committee's agenda is very much in need of setting an agenda
for the whole Congress.
What I thought I would do is comment upon five areas in
which I thought it would be useful to discuss some of the
ramifications of the GAO study in areas where I think the
weaknesses are particularly important for this Committee to
note.
The first has been touched upon, and I just want to talk
about it a little bit more, which is the absence of a market
stability regulator, something that Senator Collins mentioned,
and it is certainly the case that this is a problem.
The Federal Reserve Board was set up to be our market
stability regulator in a time when systemic risks were thought
to lie solely with depository institutions, with banks, and
having a lender of last resort function, oversight of bank
holding companies, and member banks was thought to be an act of
protection, and I think in the middle of the 20th Century that
was the case. Since the middle of the 20th Century, the role of
depository institutions has declined. Other sectors, most
notably capital market sectors, have expanded dramatically. And
it is not surprising today that when we look to see where the
system risks came from, they came from other sectors of the
economy. They came from the investment banking sector; they
came from the over-the-counter (OTC) derivatives area; they
came from innovations in mortgage lending--all things that were
not contemplated in the past. And so we need to have a
regulator of market stability that can see all potential
sources of regulatory risk, including insurance companies and
other areas of the economy.
I think that it is appropriate to think of the Federal
Reserve Board as the candidate for having that expanded power,
and I know today is not the day to talk about the exact
structure of regulatory reform. But I would just point out five
areas of weakness with the current oversight of market
stability. One is the cramped jurisdiction that the Federal
Reserve Board has, now limited to a certain number of areas,
not including insurance companies, not including many other
areas of importance systemic risk.
Another problem is the manner in which the lender of last
resort powers are structured. It has been remarked by many
people that the Federal Reserve Board had to operate at the
boundaries of its powers. Now, I think it acted legally, but it
was constrained in how it provided liquidity in the past 6
months. I think that is something that needs to be clarified in
regulatory reform.
I think, as was just alluded to by Mr. Dodaro, the
mechanisms for ensuring that the costs of systemic risk are
borne by the sectors of the industry that generate those
problems is an important weakness of our current structure. The
systemic intervention powers of the Federal Deposit Insurance
Corporation (FDIC) are charged back to the banking sector if
they are used. The TARP has an aspirational provision for
recouping some funds, but we need to have a comprehensive
approach to recouping funds to make sure that the incentives
are right in the financial services industry, that they will
bear the cost of systemic risk when they arise.
I think it is also important to recognize that the Federal
Reserve Board needs to expand its expertise to go beyond the
traditional areas of jurisdiction. The crisis with AIG and the
investment banks show that it needs to have broader expertise
and greater personnel skills in many areas that are not
traditionally supervised. Whether you want the Federal Reserve
to be a comprehensive supervisor I think is a difficult
question of regulatory design, but I think if it is going to be
the market stability regulator, it has got to expand its
knowledge in certain areas.
There may well be things that the Federal Reserve currently
does that it does not need to do in the future that should be
reassigned to other places. But if we are going to have an
effective market stability regulator, we need to think more
broadly about the powers of the Federal Reserve.
Finally, it is important to recognize that many of the
solutions to systemic risk and market stability need to be done
on the front end. The regulation of clearing and settlement
systems, limitations on investments, problems generated by the
number of investments in Fannie Mae and Freddie Mac
securities--these are all ordinary supervisory issues, and we
need to have a mechanism where the market stability regulator
can speak to the front-line regulators and, in my view, have a
veto or an override if it thinks those other regulators are not
addressing market stability issues. It is a weakness in the
structure that the Federal Reserve comes in after the fact, not
in front, and it is inevitably more costly to correct things
after the fact, and that is a weakness.
Let me go on to just mention a couple of other areas of
weakness that I think it is worthwhile for this Committee to
focus on, and the second one that I want to mention is actually
Congress' role in the current difficulties, or at least the
statutory structure that Congress has helped create.
We have a regulatory system that has lots of legalistic
divisions in regulatory authority, where the boundaries are
written in very cramped ways, every regulator has its
jurisdiction, and each regulator is jealously guarding its
jurisdiction against other regulators. That leads to a
situation where the industry can play regulators off against
each other and exploit regulatory loopholes, and the regulators
are inherently at a disadvantage.
One of the items on Senator Levin's list was the failure of
the SEC to oversee hedge funds. That was a decision by the
Court of Appeals of the District of Columbia based on an
interpretation of statute. Now, I don't agree with the
interpretation of the court in that case, but it was a problem
for the SEC that it had no jurisdictional authority.
One of the things that we need to do in regulatory reform
is to create broad jurisdictional mandates so that the
regulators have the power to go into areas and do what needs to
be done rather than having cramped constraints.
The division of regulatory authority is also totally clear
in the problems of the mortgage banking industry. If you look
at the regulatory structure that we have created in this
country, the Department of Housing and Urban Development (HUD)
had a piece of consumer protection for mortgage loans. The
Federal Reserve Board was responsible for subprime loans. There
were at least five Federal agencies in charge of depository
institutions that were making the loans. The SEC was
responsible for the securitization process in the credit-rating
agencies. State regulators had some powers over mortgage
brokerage transactions. And actually just this last summer, we
created a new licensing process for mortgage brokers.
It is no surprise that in a regulatory structure that is so
fragmented no one saw the homeownership problem arising, and
that there is no single agency to point to for responsibility
after the fact.
Another area that has been alluded to already this
afternoon but I would like to mention is the problem of
regulatory expertise and competence. This is, I think, most
apparent if one looks around the world and sees what happens
when other regulatory agencies are consolidated together. And
one of the things that happen is the quality of personnel that
is willing to work in the regulatory agencies goes up.
Professionally, it is a broader mandate. There are more
professional experiences. There are fewer positions that are
taken by political appointees. It is a more attractive career
position that attracts higher-quality personnel when we have a
broader mandate.
I think it is also the case to recognize that when you have
a narrow regulatory function, it is hard to have expertise in
every area. So the failure of Bear Stearns actually is a pretty
good example of this because when the investment bank was
getting into trouble, the SEC had to look to the Federal
Reserve Bank of New York to get the personnel it needed to
understand the problems. The Federal Reserve Board has a large
number of economists that study banking issues in great detail,
but the SEC has never had that kind of expertise, and it has
lacked the bench strength to address many of the problems
before it.
So we have a mismatch of personnel. We have an inability to
move personnel from one sector to the other, which seriously
constrains us in terms of risk and is a weakness of our system.
Another weakness of the fragmented system is the
vulnerability of specialized regulatory agencies to the problem
of regulatory capture. If you are an agency and you just
regulate one sector of the financial services industry or one
subsector, you are much more likely to identify with the
success of your constituent institutions. So I would say the
Comptroller of the Currency and the Office of Thrift
Supervision, in order to make the national charters more
attractive, cavalierly preempted State law of consumer
protection, to the great detriment of the consumers of the
regulated banks, and also making the task of State regulators
much more complicated as Federal entities were coming in with
preemption and State entities were being subject to full
regulatory structure.
I think there are many reasons one can explain that, but
part of the reason was the agencies much too much identified
with their constituents rather than thinking about what was in
the best interest of the economy and the general public.
I think in the area of consumer protection, this has
already been touched upon, but to the extent this Committee is
looking at shortcomings of consumer protection, I think the
fragmented regulatory structure is also a source of concern
here. There are lots of functionally similar products that are
regulated in different ways because different regulatory
agencies have expertise over them. If you are a clever
attorney, you can make an insurance product look like a
securities product or a banking product look like an insurance
product or an insurance product look like a securities product
and get a different regulatory structure. And there are many
examples of repositioning to take advantage of marginal
differences in regulation. That confuses the consumer, and it
creates inconsistent protections across the financial services
industry.
In the area of financial education, which I think is
tremendously important, in the end we depend on consumers to
understand the products, and we need to have those consumers be
educated. There is ample academic evidence that shows that less
educated consumers make poor choices, take worse mortgages,
have worse credit card terms. So financial literacy is a major
goal, but it cannot be done on a piecemeal basis. We cannot
have 200 different agencies engaging in financial education. It
needs to be a centralized function. It needs to be a function
that attacks the problem of financial literacy in a
comprehensive way. It needs to interact with the educational
system. That needs to be centralized, and fragmented financial
education really is no financial education.
The final point of weakness that I want to mention is also
covered in the GAO report, but it is just worth noting. We live
in an increasingly globalized financial market, and a major
task of financial regulators is to interact globally, to work
with regulators overseas. And there are a variety of reasons
for this. Among other things, we need to make sure that
transactions are not just escaping overseas and obtaining lower
regulation in other jurisdictions, but there is cooperation
that needs to be done in terms of enforcement actions,
memoranda of understanding, and working out consistent
regulatory systems.
Our fragmented regulatory system is poorly suited for this
task, having multiple entities going overseas to interact with
unified regulators in other countries. When you are overseas,
it is a common complaint about the United States that you
cannot talk to one person, you have to talk to a dozen people.
There are monthly visits by different regulators from the
United States to London, to Tokyo, to Hong Kong, and it is an
ineffective and inappropriate system.
In many areas, such as in the banking area, we have
multiple regulators representing the United States on the same
issues. That complicates negotiations, makes it more difficult
to work with our allies, and is a serious impediment to
effective regulation. So I think the interactions on the
international side are a separate area of concern that one
should look for.
I should say in this area, since it is in the Committee's
mandate, there is a lot of expertise internationally on how to
do regulatory reform. Many other jurisdictions have gone
through the process, and I think particularly the British model
is one to look at for some very interesting examples of
structuring the reform, which very much needs to be done.
Let me just close by saying the current financial situation
is a challenge on multiple levels for this country, and for the
most part our task is regaining our economic strength and
trying to restore lost value to the people of this country. The
one silver lining to the current crisis is it gives us an
opportunity to reform our regulatory structure. That is
something that has long been overdue. It has been a difficult
political task to take on. But we finally have the opportunity
to address a problem of a major sort for the United States, and
I hope this Committee will take leadership in addressing that
concern. Thank you very much.
Chairman Lieberman. Very well said. Thank you.
Professor Steven Davidoff is on the faculty of the
University of Connecticut School of Law. I think I overheard
you say you had been at Michigan before.
Mr. Davidoff. Wayne State University Law School.
Chairman Lieberman. Wayne State, so you claim you do not
have any connection with the State of Maine?
Mr. Davidoff. No. But I have been there many times, and it
is a lovely place. [Laughter.]
Senator Levin. And you apparently still have a place in Ann
Arbor?
Mr. Davidoff. Sadly, I have a house in Ann Arbor that I am
unable to sell. [Laughter.]
Chairman Lieberman. Senator Levin raised this subject.
Mr. Davidoff. It is not Senator Levin's fault.
Senator Levin. I did not know that part or else I would not
have gotten into it. But Wayne State University Law School, if
I could say, Mr. Chairman, is the law school where my wife
graduated. She is a lawyer.
Chairman Lieberman. Well, that speaks for the quality of
the law school.
Mr. Davidoff. It is the true public law school of Michigan.
Chairman Lieberman. Senator Levin is known for his
constituent service, and I am sure he will do anything he can
to help you sell your house in Ann Arbor. [Laughter.]
Mr. Davidoff. I like my house. Ann Arbor is a lovely place.
Chairman Lieberman. With all of that, Mr. Davidoff, I am
proud that our staff search for experts in this happily led us
to somebody who is now at the University of Connecticut Law
School. Please proceed.
TESTIMONY OF STEVEN M. DAVIDOFF,\1\ PROFESSOR OF LAW,
UNIVERSITY OF CONNECTICUT SCHOOL OF LAW
Mr. Davidoff. Thank you. Chairman Lieberman, Ranking
Minority Member Collins, and other Members of this Senate
Committee, I want to start by thanking you for providing me an
opportunity to testify today.
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\1\ The prepared statement of Mr. Davidoff appears in the Appendix
on page 143.
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I would like to start by agreeing with the uniform
sentiment expressed today that today's financial regulatory
architecture is fractured, archaic, and ill suited to today's
modern financial world.
What I would like to do in my testimony is fill out the
excellent GAO report by providing a short narrative of the
deficits of the past few years, which aptly illustrates the
failures of the regulatory system and its current fractured
nature. I want to start with the root causes of the financial
crisis.
The causes of the current financial crisis are still the
subject of much study and debate, and will remain so long after
Congress acts on any financial reform. Nonetheless, at this
point, 18 months into the crisis, we have a rough sketch. In
summary, historically low interest rates led to excessive
borrowing by both individuals and financial institutions. The
consequence was the rapid rise of housing prices. These prices
were increased by demand from so-called subprime borrowers.
During the period from 2000 through 2006, the amount of
outstanding subprime mortgage debt grew an astounding 801
percent to $732 trillion. These loans were often issued and
underwritten under the assumption that ``housing prices do not
fall.'' The assumption proved all too incorrect. And it is now
all too clear that in many instances borrowers were placed into
loans that they cannot now afford.
Theoretically, bankers should have been more concerned with
whether their loans would be repaid. However, the traditional
``It's a Wonderful Life'' banking model where lenders and
borrowers passed each other on the street and lenders
personally assessed the creditworthiness of their clients has
long past. Mortgages are now securitized into asset-backed
facilities called collateralized debt obligations (CDOs), and
sold into the market. Lenders now serve as intermediaries in
this ``originate to distribute'' model and are more concerned
with the ability to sell these loans rather than whether they
are repaid. Many of these lenders, particularly for subprime
mortgages, were non-bank lenders subject to differing oversight
and regulation than their bank counterparts.
It is now clear that this new securitization process
allowed for lax lending standards. In 2005, the SEC contributed
to this by liberalizing the registration process for these
securities. At that time, the SEC discarded the obligation of
underwriters of CDOs to perform due diligence on these CDOs to
confirm adequate loan documentation. In essence, for those CDOs
that were registered, the SEC relied upon private underwriters
to uphold standards. Here, the underwriters also procured a
private ratings agency to rate the CDO's tranches. Notably,
though, the SEC, due to regulatory restrictions, was only
responsible for regulating affirmative disclosure in the
securitization process when the underwriter chose to register
the securities. In no instances, as Professor Jackson
highlighted, was the SEC responsible for the mortgage
origination process or disclosure. In fact, financial
disclosure, again as Professor Jackson highlighted, is subject
to multiple regulatory agencies, none of which have the primary
goal of consumer financial disclosure.
In addition, under the Credit Rating Agency Reform Act, the
SEC was affirmatively denied the ability to regulate the
procedures and methodologies by which any rating agency
determines credit ratings. In hindsight, the SEC and other
financial regulatory agencies lacked complete oversight over
the mortgage securitization market, and it was a market that
was, at best, subject to overlapping and conflicting
regulation. This allowed market failure as lenders, rating
agencies, and borrowers all contributed to lax borrowing
standards and the taking of excess risk, the consequences of
which we are now dealing with now.
During the period from August 2007 through March 2008,
banks rushed to recapitalize their balance sheets from private
investors. Nonetheless, the week of March 11, 2008, Bear
Stearns collapsed. In hindsight, the largely unregulated
investment banking model was overly susceptible to shock.
Unlike bank holding companies, investment banks historically
had a leverage model ranging from 20:1 to 30:1 and relied on
short-term, highly movable deposits for liquidity. These
deposits came from hedge funds, for the most part--
sophisticated financial institutions that could quickly move
their assets in the case of a crisis, and this is what they
did, leading Bear Stearns to lose liquidity and into a forced
sale.
The fall of Lehman Brothers was due to similar factors. At
the time, there was a significant outcry that the failing of
Lehman and perhaps Bear Stearns was due to shorting of their
stock in the market and the crisis in confidence it created. In
some cases, it has led to cries for regulation of the credit
default market and a prohibition on shorting. Credit default
swaps (CDSs), notably, were deliberately legislated to be left
unregulated by Congress in the inaptly named Commodity Futures
Modernization Act. The veracity of these claims about shorting
and CDSs is unknown at this point. But, in fact, due to the
lack of information about trading in the CDS market, I doubt
anyone will ever be able to definitively conclude one way or
the other on this point.
The full role of derivatives generally in the financial
crisis still appears uncertain. Certainly in some
circumstances, derivatives increased risk, heightening the
impact of the rapid decline of the CDO market. More certainly,
AIG was brought down because of underwriting of credit default
swaps out of a London-based subsidiary. AIG was able to
leverage a regulatory gap. It was regulated by the Office of
Thrift Supervision as a savings and loan holding company
because of AIG's control of a thrift, but AIG was not subject
under this regulation to the same scrutiny or heightened
requirement it otherwise would have been subject to had it been
a bank holding company.
Furthermore, the Inspector General of the SEC issued on
September 25, 2008, a report on the SEC's now defunct voluntary
regulation program of the five investment banks, the voluntary
Consolidated Supervised Entity (CSE) program. The program was
doomed to fail and understaffed from the start. Three SEC
employees were assigned to monitor each bank with tens of
thousands of employees. The SEC never conducted appropriate,
in-depth inspections as to risk measurement, capital liquidity
sources, and other disclosure for these investment banks.
This was true even after Bear Stearns fell. The investment
banks were able to leverage a regulatory gap to avoid in-depth
scrutiny of their leveraging and risk processes and be
regulated to the same level as bank holding companies are.
I want to spend the next few minutes just talking about the
government response to the financial crisis and, again, how it
illustrates the fractured nature of today's regulation and
regulators.
Initially deprived of statutory ability to fully address
the crisis, the government would engage in what Professor David
Zaring and I call ``regulation by deal'' in order to attempt to
salvage the financial system. In a series of transactions, the
government nationalized Fannie Mae and Freddie Mac, bailed out
AIG, and arranged for the sale of Wachovia and the banking
deposits of Washington Mutual. Then with the passage of the
Emergency Economic Stabilization Act and the adoption of the
TARP program, the Treasury Department agreed to invest--or
force financial institutions to invest, depending upon who you
speak to--$125 billion in the country's nine largest financial
institutions.
Since that time the government has been administering the
TARP; along the way the bailout of AIG has been reworked, Citi
and Bank of America have received a second set of TARP funds--
$90 billion in total--and General Motors (GM) and Chrysler have
also received TARP funds under the automotive component of
TARP. Meanwhile, just today Treasury Secretary nominee, Timothy
Geithner, part of the prior team, announced his desire to
rework the entire program.
Each of these deals has been on different terms and
structured seemingly on an ad hoc basis, without any
organization or systematic approach. From news reports in the
Wall Street Journal and other sources, it appears that the
coordination of the FDIC, Treasury, and Federal Reserve on
these individual bailouts was sometimes strained by
disagreement over each of their regulators' role and statutory
capacity. This may have contributed to the ad hoc nature of the
government's response. The statutory limitations on these
agencies, as Professor Jackson alluded to, and the lack of an
in-place lender of last resort also affected the regulators'
ability to fully respond to the financial crisis.
I note that the perceived cure to a panic and general
credit freeze is to restore confidence in the markets. This has
at times been sorely lacking among the populace due to the
regulators' perceived ad hoc response to the financial crisis.
In conclusion, this brings us to today. I do not have time
in my testimony to recommend solutions, but Congress will
clearly hear many, and I offer some in my written testimony.
Here I want to conclude by answering the question posed by this
hearing: Where were the watchdogs?
Well, in part, as you can see from my sad narrative, the
regulators were hobbled by their deregulatory bent and limited,
fractured, and overlapping jurisdiction which left wide parts
of the financial system without oversight or regulation. Thank
you.
Chairman Lieberman. Thanks, Professor Davidoff. That was an
excellent narrative, really an excellent summary of how we got
to where we are. I must say that insofar as I expressed in my
opening statement our intention and hope that in these hearings
we would learn, so we could help to educate, and then advocate
effectively, I think all three of you have been excellent
educators of the Committee, and I thank you for it.
We will have 7-minute rounds of questions. I will begin
now.
A clear conclusion that you all share--and it begins with
the excellent GAO report--is that the current system for
regulating financial institutions in our country is fractured,
out of date, and just not able to deal with today's complicated
and immense global financial networks that do business here in
the United States.
I was thinking as you were testifying that we have all
become over the last year or so familiar with a term that I had
not heard before, which is that an entity can be ``too big to
fail.'' Right? And so we end up spending or extending billions
of dollars either of direct aid or credit.
From what you are saying, it sounds like it may not be that
these entities are too big to regulate, but they are certainly
too big and complicated for our current regulatory system to
oversee in the public interest. And that is a big part of the
problem.
I take it, just to start with the baseline question, that
it is reasonable to conclude, both from the report and the
testimony, that none of you thinks that simply fixing some of
the specific authorities of existing regulatory agencies is
enough to prevent the next regulatory crisis without a larger,
comprehensive reform. Mr. Dodaro.
Mr. Dodaro. Certainly there are some parts of the current
regulatory structure that you may want to look at.
Chairman Lieberman. Right. Sure.
Mr. Dodaro. But we do not think that you can adequately
address this problem in a comprehensive manner without making
broader changes.
Now, on the point that you mentioned about some of the
sizes of the entities and them being too big to fail, questions
have to be asked about the extent of whether or not they are
too big to manage effectively.
Chairman Lieberman. Right.
Mr. Dodaro. One of the really important themes, I believe,
that runs through a lot of this issue is the whole question of
risk management approaches and models, risk management at the
individual institution level, at the industry level, at our
national U.S. level, and at a global level. And I think that
issue really needs a lot of attention from a regulatory
standpoint, but also a corporate governance standpoint.
Chairman Lieberman. I was wondering whether you were
suggesting that there ought to be some governmental regulatory
mechanism that may say to a financial entity this next
acquisition you have in mind or the next product line you are
putting out is too much. In some sense, it sounds like a
classic antitrust function. It is a little bit different, of
course. But what would you say to that?
Mr. Dodaro. Well, I would say you need some checks and
balances in the system. Ultimately, the company's management
and the board of directors are responsible, but there has to be
a threshold of risk as to whether or not the regulators are
adequately achieving the goals that would be set up with the
new system and protecting investors and taxpayers, in
particular.
So this whole question of how to achieve the proper balance
between regulating and allowing innovation, I think, is really
going to be the tough underlying issue that really needs to be
addressed, because there is a tendency to overregulate and have
things roll back over time. Neither one of those is really the
optimum solution. So, our characteristics are intended to try
to get to see what can happen with that balance.
We also point out that there needs to be an adequate
transition period in terms of whatever change, but also, Mr.
Chairman, I would say the really other important part of this
is diligent oversight on a continual basis by the Congress. The
likelihood that this is going to be solved with one big stroke
is really----
Chairman Lieberman. One big move, understood. That is
always a danger here. We legislate, we reform, and then we walk
away.
Mr. Dodaro. Because things change, markets are going to be
fluid, and there needs to be some built-in oversight on a
regular basis.
Chairman Lieberman. Professor Jackson, you made some
interesting statements about the possibilities of expanding the
authorities and powers and jurisdiction of the Federal Reserve
Board. Given your druthers, would that be at the heart of your
comprehensive reform? And if so, would you blend or have the
Federal Reserve absorb some of the existing Federal financial
regulatory agencies?
Mr. Jackson. Senator, that is a good question, and
certainly one model that one could think about is to say the
Federal Reserve is at the heart of the system with the best
expertise, and we will fold everything in or a lot of things in
to make a super agency.
That is not personally what I would favor. I think that the
amount of centralization of authority is antithetical to a lot
of American traditions. And, more importantly, I think what you
want is a focused regulator with specific tasks.
So I would prefer a model of the Federal Reserve Board
having broader powers for market stability issues to sort of
have a roving mandate throughout the system, but another
counterweight Federal agency with consolidated supervision that
would be responsible for the front-line authority.
Chairman Lieberman. So create a new agency that would take
in some of the existing agencies.
Mr. Jackson. Yes, consolidated in the new agency. It would
have front-line supervision, and all the consumer protections
in day-to-day activities and have the Federal Reserve Board as
an expanded oversight entity that does the market stability
functions and with the lender of last resort capacity to come
in should the need arise.
Chairman Lieberman. Interesting.
Mr. Jackson. It is a little bit like the British model,
except I would envision a more robust role for the Federal
Reserve than the Bank of England has.
Chairman Lieberman. Got it. Professor Davidoff, I have
about a minute left in my time. Why don't you get into this
discussion. What would be your druthers if you were redesigning
the system?
Mr. Davidoff. If I were redesigning the system, I would
look at it analytically as three lines: One as systemic risk
regulator; second, a consumer protection agency, which is the
SEC and CFTC, which would have enhanced regulation over
financial disclosure, and third, consumer financial disclosure.
Chairman Lieberman. You would put them together?
Mr. Davidoff. I would have two separate agencies. I would
put the CFTC and SEC together.
Chairman Lieberman. That is what I meant.
Mr. Davidoff. It creates opportunities for regulatory
arbitrage. There is really no good reason to have them separate
anymore. Some people argue they should be competitors, they are
models, but we have ample models and competitors abroad
globally that can regulate them.
I think there is a third type of regulator, which Professor
Jackson alluded to, which is your capital regulator, which is
your FDIC or the Office of the Comptroller of the Currancy
(OCC). And so there are really three lines: Your lender of last
resort systemic regulator, then capital regulator----
Chairman Lieberman. Which would be the Federal Reserve.
Mr. Davidoff. Well, you can place them wherever you want.
Chairman Lieberman. Yes.
Mr. Davidoff. And I think Professor Jackson makes a good
point, which is the Federal Reserve is naturally cited as the
lender of last resort, but it is a unique independent agency.
And perhaps the capital requirements should be elsewhere with
Federal Reserve input because we want congressional oversight.
And this is why it is good that your Committee is having this
hearing because it is really a structural issue. Congress
should not be legislating the nuances, or else you are going to
get into a battle of the experts in deciding things. You should
set up a regulatory apparatus and let those regulators fill it
all in.
Chairman Lieberman. Great. Thank you. Senator Collins.
Senator Collins. Thank you, Mr. Chairman. Let me take up
where you left off.
As I look at this issue, it is clear that we have a gap
because there is no one who is responsible for assessing
systemic risk, what Professor Jackson called the ``market
stability regulator.'' So that is a problem. And it is
interesting. A few years ago, the House actually rejected
regulatory authority over Freddie and Fannie that would have
allowed regulation for systemic risk. When I look back on that
with the benefit of hindsight, it is just extraordinary that
the amendment was defeated so handily in the House.
But then there is also what I call the safety and soundness
regulators from my experience at the State level. We would not
allow a State-chartered bank or credit union to have a leverage
ratio of 30:1 that Bear Stearns did. That is just
inconceivable. So you need that safety and soundness regulator
to be extended so that a large investment bank has to meet the
same kind of capital requirements and undergoes the same kind
of audits and reviews as the local credit union--whose failure
would be far less devastating for the economy.
And then the third issue to me is who ensures that new,
exotic financial instruments like credit default swaps do not
fall through the regulatory gaps. To me, credit default swaps
are an insurance product, and yet they were not regulated as
insurance. They also were not regulated as securities.
So help me sort through who should do what, and I am going
to start with you, Professor Jackson, because you started down
that road when you said the Federal Reserve Board should have
the systemic risk authority.
Mr. Jackson. Right. Well, I do think this would fall into
the second heading of my discussions, I think, in terms of
thinking about how you are defining jurisdiction. This is a
lawyer's task, writing the jurisdiction of agencies, and it can
be done in a lot of different ways. We have tended to take a
narrow focus, so the SEC has authority over securities. It is a
defined term. The Supreme Court has decided I think maybe 15
cases at this point about what that term means. There was
litigation about whether swaps were securities in the 1980s and
1990s, and they were determined to fall outside of the SEC's
mandate for the most part, and Congress did not reverse it. It
sort of validated that decision.
So I think that whether it is the SEC or a consolidated
supervisor, one should define the jurisdiction broadly, and so,
for example, you could define the jurisdiction to be over
products that are financial in nature. That is a definition we
use in some areas, which is an open-ended definition that gives
the agency authority to say if a new product comes along, that
is financial, and we are going to exert some sort of
jurisdiction.
To pick up on a question that Senator Lieberman put
forward, I do think that the agencies have to have the power,
if a new product comes along, to say this is financial and you
just cannot sell it willy-nilly any way you want. You can sell
it but it has got to be, for example, on an exchange with a
clearing and settlement system that we can keep track of, so we
know the transparency, so we know counterparty risk. And that
does mean saying you cannot just go to London and do it on
Fleet Street any way you want because we recognize that
increases risk.
So I think the regulators have got to have the self-
confidence and the support to say certain products are too
risky. For too long we have said, well, as long as it is
institutional investors, we do not need to worry, they can fend
for themselves. The lesson of the last year is when
institutional investors get into trouble, sometimes they drag
the rest of us down, and we need to have just a different
philosophy that sometimes means saying no.
Senator Collins. Professor Davidoff.
Mr. Davidoff. I agree with that sentiment. If you do not
have regulators with broad jurisdictional authority, you will
have Ph.D.'s on Wall Street who will structure products to fill
that black hole. And so you need regulators with broad
authority, and you need it over the entire financial system.
Credit default swaps are a perfect example. They are traded
over the counter. We have no idea who the parties are. They
should be traded on an exchange, or a regulator should look at
them to see if they should be traded on an exchange.
But we have to regulate forward, not backward. We do not
know what the next crisis is going to be. So we need to have
regulators that have full jurisdictional scope.
Senator Collins. Should we have safety and soundness
regulation for entities like the Bear Stearnses of the world?
Mr. Davidoff. Absolutely. I mean, the investment banks, the
only reason the CSE program existed was because the investment
banks needed a regulator under an EU directive.
Senator Collins. But that was a voluntary program.
Mr. Davidoff. Right, it was a voluntary program that they
were trying to get out of direct oversight from the European
Union, and they existed in this netherworld of unregulated
jurisdiction.
Now, the elephant in the room, which we have alluded to, is
insurance. It is regulated by the States. It is a big problem,
how we capture those products, because if we regulate all
securities, if we have oversight of hedge funds--and here I am
talking about oversight, not necessarily regulation--the
regulator should have the power to regulate. But that should be
done through the regulatory process. But if we leave, for
example, insurance out of the mix, what do we do then?
Senator Collins. Mr. Dodaro, who should be the regulator
for what? Who should be the systemic risk regulator? Should
safety and soundness regulation by front-line regulators be
extended to all financial entities that could possibly pose
hazards to the economy?
Mr. Dodaro. Our report at this juncture does not make
specific recommendations, but the points that you are probing
on go to a couple of the characteristics that we have. One is
the systemwide risk proponent that would look across the system
and look for systemic issues. I think also, Senator Collins,
that ensuring that regulation is comprehensive, is one of the
characteristics that is meant to close the gaps with entities
and products.
Then the third component that we point out has to do with
flexibility and adaptability, and I completely agree with my
colleagues at the witness table here that we need a proactive
approach and not a reactive approach. And I think that is where
you are headed with your question, and I quite agree with that,
whoever that person is who is charged.
But it also goes back to our first objective and
characteristic in our framework, which is to set clear
regulatory goals and mandates and charter and give the
regulators the broad authority, then hold them accountable for
doing it.
Senator Collins. Thank you.
Chairman Lieberman. Thanks very much, Senator Collins.
Senator Levin.
Senator Levin. Thank you, Mr. Chairman.
Let me do something which really is not the direct purpose
of the hearing, but something that I want to do to take
advantage of your expertise while you are here. It is obvious
from your answers that you do have some opinions on not just
who should do the regulation, but whether certain activities
ought to be regulated. I do not know whether, Mr. Dodaro, you
are going to want to or be able to comment, but let me start
with our other two witnesses.
First, should hedge funds be regulated? Professor Jackson.
Mr. Jackson. Yes
Senator Levin. Professor Davidoff.
Mr. Davidoff. Yes.
Senator Levin. Are they currently regulated?
Mr. Jackson. I would say inadequately. I think this is a
good example that the SEC had an initiative to bring the
advisers under their jurisdiction. Whether that is strong
enough for all aspects of their activities, I am not sure. But
that was certainly an important first step.
I think beyond thinking about the hedge funds as entities,
it is the products--the credit default swaps, the OTC
products--that need to be brought into what I think would look
more like a futures regulation standard.
I would say here that I think this is just an excellent
area to rethink how we got into the current situation of the
CFTC and the SEC being in competition for business and trying
to attract entities by giving exemptions that play to our
disadvantage over the long run.
Senator Levin. I will get to the specifics of the hedge
funds.
Mr. Davidoff. Can I just add something on the hedge funds?
Senator Levin. Yes.
Mr. Davidoff. I think if you ask someone, if you ask a
regulator what role did hedge funds play in the current
financial crisis, I think he would look at you like a deer in
the headlights because we just do not know. And one of the
things that we need--and even the hedge fund managers who
testified about a month ago agree--is an oversight process for
hedge funds, and we need a disclosure process. It may need to
be confidential. But there are also systemic risks of
unregulated capital pools that any systemic risk regulator will
have to look at. Even the Harvard Endowment is in some terms a
hedge fund, and we need to bring those capital pools under some
oversight, or else the next systemic risk will rise there. And
it happened in Long Term Capital Management. It could happen
again.
Senator Levin. Let me move to the credit default swaps. We
have had a lot of discussion about that. The SEC Chairman,
Christopher Cox, back in October asked for jurisdiction over
those credit default swaps. Professor Jackson, should they be
regulated?
Mr. Jackson. Yes. I think that Mr. Cox's proposal was a
good one, albeit a piecemeal response, but that would be an
incremental improvement, his recommendation.
Senator Levin. Mr. Davidoff.
Mr. Davidoff. Yes, I think they should be moved to an open
exchange.
Senator Levin. Where they would be regulated.
Mr. Davidoff. Yes, where they would be regulated. That way
we can see the pricing, and the price discovery mechanism can
work. And if credit default swaps are going up on an entity, we
can see it instead of an opaque process.
Senator Levin. Senator Collins has, I believe--or last
session, at least--introduced a bill on this, and I fully
support that effort. But the bottom line is the two of you
believe that Congress should eliminate the barriers to the
regulation of credit default swaps.
Mr. Jackson. Yes.
Mr. Davidoff. Yes.
Senator Levin. By the way, Mr. Dodaro, if you have a
feeling of any of this, if this is within your ambit, just jump
in anytime.
Mr. Dodaro. Well, I will get caught up quickly.
First, on all of these areas, our belief is you definitely
need more transparency. I agree with my other witnesses that
whoever the systemic risk regulator is should have some
jurisdiction over these issues. And, Senator, I would point out
that we have raised concerns about some of these derivative
products dating back as far as 1994. GAO encourages that some
of the regulators have oversight over these derivative
products.
Senator Levin. All right. I want to keep going down a rat-
a-tat-tat list here, if I can, because I think this is
important while we have your expertise here. Now, we were
talking about credit default swaps. What about Federal
regulation of all types of swaps, including interest rate,
equity, and foreign currency swaps? Same answer or different
answer? Professor Jackson.
Mr. Jackson. Well, I think that you need to look at some of
these products on a case-by-case basis, but I think that you
need to have a single financial authority who is making a
decision about the best way to approach these instruments. In
some cases, it may not be necessary to go to exchange-based
regulation. One may want to do it by regulating the entities
that engage in the transactions. But I do not think we should
have an artificial boundary or a competition between agencies
around these instruments. I think they should be fully within
the financial sector and an expert agency should have the
jurisdiction.
Senator Levin. There ought to be jurisdiction in an agency
to regulate.
Mr. Jackson. To regulate.
Senator Levin. Fair enough. Professor Davidoff.
Mr. Davidoff. Absolutely you need the ability.
Senator Levin. All right. And the authority in an agency to
regulate.
Mr. Davidoff. Yes.
Senator Levin. Now, what about over-the-counter market
derivatives?
Mr. Jackson. I would give the same answer to that.
Senator Levin. Same answer, Professor Davidoff, or
different?
Mr. Davidoff. The same answer. You need jurisdiction over
everything.
Senator Levin. Capital reserve requirements on banks and
security firms--should Congress require regulators to impose
stronger capital reserve requirements? Should we just simply
authorize them to do it?
Mr. Jackson. I think that Congress needs to be careful not
to be too specific in its dictates, only that if you are too
specific the industry will work around it. I think that
comprehensive capital requirements are important, and it needs
to be done not just at banks and insurance companies, but it
needs to be done for conglomerates as well, including the
entities that we do not have traditional names for.
So I think one needs to be careful about specifying sector
regulations as opposed to saying we need to have a
comprehensive oversight of solvency and liquidity.
Senator Levin. Authorize an agency to do that.
Mr. Jackson. Authorize an agency, and then----
Senator Levin. That is fine. That is in keeping with your
previous answer, essentially.
Mr. Jackson. Yes.
Senator Levin. Professor Davidoff. I know this may sound
obvious to you, but let me tell you, we have to build up a
record if we are going to move quickly on this thing. I think
all of us want to get to the structural issues, and again, I
commend our Chairman and Ranking Member. This is a tough job to
do that. It is a harder job in a lot of ways because it is more
technical. It does not have the glamour of some of these other
issues, so-called.
Senator Burris. It does not have the sex appeal.
Senator Levin. Sex appeal, there you go. It is essential
that it be done, but we cannot let that effort stop us from
doing things we have to move very quickly on. So that is why I
wanted this record to----
Mr. Davidoff. Can I just add one more thing here----
Senator Levin. Of course.
Mr. Davidoff [continuing]. To your very good point, which
is Congress should use its political capital to set up a
structure, and they should not get bogged down in the details.
Sometimes they should, but bank capital requirements is a fight
that Congress does not need to pick. They can have the
regulator have the authority and give them the authority to set
it.
Senator Levin. But it is clear that we ought to act to give
the regulators those kinds of authorities?
Mr. Davidoff. Yes.
Senator Levin. My time is up. I have some additional
questions, Mr. Chairman, for the record along the same line,
and I very much appreciate the patience of our witnesses
because this is really slightly different than what they were
called to testify on, which is very valuable testimony. But I
want to thank you for your testimony.
Chairman Lieberman. Thanks, Senator Levin. I agree with
you. To go back to a metaphor you used in your opening
statement, which is used a lot but it is very relevant here,
and your last series of questions made the point, which is:
There are a lot of financial beats in America today that do not
have a cop on them, and that is part of the reason why we are
in the mess we are in now.
The second thing is that the public gets this, and they are
really infuriated, and it does create a political moment in
which we can achieve the kind of comprehensive, proactive
reform in regulation of financial entities for which you have
all in one way or another called. So, obviously, at some
political moments you can overreact. This happens to be a
political moment, I think, where the public wants us to do, in
fact, what we should do. And you are testifying from a very
non-political point of view that is exactly the case.
Senator Levin. If I could just interrupt for one more
second. We had the SEC months ago asking us for authority to
regulate credit default swaps.
Chairman Lieberman. Yes.
Senator Levin. Now, it should not take much, as far as I am
concerned, to do that little piece as quickly as we can. We are
talking--I do not know--$1 trillion?
Mr. Davidoff. Twenty trillion dollars.
Senator Levin. Twenty trillion dollars of exposure?
Chairman Lieberman. Here is an interesting number. From
June 2006 until June 2008, the market value of outstanding
credit default swaps increased from $294 billion to $3.1
trillion. So in just 2 years, it went up tenfold. That is a lot
of money, even around here. You agree.
Senator Levin. Thank you.
Chairman Lieberman. Thank you. Senator Tester is next. For
Senator Burris' information, we have a rule on this Committee
that we call on the Senators in the order of arrival, so you
will be next after Senator Tester.
OPENING STATEMENT OF SENATOR TESTER
Senator Tester. Thank you, Mr. Chairman, and I, too,
appreciate the hearing that you and the Ranking Member have
lined up here. I do not know how many Members of this Committee
are also on the Banking Committee. I am one. Senator Carper was
one also. I do not think he is on it anymore. And I do not mean
to speak for the chairman of the Banking Committee. You know
him better than I do. But I would say that any suggestions this
Committee could give to the Banking Committee would be well
accepted. This is a very complex issue. And as you pointed out,
it is an issue that I think the public wants something done
here to re-establish faith in the marketplace.
Chairman Lieberman. Thanks, Senator Tester. I forgot that
you were on the Banking Committee. I did talk to Senator Dodd
about the hearing, and he was encouraging. And, obviously, we
defer to you in terms of legislation, but maybe this Committee
can offer some suggestions about what form that should take.
Senator Tester. We would be more than happy to take them
forward and would be more than happy to hear suggestions even
on a personal basis, because like I said, it is complex.
I guess the question I would have for all three of you--you
understand how complex the markets are, and you already talked
about the holes and the overlaps and the fact that it does not
work very well right now. How much time do you think, if we
really got after it, would it take to develop a structure that
would be comprehensive enough to add consumer confidence to the
marketplace, but yet not so detailed that we have to fight
fights we did not have to fight, and not so regulatory that it
would take away flexibility in the system and deter growth?
Just give me an idea on how long you think that would take to
do something that would be thorough.
Mr. Jackson. Well, I think that is a good question, and the
way I think about it is on two levels. For Congress and the new
Administration to come to a consensus about the direction that
we should go in, whether it should be the two-peak model that I
was outlining or a three-peak model that Professor Davidoff was
suggesting, or a more narrow set of consolidations with a
different agenda, I think that is something that could be
decided in this session relatively quickly.
I think that the task of implementing is one that you need
to give a lot of thought to. Just as an example, in the United
Kingdom there was a 3 to 4 year process from when the Blair
government decided it was going to consolidate its
supervision--it created a shell entity that carried the
baggage, but the legislation took 3 years to enact. And,
actually, they created the agency first, and it had the task of
helping draft its own legislation. So I think the more you go
to a really comprehensive solution, the more you are going to
need to draw on expertise for this very technical task.
One example, something that came up here that we did not
mention in our testimony, is dealing with financial institution
failures. Right now one of the problems, one of the reasons
things are too big to fail is that we do not have a mechanism
for wrapping up big institutions because we have the banks, the
securities companies, the insurance companies, and the Federal
Bankruptcy Code all interacting.
Well, we should have a consolidated disposition process so
when Lehman goes bankrupt, we can actually deal with it. And
then we actually could make it fail because we would have a
mechanism.
Senator Tester. So you are saying several years.
Mr. Jackson. Several years, yes.
Senator Tester. Mr. Davidoff.
Mr. Davidoff. I think I agree with that assessment. But I
think that Congress can pass a bill that does it this session.
Senator Tester. Mr. Dodaro.
Mr. Dodaro. I think that part of it depends on a couple
factors: One, that Congress required the Congressional
Oversight Panel under TARP to submit a regulatory reform
proposal; and also required the Secretary of Treasury to have a
proposal. There have been a couple that have come forward from
other sources, and to the extent to which there is a consensus
gathering on some of those issues I think is important. But I
think it is going to take time to do it right and to do it
comprehensively.
Senator Tester. Well, let me ask you this, then: If it
takes that kind of time, do you think that there is any threat
that--and I mean that just as it sounds--a regulatory system
from outside this country could actually become the standard by
which we live, from the European Union or Pacific Rim?
Mr. Davidoff. I think the answer to that is no. I mean,
they are equally as troubled, and capital flows, although they
can shift rapidly, are staying concentrated in the United
States due to our----
Senator Tester. Do you see it the same, all of you? How
about you, Mr. Jackson? You understand the question?
Mr. Jackson. No, I do not. Can you just repeat what the
question is?
Senator Tester. What I am concerned about is that our
regulatory system is screwed up right now, to be kind. The
financial crisis is a worldwide situation, and if our reform is
not done in a reasonable amount of time, would we have to live
under the rules of another system--the European Union's
financial system or the Pacific Rim's or however you want to
put it? Do you see what I am saying? If ours is inadequate,
does that mean we have to take theirs? Does that mean the
companies, the investors, and all of the above adopt theirs?
Mr. Jackson. Well, I think that, as Professor Davidoff
says, the companies will stay in the United States because
there is so much business in the United States, and they are
going to be here, and they will live with our rules.
I think that we can learn from other jurisdictions, and I
think we can have a more effective and cost-effective
regulatory system if we move to consolidation, which is what is
done around the world.
Senator Tester. I would agree with you.
Mr. Jackson. But we control our regulatory fate.
Senator Tester. Good. That is all I need to know. Mr.
Dodaro, do you see it the same way?
Mr. Dodaro. Basically.
Senator Tester. Perfect. I have got a question, because it
has been brought up a few times. My mother brought it up to me
a while back, and it is something that we bounce off and around
once in a while. We are 10 years after the Gramm-Leach-Bliley
Act, which means we are also 10 years after the undoing of the
Glass-Steagall Act. If the Glass-Steagall Act had still been in
effect, do you think this same problem would have happened?
Mr. Jackson. I am fairly confident the same problem would
have happened. The securitization process was already underway,
and we did not need Gramm-Leach-Bliley to facilitate that.
Mr. Davidoff. I think it exacerbated it. The banks and the
investment banks began competing with each other, and the
investment banks were not built to compete in that way.
Senator Tester. So you are saying the Gramm-Leach-Bliley
Act exacerbated it.
Mr. Davidoff. Yes.
Mr. Dodaro. I think the question is more what was not done
rather than what was done. And I think the necessary
adjustments were not made to the regulatory structure to follow
the policy decisions and what was going to occur in the market.
Senator Tester. Thank you, Mr. Chairman. I, too, would like
to welcome Senator Burris to the Committee. I am sure that his
opinions and perspectives will be much valued.
Chairman Lieberman. Thanks, Senator Tester. Again, I am
really happy that you are on the Banking Committee, and that
gives us a good link to the work of that committee.
Senator Burris, it is really a great honor--having met you
before you came to the Senate, knowing of your service in
Illinois, particularly the time as Attorney General, but
obviously you have done a lot beyond that--to call on you for
the first time to question the witnesses. Senator Burris of
Illinois.
OPENING STATEMENT OF SENATOR BURRIS
Senator Burris. Thank you, Mr. Chairman. By the way, Mr.
Chairman, I am also an old banker. I started out my career as
the first black in this Nation to be a bank examiner for the
Comptroller of the Currency, and I am sitting here just taking
all this in.
Chairman Lieberman. That is great.
Senator Burris. And I have a couple of questions I would
like to ask.
One, have we really listed the various agencies? We have
the FDIC. We have the SEC. How many agencies are involved that
would be impacted by any type of regulations? And would we have
to then seek to come up with some type of blanket or overall
package that would impact each one of these agencies that has
these piecemeal jurisdictions over all of these various
entities? How many are there? You also try to get the
Comptroller of the----
Mr. Davidoff. In the GAO report, they have nine, I believe,
primary agencies. Which would be 10 if you included the
Treasury. But I would ask that they confirm that.
Mr. Dodaro. Yes, there would be 10 with the Treasury, and I
think your question is appropriate, both in designing the
reform that would be put in place, but also making the
transition as----
Senator Burris. As to try to tie all those together and get
all of those different interests that are going to be
protecting their turf and all the other types of situations
that could cause a problem. Professor Jackson.
Mr. Jackson. I think that there actually are some that the
GAO report may not have included. I would include the
Department of Labor with respect to Employee Retirement Income
Security Act (ERISA) issues. I would include HUD with respect
to mortgage lending. You could say that the most important
financial agency for most people is the Social Security
Administration with its retirement savings program.
So there are a host of little pockets around government in
addition to the primary agencies that one should think about
collectively. But it is a large number.
Mr. Davidoff. I would add that I do not expect that
everything will be cleaned up into a neat package. I would
recommend you build dominant regulators, whether you adopt a
twin-peaks model, the three-peaks model, and have them over
time--have their primary goal so they can absorb these
functions.
Senator Burris. And one other point that may seem a little
bit farfetched, but I have to take my mind to the ultimate of
all this, and that is the consumer and how would that consumer
get impacted by this overall change in regulations. It was the
consumer that ended up getting all caught up in these various
different piecemeal approaches as the subprime lending, and
then not only subprime but prime, got caught up in these equity
loans and dropping house values. So that also impacted what
happened in our financial markets because there are a lot of
individuals who are not subprime who were just underwater.
Their mortgages exceed the overall value of the property that
they are living in, and that constant pressure of equity, take
out the equity because it is not going to go down, and we found
ourselves in serious trouble.
The consumer has to be taken into consideration of how
these regulations are going to impact them, and I just hope
that we would give some thought to just how that person would
ultimately be impacted by that.
Mr. Jackson. Senator, one of the problems, as I see it, is
that each of our agencies has a consumer protection division or
a division of consumer affairs, but it takes a second seat to
other functions at the Federal Reserve or at the OCC or the
other agencies. And what we need to do is increase the salience
and the importance of the consumer protection function, and
that can be done with an accountability standard. It can be
done in a consolidated agency by having a division of consumer
affairs, perhaps with a political appointee and Senate
confirmation to elevate the status. Or it could be done with a
specialized market conduct regulator that has consumer
protection as a mandate.
But I think it starts with Congress saying that this is a
major goal and setting up a structure that someone has that as
their main mission, not as a secondary or tertiary mission,
which tends to be what is going on nowadays.
Senator Burris. Thank you very much.
Mr. Dodaro. Senator, I completely agree with that, and that
is one of the main characteristics that we point out that
should be in the framework of crafting and evaluating proposals
to reform the structure. Also, the States play a very important
role here, as I am sure you are aware, based on your past
position.
Senator Burris. I am a former State Comptroller.
Mr. Dodaro. And I do think that whatever is done ought to
be to preserve and to build on that check and balance at the
State level.
Mr. Davidoff. And, again, I would just add a small point,
which is it should have broad jurisdiction. So it is not just
mortgage disclosure. It is credit card disclosure. It is
financial protection for consumer financial products.
Senator Burris. Thank you, Mr. Chairman.
Chairman Lieberman. Thank you very much, Senator Burris. I
appreciate that. Your question was an interesting one, and if
you add on the State agencies that really do get involved, you
could get pretty rapidly up to about 200 separate oversight--we
have some ability, but we do not want to overdo it to deal with
the State agencies as well and allocate authority. But it
really is a fragmented system, and it does leave a lot of gaps,
which give people room to play games in between.
Senator Burris. Mr. Chairman, they mentioned one industry
that really needs to be looked at, and that is the insurance
industry.
Chairman Lieberman. Yes, sir.
Senator Burris. We really have to check out the insurance
industry.
Chairman Lieberman. Thank you. I look forward to working
with you on the Committee.
We will do a second round for any of the Senators who want
to ask additional questions.
Professor Davidoff, I want to ask you one thing briefly,
which is, in your testimony, interestingly, you mentioned that
the lack of coordination between some of the existing
regulatory agencies--in the case you particularly mentioned the
FDIC, the Treasury, and the Federal Reserve--may actually have
contributed to the ad hoc and ultimately inadequate nature of
the government's response to the current fiscal crisis. So the
fragmentation in the system may not only create gaps that allow
for the problems, but it also creates a problem in responding
to a crisis or a scandal. Correct?
Mr. Davidoff. Correct. Obviously, I was not in the
discussions, but from news reports it is clear that the
regulators conflicted over what to do at certain times, and
they lacked the full authority to address the crisis. And these
bailouts, one reason why they are so haphazard is because they
were structured within narrower limits of the law than they
were subject to.
Chairman Lieberman. I believe Mr. Dodaro first and then
others mentioned the ideal or the goal that we may, as part of
our reform, want to create a system in which the financial
entities are asked to bear the cost of the risk. Just
conceptually--the canvas is empty now and we are thinking about
how to paint on it--what kind of system would that involve?
Would it be fees up front?
Mr. Dodaro. Well, basically you would have to have some
kind of fee structure. It would basically take the Bank
Insurance Fund concept that is in place and replicate that or
adapt it--is probably a better word--to the other types of
services and products. This goes, too, to how the regulators
should be funded to preserve their independence. So I think it
is both a system that needs to be put in place modeled after
the Bank Insurance Fund, conceptually, that would require that
some fees be paid into a centralized fund that could then
provide for the industry that is in need of it, but also have
it be funded in a way where the regulators have clear
independence. Right now they are funded in different schemes,
which contribute to some of this difficulty in deciding how to
hold people accountable.
Chairman Lieberman. We have been reminded in the Bernie
Madoff case that there is a fund there that can be drawn on to
a limited degree to try to compensate people who were cheated
by Mr. Madoff. But I presume that there are large areas of
financial transactions where there is no such fund and,
therefore, there is no coverage for loss. Correct, Professor
Jackson?
Mr. Jackson. There is a complicated system of specific
guarantees. It is limited given the losses in the Madoff case,
but it is available for fraud of the sort that he engaged in
apparently. And there is the FDIC fund for banks, there are
State guarantee funds operated at the State level for insurance
companies to protect individuals when institutions fail.
I think the model for a systemic recovery would be the FDIC
Improvements Act of 1991 (FDICIA), which basically says that if
the FDIC saves a bank that is too big to fail and takes on
extra costs, those extra costs are then charged back to the
whole banking sector over some period of time. And TARP has
that characteristic, too. There is a provision that says if
TARP loses money--which it seems like it will--then in 5 years,
the Treasury has to make a recommendation for a charge-back. So
that is the kind of mechanism on the systemic risk side.
I think for ordinary failures, the pre-funding model, which
Mr. Dodaro referred to, is the sensible one. The FDIC fund is
kept at a certain percentage of deposits, so that handles
routine failures. But then when there is a special failure, you
need to have some special mechanism. And it should be
consistent throughout the financial services industry, and it
is not right now. If the Federal Reserve loses money on some of
its interventions, there is no mechanism to get recovery and
there is no general system for charge-backs that I think would
be important to put in place.
Chairman Lieberman. Would you like to add anything to this
discussion?
Mr. Davidoff. No. I think it has been adequately addressed.
Chairman Lieberman. Good enough. Let me, since we are
painting on a big canvas that is, obviously I would like to
think, not filled now--as we reconsider where we are--we are
dealing here in so many cases with an extraordinarily different
international financial system where enormous sums of money
travel with incredible rapidity, and one of you mentioned,
using it for another point, how frustrated European regulators,
or the British, are sometimes when they come here because they
have to shop around or figure out who to talk to.
This may be reaching a bit beyond, but in response to the
current crisis--last year I remember reading that there was a
town in Norway that was going under financially because it had
put its money in mortgage-backed securities that were failing.
Senator Burris. And Iceland.
Chairman Lieberman. And Iceland, exactly. So should the
United States be initiating some round of international
discussions now to create either new international entities for
financial regulation or institutionalizing or regularizing some
kind of interaction between national regulators?
Mr. Jackson. Well, I mentioned the international
connections, and I do think it is increasingly important for us
to have coordination and cooperation, particularly with our
leading economic allies. I think the tenor of today's
discussion of having more regulation, tightening the
regulation, is entirely appropriate. But it means that the
pressure to move offshore is going to be strong.
Chairman Lieberman. Right.
Mr. Jackson. And there are two places people can move
offshore. They are to the developed countries--Europe, Asia,
and major markets--where we can and should have good
coordination. I think the task of absolute harmonization is not
an appropriate aspiration because their systems are different,
their traditions are different. But we need to have convergence
and coordination with these major entities. Then we need to
collectively deal with the second group of entities, which are
the offshore centers that we can only deal with collectively.
And we have had some good experience internationally
cooperating on that, but we need to be working with our allies
to protect all of us against the offshore centers. So that is a
priority.
Chairman Lieberman. Mr. Dodaro or Mr. Davidoff, any
response to our international responsibilities?
Mr. Dodaro. Well, I think there are two things at a
minimum. One is there have been some international bodies of
individuals from the different countries that have had some
dialogues, and I know this was mentioned to me when I was in
the United Kingdom talking to one of their treasury officials.
And so there are proposals both to perhaps more
institutionalize this, expand this type of regular discussion
and dialogue on issues. Second, there should be some
discussions looking at international organizations, like the
International Monetary Fund and others, that could perhaps play
an enhanced role in this.
I am not positing any particular outcomes, but I do think
international dialogue is very important as part of the
equation in this particular issue.
Mr. Davidoff. I would just add that I think there is
already an extraordinary amount of dialogue between regulators,
and the Federal Reserve, in fact, entered into a dollar loan
program with the other banks in Europe because of their
difficulties.
I think that the issue is that although dialogue is good,
we have to take a stand on some regulation and say this is
where we will go, and because someone else does it differently
does not mean that we have to set it there.
Now, that should be done with the regulatory process, and
we need to keep the preeminence of the U.S. capital markets,
and the best way to do that is through treaties and cooperation
but also by saying you are not going to be able to come into
our system, which is the largest system, if you don't play by
our rules.
Chairman Lieberman. Excellent. Thanks. Senator Collins.
Senator Collins. Thank you, Mr. Chairman.
Professor Davidoff, I want to talk further with you about
the ``too big to fail'' issue, which the Chairman raised at one
point. It concerns me that we are creating a classic moral
hazard. If we send the signal--and, indeed, we are sending the
signal--that if you are big enough so that there are
consequences to the economy in terms of job losses or other
cascading effects that we are not going to allow you to fail,
we take away any incentive to carefully manage risk.
In addition, we encourage companies to become bigger and
bigger or to enter into financial arrangements where there are
more complex and interlocking transactions to make these
institutions' failure too consequential for our economy.
How do we prevent that? I know that is not an easy
question, but I am really concerned that we are sending a
message to just become bigger and bigger, riskier and riskier,
and don't worry, Uncle Sam will bail you out?
Mr. Davidoff. This is a hard one. Let me give you just a
quick anecdote. When Lehman failed, it defaulted on its
commercial paper, which was held by the money market funds,
including Prime Reserve, which broke the buck. In the space of
48 hours, over $200 billion was taken out of money market
funds. Money market funds, if they do not have money, can't buy
commercial paper. Most of industrial America finances its
operations through commercial paper. Literally, the cash
machines almost shut down. Because Lehman defaulted on its
commercial paper, the money market funds were losing all their
funds and couldn't fund the commercial paper market. Companies
couldn't get their commercial paper, and they were unable in
that market to get their financing. And that just shows how
tightly interconnected the world is today.
I think what you do--and I look forward to a vigorous
debate and the other experts offering their opinions--is two
things. First, ironically we have been building big
institutions through this process. You need to manage those
institutions. And, second, I think this has been such an
extreme event that the moral hazard effects may be reduced. But
we need to put in incentives for the people who are trading and
running these institutions that they will be penalized.
I hate to jump into the executive compensation arena--and
we certainly shouldn't, in doing regulatory reform--but you
need incentives that people will be punished. They can't leave
with a $1 million exit package. If their institutions fail,
they should leave with nothing, including without their country
club membership.
Senator Collins. Professor Jackson, I would like you to
address this as well, but I also want you to address a related
issue. When I look at the financial markets--and it is related
to the problem I have just outlined--an issue at risk is
divorced from responsibility at every step along the way. It
used to be that your community bank made the loan, kept the
loan, so if the loan went bad, that institution bore the
consequences. Now, the mortgage broker may make the loan and
take his fee. He does not care what happens to the loan after
that. Then it goes on to the financial institution, which takes
its fee. Then it is sold on the secondary market. Everybody is
getting a cut along the way. Then when the mortgage is sliced
and diced and securitized, it means that nobody is really
bearing the risk of the decisions that were made. And yet
everybody is taking a cut and getting paid along the way.
Mr. Jackson. Right.
Senator Collins. And I don't know what we do about this.
Mr. Jackson. Well, this has definitely been a problem. You
describe the nature of the huge moral hazard agency problem
that the mortgage financing system has generated.
One thing that I will say going forward is if we look at
the system backwards and we think of that pension fund up in
Norway that ended up holding mortgage paper, it is going to be
a lot more careful the next time it buys American securities,
if it ever does.
So I think we can expect some pretty severe market
corrections, and one of the ironies is we are living in a
market over-reaction. No one wants to finance mortgages
anymore, which is part of our problem that we are currently in.
So some of the correction is going to come from people who
have been burnt who are going to be more careful. We clearly
need to look at these relationships and decide when there is
not enough skin in the game and whether we want to have a
mortgage brokerage industry operating the way it has in the
past. I am quite dubious anyone will ever buy mortgages from
the old mortgage broker system. But we need to look at those
conflicts very carefully.
On too big to fail, one thing I would just like to say is
it is important for groups like GAO to think hard about why
institutions are too big to fail. And sometimes the reason is
we have allowed them to enter into such complicated
transactions and complicated networks that we can't unwind
them. So I think AIG, Lehman, and Bear Stearns have this
characteristic. The solution is make a better swap system with
clearinghouses, and then if we had a good clearing system, we
can let them fail.
So you can prevent ``too big to fail'' by not having
complex payment systems or complex clearing systems. So that is
a prospective solution.
In the case of Fannie Mae and Freddie Mac, they are too big
to fail because they had too large a share of the mortgage
business, and we also let every bank in the country buy as much
stock or bonds of Fannie and Freddie as they wanted. Now, that
is a recipe for too big to fail.
If we are going to have government-sponsored enterprises
(GSEs) in the future, which is an open question, we should make
them smaller. We should not let their financial significance be
so big so that if one of them needs to shut down we can't just
shut it down.
So we can correct some aspects of too big to fail going
forward. If we have a disposition mechanism that can handle
liquidation in a sensible way, that will also give us more
latitude.
So smart regulation can allow us to enforce market
discipline, and I think that is an important lesson going
forward.
Senator Collins. Thank you.
Mr. Chairman, I am going to have to leave, and I apologize
that I will not hear the Senator's final round of questions, if
he has some--he is done? Well. Could I just read for the record
from Warren Buffett?
Chairman Lieberman. Go right ahead.
Senator Collins. In 2002--he is not called ``The Oracle''
for nothing--he wrote to his shareholders, and he said, ``We at
Berkshire Hathaway try to be alert to any sort of mega-
catastrophe risk, and that posture makes us unduly appreciative
about the burgeoning quantities of long-term derivative
contracts and the massive amount of uncollateralized
receivables that are growing alongside.''
Listen to this statement: ``In our view, however,
derivatives are financial weapons of mass destruction, carrying
dangers that, while now latent, are potentially lethal.''
How sad it is that when Warren Buffett said this in 2002
that the regulators apparently weren't listening.
Chairman Lieberman. Amen. Thanks, Senator Collins.
Senator Burris, no further questions?
Senator Burris. No.
Chairman Lieberman. Thanks so much. I appreciate it.
The three of you have been excellent witnesses and, again,
I thank you, Mr. Dodaro, for the GAO report. You have really
gotten us off to a good start here. We are quite serious about
this. Actually, I think in talking to the Members, you have
engaged our interest.
I wonder if I could presume on your service to the
Committee thus far--this is a pleasure that a Senator gets in
giving two law professors a homework assignment, so to speak,
which is, I am really intrigued by the two-peak/three-peak
model. I am not asking for a law journal article because I know
you are very busy, but if you would for the benefit of the
Committee, in writing, over the next couple of weeks just
outline, with what we have now, how would you bring agencies
together? How would you change things? I think it would be very
helpful to us and to the Congress overall.
Mr. Dodaro, to the extent that you are able to do that
within your mandate, we would, of course, really welcome the
same from you. And we are glad to talk to you more about the
best way we can do that.
Mr. Dodaro. Yes, I would like to give that some thought,
and we could have some follow-up dialogue.
Chairman Lieberman. Good.
Mr. Dodaro. And I would also like to recognize the fine
efforts of the GAO team that put the report together.
Chairman Lieberman. It is another excellent piece of work
to assist Congress and in the public interest by GAO. I
appreciate it.
We will keep the record of this hearing open for 15 days in
case any of you want to submit additional testimony or any of
the Members want to submit testimony or questions to you. But I
can't thank you enough for bringing forth your expertise to
help us prevent another crisis such as the one we are going
through now.
With that, the hearing is adjourned.
[Whereupon, at 4:09 p.m., the Committee was adjourned.]
WHERE WERE THE WATCHDOGS?
SYSTEMIC RISK AND THE BREAKDOWN
OF FINANCIAL GOVERNANCE
----------
WEDNESDAY, MARCH 4, 2009
U.S. Senate,
Committee on Homeland Security
and Governmental Affairs,
Washington, DC.
The Committee met, pursuant to notice, at 9:02 a.m., in
room SD-342, Dirksen Senate Office Building, Hon. Joseph I.
Lieberman, Chairman of the Committee, presiding.
Present: Senators Lieberman, Tester, Burris, and Collins.
OPENING STATEMENT OF CHAIRMAN LIEBERMAN
Chairman Lieberman. Good morning and welcome.
Thanks for coming a bit early. As you know, we moved the
hearing up so that we might attend the joint session to hear
British Prime Minister Gordon Brown.
This is the second in our series of hearings examining the
structure of our Nation's financial regulatory system in the
aftermath of its obvious failure to protect us from the
economic crisis that we are suffering through now. We are
undertaking this series of hearings pursuant to Senate rules
that give our Committee the responsibility for ``the
organization and reorganization of the Executive Branch of the
government'' as well as for the study of ``the efficiency,
economy and effectiveness of all agencies and departments of
the government.''
By examining what changes should be made to improve and
modernize the organization of the Federal regulatory system, we
are not only fulfilling these responsibilities, but we hope to
be preparing ourselves to make recommendations to our
colleagues on the Senate Banking Committee about reforms that
they may be considering reporting out to deal with gaps in our
financial regulatory system.
In other words, we see our unique role here as reaching a
judgment about the structures through which we are regulating
financial institutions, and not so much about the day to day
regulations. This is particularly important based on what we
heard at our first hearing from the witnesses, which was that
our Nation's outdated and fragmented system of financial
regulation is unable to handle risks that occur across many
different types of institutions, markets, and activities.
Today's hearing will examine the pros and cons of creating
a systemic risk regulator for the financial services industry.
The first obvious question is what is a systemic risk
regulator?
I gather that it means a risk that a failed institution, a
risky activity, or a particular event could broadly affect the
financial system rather than just one institution or activity.
And, frankly, I want our witnesses to help educate me about the
difference between that systemic risk regulating function and
the other problem that we heard about at the last hearing,
which is that there are, today, gaps in our regulatory system
that leave trillions of dollars of economic activity
unregulated.
The fact is that there is no one government agency or
market participant responsible for monitoring systemic risks to
the integrity of our entire financial system, and that is a
significant fact.
Many experts believe that the gap should be bridged by
creation of what we are calling a systemic risk regulator who
would supervise or which would supervise the financial system
holistically. Federal Reserve Chairman Ben Bernanke has given
us another title to chew over. He has referred to such an
entity as a macro-prudential regulator. And I will wait for the
three of you to help me understand that.
Part of the reason our current watch dogs failed, we
learned at the last hearing, is because each has just a piece
of the system to oversee. That, as I said a moment ago, leaves
gaps.
For as long as there have been markets, obviously, there
have been speculative bubbles and resulting financial crises.
But through sensible regulation, I believe we can improve the
ability of our financial system to prevent and withstand such
shocks, reduce vulnerability to extreme crises and limit the
damage to our economy when a crisis occurs.
And so, we come to this hearing with a series of questions
and an excellent group of witnesses, questions like: Can the
role of monitoring and responding to systemic risks be
accomplished by expanding the authority of one or more existing
regulatory institutions or should Congress create a totally new
entity to act as a systemic risk regulator?
What would be the responsibilities of that body?
What tools would it need to meet those responsibilities?
And what would its relationship be with other regulators?
We have an excellent panel of witnesses before us today,
and I look forward to their testimony.
Senator Collins.
OPENING STATEMENT OF SENATOR COLLINS
Senator Collins. Thank you, Mr. Chairman.
Today, as the Chairman has indicated, our Committee is
examining the need to establish a systemic risk monitor that
might have helped to prevent the financial crisis that our
Nation now confronts, and I will stick with the term systemic
risk monitor rather than macro-prudential regulator.
America's financial crisis has spread from Wall Street to
Main Street, affecting the livelihoods of people all across the
country. The American people deserve the protection of a new
regulatory system that modernizes regulatory agencies, sets
safety and soundness requirements for financial institutions to
prevent excessive risk-taking and improves oversight,
accountability and transparency.
Our financial regulators should have had the ability to see
the current collapse coming and to act quickly to prevent or
mitigate its impacts. Unfortunately, oversight gaps in our
existing system, risky financial instruments with little or no
regulatory oversight and a lack of attention to systemic risk
undermined our financial markets. When the entire financial
sector gambled on the rise of the housing market, no single
regulator could see that everyone from mortgage brokers to
credit default swap traders was betting on a bubble that was
about to burst. Instead, each agency viewed its regulated
market through a narrow tunnel, missing the total risk that
permeated our financial markets.
When the housing market collapsed, the impact set off a
wave of consequences. Borrowers could no longer refinance their
mortgages. Credit markets were frozen. Consumer demand
plummeted. Businesses were unable to make payments or to meet
payrolls. And workers were laid off, making it even more
difficult for families to pay their mortgages.
In Maine, the unemployment rate has reached a 16-year high
of 7 percent at the end of 2008. There were also more than
2,800 foreclosures in my State, not that many compared to other
States but nearly a 900 percent increase from the previous
year.
This financial crisis has harmed virtually every American
family. Taxpayers have financed bailout after bailout of huge
financial institutions at the cost of trillions of dollars.
These drastic and expensive rescues might not have occurred had
there been a regulator evaluating risk to the financial system
as a whole. Such a regulator could have recognized the house of
cards being constructed in our financial markets.
While there are certainly many regulators at both the
Federal and State levels, not one of them had the ability to
evaluate risk across the entire financial system. For example,
the Federal Reserve could clearly see the large number of
securitized mortgages of banks within its jurisdiction, but it
had virtually no visibility into the full extent of
securitization at non-federally regulated banks or financial
institutions under the purview of the Securities and Exchange
Commission (SEC).
What was needed then and is needed now is the systemic risk
regulator. The Government Accountability Office (GAO) and other
government and industry officials as well as academic experts
have called for the creation of such a monitor.
But, as the Chairman indicated, the creation of a systemic
risk monitor raises many new questions about its structure and
authority. Should it be an existing regulator such as the
Federal Reserve that is charged with monitoring systemic risk
or should an entirely new entity be tasked with that
responsibility?
My belief is that we should establish a council composed of
the heads of our Nation's financial regulatory agencies that
could be an interagency task force.
We must also consider what should occur when systemic risk
is detected. Should a systemic risk entity be empowered to
issue its own regulations to review and approve new financial
instruments and to fill the regulatory black holes that result
from overlapping or narrow agency jurisdictions or should the
monitor be required to work through existing regulators?
In designing a better regulatory framework, we must take
care not to create a moral hazard by implying that this entity
exists to make failure impossible. We must also take care not
to stifle the creation of innovative, useful new products nor
to prevent beneficial risk-sharing. The challenge is to ease
the turmoil caused by failing of important institutions without
setting off a cascade of trouble for otherwise healthy
entities.
In other words, we need a better system to prevent the
development of catastrophic concentrations of risk at firms
like Bear Stearns, AIG, and better systems to mitigate the
collateral damage if they do fail.
Our goals must combine several vital objectives: Stability
for the financial system, safety and soundness regulation for
institutions, protections for investors and consumers,
transparency and accountability for transactions, and increased
financial literacy for the public. Significant regulatory
reforms are required to restore public confidence and to ensure
that a lack of regulation does not allow such a crisis to occur
in the future.
In fact, I would contend that one reason why we have not
seen a stabilization of our markets is because the public
continues to lack confidence. One step that we can take that
would make a real difference is the creation of a stronger,
more effective regulatory system to help restore that
confidence, and that is why this set of hearings that the
Chairman has initiated are so important.
Thank you, Mr. Chairman. I look forward to hearing our
witnesses.
Chairman Lieberman. Thanks very much, Senator Collins. I
agree with you totally on that last point.
I know people within the Administration and our colleagues
on the Banking Committee are working on this. It is very
important because, obviously, the troubles in the markets,
notwithstanding what we and the Administration have been trying
to do, reflect a lack of confidence, and one part of that
clearly is in the ability of the government to protect
investors and consumers.
Let's go right to the witnesses with thanks that you are
here. First is Dr. Robert Litan, Vice President for Research
and Policy at the Kauffman Foundation.
Thanks for being here.
STATEMENT OF ROBERT E. LITAN, PH.D.,\1\ VICE PRESIDENT FOR
RESEARCH AND POLICY, EWING MARION KAUFFMAN FOUNDATION
Mr. Litan. Thank you very much, Mr. Chairman and Senator
Collins for inviting me to appear on this very distinguished
panel.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Litan appears in the Appendix on
page 158.
---------------------------------------------------------------------------
We are here, of course, because we are all in the midst of
the worst financial crisis of our lives and because of our
ardent desire to never see something like this again. To
realize this objective, we must reduce and contain systemic
financial risk, the subject of this hearing.
Your staff has asked me to provide a few scene-setting
remarks before addressing the questions you posed.
Our financial system has long rested on two pillars: Market
discipline and sound regulation and supervision of key
financial institutions and markets. Both pillars failed us.
Shareholders and creditors of now failed financial
institutions did not prevent what happened, but also we did not
have policies in place to assure that market discipline would
work effectively.
Mortgage documents and the securities backed by mortgages
were not transparent. With too many borrowers, the institutions
that securitized their loans and the institutions that bought
these securities also did not have enough money at risk to
ensure prudent behavior.
Likewise, we all thought that regulators were on top of the
risk and the capital levels at our financial institutions. We
were wrong.
Reforms are needed to fix these errors. We are here today,
however, to do more than that, specifically, how to address
systemic risk which, as you, Mr. Chairman, accurately
described, is the transmission of losses at one or more failed
financial institutions simultaneously or at near time
coincidence with each other throughout the rest of the
financial system.
I also agree with you that we cannot expect to prevent all
future asset bubbles like the housing bubble, but the public
does have a right to expect reform to reduce the size of those
future bubbles and, obviously, to reduce the economic costs
when they pop.
The place to begin is to establish an effective system of
regulating the solvency and improving the transparency of
systemically important financial institutions (SIFIs).
In my view, this oversight is best carried out by a single
agency, not a collection of agencies, with due apologies to
Senator Collins. President Truman had a famous sign on his
desk: The buck stops here.
Well, the buck stops here dictum, if we apply it here, and
I think we should, means that one agency, not many agencies,
should have clear responsibility over SIFIs. Among the
alternatives that I survey in my written remarks, I believe
that the ideal solution, if I could play God, is to consolidate
all the Federal financial regulation into two bodies, one for
solvency and the Treasury under former Secretary Henry Paulson.
Chairman Lieberman. Just go into that a little bit. When
you say all, just give us a little more detail of what agencies
we are talking about.
Mr. Litan. On the banking side, I am talking about all the
banking agencies. I think we ought to have Federal regulation
of large systemically important insurers which we, of course,
now do not have at all.
Chairman Lieberman. So when you are saying all the banking
regulators, you are talking about the Office of the Comptroller
of the Currency (OCC).
Mr. Litan. OCC and the Federal Deposit Insurance
Corporation (FDIC).
Chairman Lieberman. Right.
Mr. Litan. And the Federal Reserve functions of solvency.
And you have large insurers. I would put them there too.
You would have the solvency of broker dealers. Essentially,
an agency charged with solvency. Then you would have an agency
charged with consumer protection which would consolidate all
the consumer protection arms of each of these agencies. Plus, I
would add the consumer protection power of the of the Federal
Trade Commission (FTC), and we ought to have a financial
consumer protection agency.
I mean those are the two functions that we are worried
about, and in an ideal world I would consolidate them.
Chairman Lieberman. Then the SEC and the Commodity Futures
Trading Commission (CFTC)?
Mr. Litan. I would combine those and make them part of the
consumer protection agency.
Chairman Lieberman. OK.
Mr. Litan. And the Paulson Treasury plan had--I am
departing now from my prepared remarks here. But they also
suggested that the Federal Reserve would be a free safety,
roaming out there to pick and choose what it wanted to do.
In my written remarks, I am worried about the free safety
model because it is just a recipe for regulatory overlap,
especially with vague and ambiguous powers that you would give
the Federal Reserve.
So, to go back to what I was saying, that is my ideal
world.
We do not live in an ideal world, and I do not expect
something like this to happen. I would be glad if it did. So,
as a fallback, I urge that the Federal Reserve be the logical
systemic risk regulator.
My third choice would be to create a new regulator and
leave everything else intact. I am not wild about this
alternative because we already have enough cooks in the
kitchen. This would just add another one, and it would be a
recipe, I think, for overlap, jurisdictional fights, and
fingerpointing after the fact and so forth.
And, finally, we come to the last suggestion which is the
so-called college of supervisors. I am not wild about this
either because it preserves too many cooks in the kitchen. I
think, again, as I said, it violates the buck stops here
principle. So that is my least favorite alternative.
Now there are a lot of details of how systemic risk
regulation would have to be carried out, and so I think the
Congress, if I were writing legislation, should provide very
broad language and leave the details to the agency and then
have Congress oversee the agency rather closely.
Let me just give you an example of a few of the issues that
would have to be addressed:
First, there has to be a clear process for identifying the
SIFIs and to allow an institution that is designated as a SIFI
to remove itself if the situation warrants.
Factors such as size, leverage and the degree of
interconnection with the financial system, as the Group of
Thirty has suggested, would be, I think, obvious ways to define
the SIFIs. Clearly, large banks, large insurers and,
conceivably, some hedge funds and some private equity funds
could meet the SIFI test. So would the major clearinghouses,
the exchanges, including the new exchanges or clearinghouses
that are now contemplated for credit default swaps.
Footnote: There is a recent report by the Geneva Reports on
the World Economy--an excellent report, by the way--that has
come out. It also recommends something like this, but it
suggests in an ideal world that the list of SIFIs would be kept
private. You would not publicize the names of them to address
the moral hazard concern that, Senator Collins, you rightly
point to.
I do not think that is feasible because the reality is you
would have to disclose, if you were a public company, what
special rules you are subject to, if you have higher capital
and liquidity rules. And the markets would be able to interpret
very clearly, if you have these higher standards, that you are
a SIFI. So I think you cannot keep the list quiet. That is just
my view.
Second, SIFIs should be subject to tougher regulation,
specifically capital and liquidity, than other financial
institutions precisely in order to address the moral hazard
concern. Capital standards should be countercyclical but only
if the minimum capital standard is raised over time and--and
this is very important--the required ratios for good times and
bad are publicized in advance so that everybody knows what the
rules are. If you do not have clear rules what will happen is
that you will relax the rules in bad times, but you will not
raise them in good times. So the capital rules have to be super
clear at the outset.
Third, the systemic risk regulator should not rely solely
on supervisors to watch over SIFIs because we know that
supervisors and regulators are not perfect. Trust me. I have
been hearing an earful from the public about this.
So I think we need to harness what I call stable market
discipline to supplement regulators, and the best source of
stable discipline is long-term uninsured, unsecured, and
subordinated debt. SIFIs should be required to back a certain
portion of their assets with this long-term debt, or the long-
term money which cannot run. Such debt is not like short-term
deposits. Because the long-term money is stuck, the holders of
such debt have tremendous incentives to monitor the institution
to insure that it is not taking excessive risk, and that is
another way to address the moral hazard concern.
Fourth, and this is critically important, SIFIs should be
required to submit and gain approval for early closure and
loss-sharing plans in the event they get into trouble. These
plans could limit, though possibly not eliminate, losses from
their failure. I was going to address some of the critics of
the SIFI approach, but I think we have addressed the moral
hazard concern, and I will not go into great detail on that
issue. I have a number of responses to the other criticisms in
my written testimony.
I have a couple final points. One is that you cannot put
all your eggs in a systemic regulator basket. There have to be
other tools to address systemic risk, and so I address two of
them in my testimony.
First, my colleague, Alice Rivlin at Brookings, has
suggested that the systemic risk regulator provide an annual or
perhaps more frequent report to Congress on systemic risk
regulation. Highlight the areas, for example, of rapid asset
growth or areas where there may be particular vulnerabilities
so that the system, you and the public are alert to the
dangers. And, if there are needed recommendations, the
regulator would provide them.
Second, regulators should encourage financial institutions
to tie their pay to long-term performance, not to short-term
results.
Finally, I want to say just a few words about the global
nature of the problems we are facing and what we should do
about them globally.
Clearly, we are all witnessing the fact that the troubles
in the United States have now reverberated around the world.
So, naturally, the rest of the world wants us to participate in
some kind of global macro solution to the current problems.
That is why President Obama is going to the April 2, 2009,
meeting in London. That is why President Bush agreed to the G-
20 meeting in November.
I have a couple words of caution, not that I am against
global coordination. I am all for that. We need to learn from
other countries. But for those who say that we ought to
harmonize all our rules with the rest of the world before we
act, I strongly disagree, and I will give you a prime example
why.
We have something called the Basel II Capital Accords. I
have written for years about how I think these things were
horribly mistaken. As it turns out, the biggest mistake is they
took 10 years to develop, and by the time they went into effect
we had a full blown banking crisis. And so, I hate to repeat
that episode.
By the way, the substance of the Basel rules turned out to
be bad. They ignored liquidity. They were 400 pages of
complexity that only risk modelers could love. They delegated
authority to credit rating agencies, and now we learned how
that was a mistake. There were complicated formulas that tried
to measure risk that did not do it well.
The bottom line is let's not spend our time trying to
negotiate with the rest of the world what our rules should be.
We know enough to fix our own problems, and we should do that.
And the final point I would like to make goes to the issue
of a global financial regulator. I do not think any of the
countries in the G-20 are ready to cede financial regulation to
an uncreated, untested global regulator. We have plenty of work
to do at home, and I think we should do it.
That will conclude my formal remarks. Thank you.
Chairman Lieberman. Thanks very much, Dr. Litan. Very
helpful. Very interesting.
I gather that at 11 a.m., according to the previews, Prime
Minister Brown may be talking about an international global
financial New Deal. Though I must say I heard him respond to a
question about that on the radio yesterday, and his answer was
quite vague which meant either that he was holding the details
for this morning or there are no details, and we will see as
time goes on.
Senator Collins. Mr. Chairman, I just want to explain to
our witnesses that I have a conflict that I need to leave for.
I have read all of their testimony, and I am very interested.
If humanly possible, I will try to get back, but I do look
forward to talking further with the experts that you have
brought together today.
Chairman Lieberman. Thanks very much, Senator Collins, and
I understand why you have to go. And thank you for being in
this, as in most everything else, such a supportive partner.
Thank you very much.
Next, we are going to hear from Damon Silvers who is
Associate Counsel at the AFL-CIO and a member of the Troubled
Asset Relief Program (TARP) Congressional Oversight Panel.
We probably could hold a separate hearing on that, but for
now we welcome you on the question before us this morning, Mr.
Silvers.
STATEMENT OF DAMON A. SILVERS,\1\ DEPUTY CHAIR, CONGRESSIONAL
OVERSIGHT PANEL, AND ASSOCIATE GENERAL COUNSEL, AFL-CIO
Mr. Silvers. Thank you, Mr. Chairman, and thank you for the
honor of inviting me here today.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Silvers appears in the Appendix
on page 178.
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As you know, I am Associate General Counsel of the AFL-CIO,
and I am a member and Deputy Chair of the Congressional
Oversight Panel.
My testimony today will include a discussion of the
Congressional Oversight Panel's report on regulatory reform
mandated by the Emergency Economic Stabilization Act of
2008.\2\ However, my testimony reflects my views and does not
necessarily reflect the views of the panel, its chair,
Elizabeth Warren, or its staff.
---------------------------------------------------------------------------
\2\ The report submitted by Mr. Silvers appears in the Appendix on
page 190.
---------------------------------------------------------------------------
We have inherited a financial regulatory landscape designed
in part to address issues of systemic risk. The SEC's
disclosure-based system of securities regulation and the FDIC's
system of deposit insurance came into being not just to protect
the economic interests of depositors or investors but as
mechanisms for insuring systemic stability, respectively, by
walling off bank depositors from broader market risks and
ensuring that investors in securities markets had the
information necessary to police firm risk-taking and to monitor
the risks embedded in particular financial products.
But, as both the Chairman and Senator Collins have noted,
in recent years, financial activity has moved away from
regulated and transparent markets and institutions and into the
so-called shadow markets. Regulatory barriers like the Glass-
Steagall Act that once walled off less risky from more risky
parts of the financial system have been weakened or dismantled.
And we have seen a significant concentration in banking
activity in the hands of very large financial institutions.
So we entered the recent period of extreme financial
instability with an approach to systemic risk that looked a lot
like that applied during the period following the creation of
the Federal Reserve Board but before the New Deal.
But with the collapse of Lehman Brothers and the Federal
rescues of AIG and Fannie Mae and Freddie Mac, the Federal
response turned toward a much more aggressive set of
interventions in an effort to ensure that after the collapse of
Lehman Brothers there would be no more defaults by large
financial institutions. Of course, this kind of approach was
made much more explicit by the Emergency Economic Stabilization
Act and the TARP program.
It has become very clear that our government and other
governments around the world will step in when major financial
institutions face bankruptcy. We do not live in a world of free
market discipline when it comes to large financial
institutions, and it seems unlikely that we ever will. But we
have no clear governmental entity charged with making the
decision over which company to rescue and which to let fail, no
clear criteria for how to make such decisions, and no clear set
of tools to use in stabilizing those that must be stabilized.
And I would submit to you that, unfortunately, the Act
passed last fall did not really fix these problems.
In addition, we appear to be hopelessly confused as to what
it means to stabilize a troubled financial institution to avoid
systemic harm. In crafting a systematic approach to
systemically significant institutions, we should begin with the
understanding that while a given financial institution may be
systemically significant, not every layer of its capital
structure should necessarily be propped up with taxpayer funds.
In response to these circumstances, the Congressional
Oversight Panel, in its report to Congress mandated by the
Emergency Economic Stabilization Act, made the following points
about addressing systemic risk:
First, we agreed with both you and Senator Collins and the
prior witness that there should be a body charged with
monitoring sources of systemic risk in the financial system,
and we left open the options that it could be a new agency, an
existing agency, or a group of existing agencies.
Second, the body charged with systemic risk management
needs to be fully accountable and transparent to the public in
a manner that exceeds the general accountability mechanisms
present today either in the Federal Reserve Board or in other
self-regulatory organizations. If the Congress and the
President were to look to the Federal Reserve, the panel
recommended that there would have to be governance changes.
Third, contrary to Mr. Litan's testimony, we should not
identify specific institutions in advance as too big to fail,
but, rather, we should have a regulatory framework in which, in
a graduated fashion, institutions have higher capital
requirements and pay more in insurance funds on a percentage
basis than smaller institutions which are less likely to need
to be rescued as being too systemic to fail.
Fourth, we do, here, very much agree with Mr. Litan that
systemic risk regulation cannot be a substitute for routine
disclosure, accountability, safety and soundness, and consumer
protection regulation of financial institutions and financial
markets.
Fifth, effective protection against systemic risk requires
that shadow markets--institutions like hedge funds and products
like credit derivatives--must not only be subject to systemic
risk-oriented oversight but must also be brought within a
framework of routine capital market regulation by agencies like
the Securities and Exchange Commission.
Sixth, and here again I echo the testimony of the prior
witness, we found that there are some specific problems in the
regulation of financial markets--such as issues of incentives
built into executive compensation plans and the conflicts of
interest inherent in the credit rating agencies' business model
of issuer pays--that need to be addressed to have a larger
market environment where systemic risk is well managed.
And, finally, the panel found that there will not be
effective re-regulation of the financial markets in general,
and including in the area of systemic risk, without a global
regulatory floor. However, I think it is very clear that our
recommendations agree with Mr. Litan that this should not and
cannot be an excuse for inaction here in the United States now.
As to who exactly should be the systemic risk monitor,
well, the panel made no recommendation.
I have come to believe that the best approach is a body
made up of the key regulators much as Senator Collins
described. There are several reasons for my conclusion.
First, such a body must have as much access as possible to
regulatory agency expertise and to all the information extant
about the condition of the financial markets, including not
just banks and bank holding companies but securities,
commodities, and futures and consumer credit markets, more
broadly.
The reality of the interagency environment is that for
information to flow freely all the agencies involved need some
level of involvement with the agency seeking the information,
and I do not believe it is practical or wise to try to
duplicate or centralize all capital markets information in one
new agency or one existing agency.
Second, as I noted earlier, the panel concluded this
coordinating body must be fully public.
While many have argued the need for this body to be fully
public in the hope that would make for a more effective
regulatory culture, the TARP experience which you alluded to,
Mr. Chairman, highlights a much more bright-line problem. An
effective systemic risk regulator must have the power to bail
out institutions. The experience of the last year is that
liquidity provision is simply not enough in a real crisis.
An organization that has the power to expend public funds
to rescue private institutions must be a public organization.
Here, the distinction really is between lending money and
investing in equity much as we have done in the TARP program,
though such a body should be insulated from politics--much as
our other financial regulatory bodies are--to some degree by
independent agency structures.
As to the Federal Reserve, while the Federal Reserve can
offer liquidity, many actual bailouts, as I said, require
equity infusions which the Federal Reserve currently cannot
make nor should it be able to make as long as the Federal
Reserve continues to exist as a not entirely public
institution. In particular, the very bank holding companies the
Federal Reserve regulates today are involved in the governance
of the regional Federal Reserve banks that are responsible for
carrying out the Federal Reserve's regulatory mission on a
daily basis and would, if the current structure were untouched,
be involved in deciding which member banks or bank holding
companies would receive taxpayer funds in a crisis.
These considerations also point out the tensions that exist
between the Board of Governors as to the Federal Reserve's role
as central banker and the great importance of distance from the
political process in that function and the necessity of
political accountability and oversight once a body is
discharged with disbursing the public's money to private
companies that are in trouble. That function must be executed
publicly and with clear oversight or else there will be
inevitable suspicions of favoritism that will be harmful to the
political underpinnings of any stabilization effort, and I
think we have seen some of that in recent months.
One benefit of a more collective approach to systemic risk
monitoring, as Senator Collins suggested, is that the Federal
Reserve Board could participate in such a body, and I believe
that is essential. You cannot do this function, I think,
without the Federal Reserve's involvement while having to do
much less restructuring of the Federal Reserve's governance
that would likely be problematic in terms of the Federal
Reserve's monetary policy role.
More broadly, these issues return us to the question of
whether the dismantling of the approach to systemic risk
embodied in the Glass-Steagall Act was a mistake.
We would appear now to be in a position where we cannot
wall off more risky activities from less risky liabilities like
demand deposits or commercial paper that we wish to insure. On
the other hand, it seems mistaken to try and make large
securities firms behave as if they were commercial banks.
Finally, as I said earlier, the regulation of the shadow
markets and of the capital markets as a whole cannot be shoved
into the category labeled systemic risk regulation and then
have that category effectively become a kind of night watchman
effort.
The lesson of the failure of the Federal Reserve to use its
consumer protection powers to address the rampant abuses in the
mortgage industry earlier in this decade is just one of several
examples going to the point that without effective routine
regulation of financial markets, efforts to minimize the risk
of further systemic breakdowns are not likely to succeed.
In conclusion, the Congressional Oversight Panel's report
lays out some basic principles that, as a panel member, I hope
will be of use to this Committee and to Congress in thinking
through the challenges involved in rebuilding a more
comprehensive approach to systemic risk.
The key, though, in the end is to make sure that as
Congress approaches the issue of systemic risk, it does so in a
way that bolsters a broader re-regulation of our financial
markets, closing in a day-to-day way the profound gaps in our
system that both you and Senator Collins alluded to, and that
systemic risk regulation, while it is important that it be
done, does not become an excuse for not engaging in that
broader re-regulation.
Thank you very much.
Chairman Lieberman. Thanks, Mr. Silvers. Excellent
statement. I will have some questions for you.
Our last witness is Bob Pozen. It is good to see you again.
Mr. Pozen. Glad to see you, Senator.
Chairman Lieberman. We go back some distance to our halcyon
student days.
Mr. Pozen. Yes, those were the days.
Chairman Lieberman. Those were the days, my friend. That is
the end of our discussion of that subject.
But, Mr. Pozen has gone on to be a leader in the financial
services business over the years. He comes to us today from MFS
Investment Management and has really been a creative thinker on
a lot of public finance questions over the years, to the
benefit of Congress and previous presidents.
So, it is great to have you here today to help us
understand this question and hopefully to do something
constructive about it. Thank you.
STATEMENT OF ROBERT C. POZEN,\1\ CHAIRMAN, MFS INVESTMENT
MANAGEMENT
Mr. Pozen. Thank you, Senator, and thank you and your
Committee for inviting me to speak.
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\1\ The prepared statement of Mr. Pozen appears in the Appendix on
page 304.
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Instead of giving a long presentation, let me try to really
focus in on a few of the issues.
Are we likely to have more or less systemic risk failures?
There was a study done on how many financial crises we have
had in the 20th Century. This study was done by Professor
Eichengreen from Berkeley. From 1945 to 1971, there were 38
financial crises across the world. Between 1973 and 1997, there
were 139 financial crises of which 44 took place in high income
countries. In the last decade, besides this one, we have seen
the Asian financial crisis and the dot.com crisis.
So I think it is fair to say that the trend line for crises
is definitely rising.
Now you ask a good question about what is systemic risk,
and I do agree that it is a term that is loosely thrown around
a lot. To me, one of the more useful exercises is to think
about what historically have been the leading indicators that
have come before financial crises if you look at them as a
group. There are five indicators that we can say that tend to
occur, though not always, before a financial crisis.
The first is that when a country has a very much above
trend line set of real estate prices. This is not just true in
the United States but was true in Japan, and also was true in
Australia and other countries.
A country must be way above trend line, which is what we
were, and financed by a credit boom. You need both--not just
real estate prices above trend line, but also financed by a
credit boom of easy money. That combination is often associated
with a crash at the end.
The second leading indicator is very high leverage ratios.
For example, if we look at all the things that happened in
2004, the SEC agreed to essentially allow the five investment
banks to triple their leverage ratios from about 10 to 1 to 30
to 1.
Such a high leverage does lead to a potential for systemic
risk because then all you need is a small loss, and you are in
trouble. At that point, you would like to raise capital, but
you cannot. And so, you start selling assets, which depresses
the price of assets held by others. In this manner, you start a
downward spiral.
The third leading indicator is when you have gaps in the
regulatory system. Here, probably the most obvious was for
credit default swaps (CDS). But these gaps for CDS were not
hidden. People knew them. People saw them. People had a chance
to make a decision on them, and they chose not to act. Then in
this regulatory vacuum, credit default swaps increased quickly
to the $50 to $60 trillion level of nominal value.
The fourth leading indicator is having an asset class that
experiences explosive growth. That is what we saw in the
collateralized debt obligation (CDO) market, for instance. When
you see a product that goes from small to very large, you ought
to beware. Similarly, we went from $250 billion in hedge funds
assets to $2 trillion in about 10 years. Either hedge fund
managers are absolute geniuses or there is something that does
not quite make sense there. So this type of growth spurt is
very much worth looking at.
The fifth leading indicator is the mismatch between long-
term assets and liabilities. This, obviously, was
characteristic of the savings and loan crisis where you had
long-term mortgages and short-term deposits.
What is less known is that many issuers of securitized
assets recreated this mismatch problem. So you would have long-
term mortgages bought by a special purpose entity, which would
be financed by 60-day or 180-day commercial paper. Such a
mismatch has the potential to create a liquidity crisis.
So those are five areas that we really ought to look at
closely. It may be more useful, rather than talk theoretically
about systemic risk, to focus on those five types of
situations.
What should we do to prevent systemic risks from
materializing? Let's start with efforts to close the regulatory
gaps. We had a chance to regulate hedge funds as well as credit
default swaps. But we chose not to in both cases--one a
product, the other an institution.
So there were regulatory gaps which were discussed but not
closed, not for lack of knowledge, but for lack of political
will.
Second, we gave various regulators only partial
jurisdiction over their own turf. The most important example is
that the SEC did not have jurisdiction over the holding company
of investment banks. In fact, if you look at the whole Lehman
complex--let's say there were 200 subsidiaries--the SEC
probably had jurisdiction over less than 10.
So you need a consolidated regulator for each institution
because we know people can play games with affiliates and
parents and these sorts of things. That is really a crucial
objective.
Third, as Mr. Litan mentioned, we should not try to have
all institutional monitoring done by Federal officials. We need
help from the market, and the best helpers in the market are
the debt holders. Unfortunately, we have now undertaken a
program where the FDIC is guaranteeing 100 percent of almost
all debt for 10 years--not only of banks and thrifts, but also
of their holding companies. Please note that thrift holding
companies include General Motors and General Electric.
By these broad guarantees, we have created a moral hazard.
We have eliminated the people in the market who are most likely
to help us police these institutions--the large debt holders of
these institutions.
Last, I think we do want to make sure that we are looking
at institutions across the board and not just ones that have
Federal charters. One category of institution with potential
systemic risk is very large insurance companies which are
regulated by the States. We also have the very large mortgage
lenders, which under last summer's act are licensed by the
States. Those are two areas where we should think about whether
a few very large institutions might come under a Federal
regulator.
My last point is that we should not try to form a new
Bretton Woods, whatever that means. We have a hard enough time,
as you know, getting everyone in the Senate to agree on
legislation. Since the chance of getting all major countries to
agree on a new international institution is remote, we should
not spend a long time waiting for this to happen.
What should we do here in the United States?
I am personally quite skeptical about the consolidation of
all financial agencies into one. We did not see a lot of
benefit from the Financial Services Authority (FSA) in the
United Kingdom, a consolidated regulator, in terms of
preventing a financial crisis. These consolidations of agencies
have as many problems as they do benefits.
As Mr. Litan pointed out, you do not want too many cooks.
You want one person or agency with responsibility for each
financial service. Also, you want an agency that is pretty
nimble. If it is a big bureaucracy with lots of different
divisions, it is hard to move quickly.
I tend to think that the Federal Reserve is the right
agency to be the monitor of systemic risks. It has a lot of
experience in keeping tabs on macroeconomic trends.
I also agree with Mr. Litan's point that the Federal
Reserve has been acting as a consumer protection agency in the
mortgage disclosure area. It is not a function that fits in
very well with what the Federal Reserve does. Quite frankly,
the Federal Reserve did not do a very good job in that area, so
I would tend to move that function to another agency.
According to Federal Reserve officials, their jurisdiction
over banks and bank holding companies helps them understand
risk and other financial issues. So I would leave that
jurisdiction with the Federal Reserve.
My model, which I outline in my written testimony, is that
the Federal Reserve would be the central risk regulator. The
buck stops there. But it would not be the primary regulator of
all large financial institutions. We would leave that to the
functional regulators for several reasons.
First, I do not want to identify these systemically risky
institutions because then everybody will want to become one.
This could pose an antitrust problem. Institutions will want to
merge so that they can become too big to fail. If you are
systemically monitored and you are labelled that way, then
everyone will feel you will never be allowed to fail and act
accordingly.
Second, I think the functional regulators know a lot more
about their areas than the Federal Reserve does. For instance,
in my view, large hedge funds should be registered with the
SEC, which should inspect their books and have them file
reports. But the SEC should funnel information to the Federal
Reserve that relates to macro risks.
And so I see us as having a lot of functional regulators
feeding information to the Federal Reserve, and the Federal
Reserve with the job of putting it all together. I would not
start a new agency just to monitor systemic risk. To start a
new bureaucracy takes a lot of time and effort.
I think the Federal Reserve, if it lost its mortgage
disclosure function, is the appropriate agency to monitor
systemic risks. It would have to develop more expertise in
capital markets, but it would be sent information by all the
functional agencies with their experts.
Then, if the Federal Reserve decided action needed to be
taken to reduce the potential for a systemic failure, it would
not just act itself. It would go back and consult with the
primary regulator, the SEC, the insurance regulator, or the
FDIC, so we would get a combined effort. You really would not
want the Federal Reserve acting alone on systemic risk without
the knowledge or expertise of the relevant functional agency.
So that is my recommended approach. I guess my approach is
roughly between those of the prior two speakers. It is making
the buck stop with the Federal Reserve, but setting up a system
by which it relies on inputs from all the functional
regulators. This approach would produce some of the benefits of
coordination that Mr. Silbers was advocating.
Chairman Lieberman. Thanks. It is very interesting, and
very helpful. We will have 7-minute rounds of questions.
I find your term, central risk regulator, to be more
comfortable than the systemic risk regulator. You have said,
Mr. Pozen, in your ideal vision of what should happen here, the
Federal Reserve would be the central risk regulator, and Mr.
Silvers and Dr. Litan have also spoken about the value of a
central risk regulator whether it is a new agency or a college
of regulators.
I want to understand what this central risk regulator does
in your vision of the Federal Reserve playing that role. To go
back to my earlier observation, it is different, is it not,
from filling the gaps that exist in current regulation?
Mr. Pozen. Absolutely.
Chairman Lieberman. In other words, if credit default swaps
in the trillions of dollars or hedge funds in the trillions of
dollars are operating essentially unregulated, the systemic
regulator or central risk regulator may keep an eye on that,
but we need to give somebody else the authority to regulate
them.
Mr. Pozen. I agree with that. Under my approach, there
would always be someone else as the primary regulator except
for Federal Reserve banks and bank holding companies.
Chairman Lieberman. What would the Federal Reserve, as a
central risk regulator, do?
Mr. Pozen. I think the Federal Reserve would focus on the
five historic indicators of financial crises outlined in my
testimony.
Chairman Lieberman. So they would watch out for those.
Mr. Pozen. Yes, they would look to see which products or
which institutions were growing very rapidly.
Chairman Lieberman. Right.
Mr. Pozen. They would look to see what financial firms had
very high leverage ratios. They would look to see whether any
sort of financing bubbles are being created. And I am sure if
they look carefully at the history of financial crises, they
would wind up with 10 more concrete indicators of what factors
are likely to cause a financial crisis. Those are the areas
where they ought to focus.
Further, it seems to me, it would be part of the Federal
Reserve's job to point out where gaps exist and to request that
gaps be filled in the regulatory structure.
Chairman Lieberman. OK.
Mr. Pozen. They would not be the ones to fill them, but
they would say: OK, we have this new product. It is a credit
default swap. The New York State Insurance Department has
declared it is not an insurance contract, but it is growing
very quickly.
It is very important. It really should not be regulated by
the States. It should be regulated by some Federal agency. We
call on Congress to fill this gap.
Chairman Lieberman. Yes.
Mr. Pozen. And that would be a second important function.
Chairman Lieberman. So, right now, the Federal Reserve is
not carrying out that kind of central risk regulation oversight
function, not asking the kinds of questions that you and the
others think should be asked as what might be called early
warnings of coming broad-scale failure.
Mr. Pozen. Yes. I think, unfortunately, the Federal Reserve
tends to get involved when the failure is upon us.
Mr. Silvers. When the horse is out of the barn.
Chairman Lieberman. Right. Does it have the authority now
in statute to perform that central risk regulation?
Mr. Pozen. I do not think it really does.
Chairman Lieberman. So that would be something we would
need to do.
Mr. Pozen. It has broad authority relative to bank holding
companies.
Chairman Lieberman. Right.
Mr. Pozen. But it really does not have authority as a
general risk monitor. It can cooperate with the other agencies,
but they are not under an obligation to give the Federal
Reserve information on a regular basis.
Chairman Lieberman. Of course, if the Federal Reserve is
not performing that central risk regulating role, no other
institution is either.
Mr. Pozen. That is true, and I think that the Federal
Reserve probably would need to broaden its capabilities. There
are certain areas where the Federal Reserve is very strong,
say, in macroeconomic analysis. Becoming a general monitor of
systemic risks would require that the Federal Reserve become
more sophisticated in capital markets.
Chairman Lieberman. Right.
Mr. Pozen. As I say, while the Federal Reserve has acted in
part as a consumer protection agency, this seems out of sync
with its core functions.
Chairman Lieberman. I agree.
Mr. Pozen. So we ought to think carefully. There may be
other functions that should be taken out of the Federal
Reserve's mandate.
Chairman Lieberman. Taken away, yes.
Mr. Pozen. And so, the Federal Reserve ought to be a bank
regulator and a central risk monitor.
Chairman Lieberman. Yes. In a way, you are answering the
concern that some like former Treasury Secretary Paul Volcker
have expressed, that if we put this function--central risk
regulator, early warning, etc.--on the Federal Reserve, we may
be overloading it. But you are saying, take some of what it is
doing now away from it because it is less urgent.
Mr. Pozen. I think it is not only less urgent, it is a
consumer protection function. As I am sure Mr. Silvers would
agree, consumer protection should be the main focus of an
agency.
If you tell an agency, you have to be a prudential
regulator and you have to also look after consumer protection,
consumer protection tends to get subordinated and solvency
takes precedence.
Whether it is the SEC, the FTC, or some other agency,
investor protection and consumer protection need to be placed
with an agency where that is their main mandate.
Chairman Lieberman. Mr. Silvers and Dr. Litan, is there
general agreement on what the systemic or central risk
regulator should be doing?
I know there is disagreement on who should do it among you.
But do you agree that it is to ask the kinds of early warning
questions that Mr. Pozen has described?
Mr. Silvers. Mr. Chairman, I would sort of unpack that a
little bit more, I would guess.
Chairman Lieberman. Go ahead.
Mr. Silvers. Well, two points. One is that I think our
history of our existing regulatory bodies, including the
Federal Reserve and particularly the Federal Reserve, at
performing that early warning function has not been very good.
In our report, we recommend essentially a body of
nongovernmental experts, academics, people like my colleagues
on this panel not embedded in the daily to and fro, who would
play that kind of reconnaissance function. That recommendation
from the Congressional Oversight Panel, I think is in large
part based on the actual track record of the Federal Reserve
and, to a lesser degree, the other agencies.
Chairman Lieberman. That is very interesting. And that is
different from the college of regulators?
Mr. Silvers. Yes. That is a different panel. It is not
something with significant staff. Its sole purpose is to have a
check outside the regulatory processes and the political
processes, intellectually.
Mr. Pozen. I think it is an interesting idea. It is like an
advisory commission to the Pentagon, as we now have in defense.
Mr. Silvers. Well, precisely.
Mr. Pozen. I think it is very consistent with having the
Federal Reserve as the central risk monitor. This would be a
group that would act as an idea generator and would keep the
Federal Reserve on its toes. It seems like a good proposal.
Mr. Silvers. In particular, it would issue a mandated
report, in our view, to Congress on what is coming over the
horizon.
Second, Mr. Chairman, this, I am afraid, is influenced by
my experience and our experience with respect to TARP, that we
looked at the systemic risk regulator as, in part, having this
advance warning function but also necessarily being the body
that acts when a systemic crisis occurs.
And it turns out, of course, we have experienced it when a
systemic crisis does occur, that the range of action often
turns out to be much more extensive and much more involving
public money than we might have thought in advance.
Chairman Lieberman. Right. I am over my time. But, Dr.
Litan, why don't you get into this a moment?
Mr. Litan. Yes. So, I have a couple of points.
One, the idea of an outside body doing the warning is an
interesting idea. It is not mutually exclusive. You can have
them and the Federal Reserve do this. So I think that is point
one.
Point two, in an ideal world, you would like to keep the
list of the SIFIs private.
As a practical matter, however, the markets will interpret
any large institution that, for example, may have larger
capital requirements or different liquidity requirements as
being a SIFI. It will take the markets about five seconds to
figure out that the regulators are treating these institutions
differently, and, as a practical matter, the secret will be
out.
And the last point is the issue that Mr. Pozen has raised
and, actually, Mr. Chairman, you raised. Do we agree on exactly
what this regulator should do? We all agree that early warning,
probably supplemented with some outside advice, but I think
there is some disagreement about how much the systemic
regulator needs to get into the weeds.
So, under one model, let's say Mr. Pozen's model, they
delegate, but they are overseeing and they are issuing
thunderbolts, if you will.
In my model, I am actually having them on the front lines
and being involved in the direct supervision of the
systemically important institutions. They have the expertise
already from supervising large bank holding companies. They
would need more staff, I admit. I think you would probably
borrow them from the Comptroller and other agencies.
But the thing that worries me about the sort of delegation
model is that it violates the ``buck stops here'' principle. I
worry that the Federal Reserve Chairman will call up the OCC
and say, look, you ought to watch Citigroup and certain other
large institutions more carefully. And the Comptroller says, I
do not agree. And then they argue.
That is what happens in the real world. Now not all the
time, and it is true that the Federal Reserve Chairman does
have a lot of influence. But I have been in government before,
at least in the Executive Branch. People have different views
about these things.
Ultimately, at the end of the day, let's take the Federal
Reserve if they are going to be the agency. If they are the
ones shelling out the bucks, it seems to me they ought to have
the final say on what is going on underneath with the
institutions.
Mr. Silvers. But they are not shelling out the bucks. That
is the problem.
Chairman Lieberman. I will give you a quick response, and
we will go to Senator Tester.
Mr. Pozen. Thanks. First, that would require the Federal
Reserve to have deep expertise in six or seven different areas.
That is not likely.
Second, I think the buck still stops at the Federal
Reserve. It just gets information from these other agencies.
And, third of all, we do have the President's working group
to resolve disputes among financial agencies.
Mr. Silvers. Senator Lieberman, just one sentence about
this: The Federal Reserve is not ultimately shelling out the
bucks. The taxpayer is, meaning that when we move to a real
systemic crisis, as we have learned through TARP, it is the
taxpayer shelling out the bucks. And that is why. That
underlies my view that it needs to be a public body.
Chairman Lieberman. So the question is not only where the
buck stops but who is shelling out the bucks.
Mr. Silvers. Right.
Chairman Lieberman. OK.
Senator Tester, you may have heard a term being used by Dr.
Litan, SIFIs. I want to assure you that you arrived at the
right hearing, that we are not exploring the world of Dr.
Spock. SIFIs, as I have learned this morning, are systemically
important financial institutions.
With that, it is all yours.
OPENING STATEMENT OF SENATOR TESTER
Senator Tester. That is good to know, Mr. Chairman. I
appreciate that because I was thinking maybe I did not do
enough reading last night.
I, first of all, apologize for not being here for the
beginning of the testimony. I appreciate you being here as
always, and I appreciate the Chairman for calling this hearing.
As you folks well know, how we get consumer confidence back
in the system is going to be critically important and how we do
it and do it right is not going to be, at least from my
perspective, easy.
Let's just talk about the Federal Reserve for a second and
follow up on some of the things the Chairman was talking about.
If it becomes the major central systemic regulator, is there
fear of too much power in one agency?
Mr. Pozen. Senator Tester, it is a good question. I would
answer that in two ways:
First, we were talking--and I am not sure exactly when you
came in--about taking some functions away from the Federal
Reserve such as consumer protection in the area of mortgage
disclosure. This is not central to the Federal Reserve's
mission, and perhaps it has not done as good a job as it should
have.
Second, at least under my model, the Federal Reserve would
not be the primary regulator of, say, an investment bank or an
insurance company. That would still stay with the functional
regulators, who would work closely with the Federal Reserve.
Information relating to systemic risk would be channeled to the
Federal Reserve from the SEC, the Comptroller of the Currency,
etc., and the Federal Reserve would have the ability to get
more information from these agencies.
By contrast, if we ask the Federal Reserve to be the
primary regulator of, say, the 20 largest financial
institutions, then it would have a lot of power, and it would
have to develop a lot of different kinds of expertise.
In my view, you solve the problem of having the Federal
Reserve becoming too powerful by following a decentralized
approach. I would call it a specialized expertise model. For
example, the SEC would spend most of its time on investor
protection; it is not focused on systemic risks. But the SEC
would pass on risk-related information to the Federal Reserve,
which would aggregate it with other data in analyzing systemic
risks. The SEC is an investor protection agency, and that is
what it does best.
Mr. Silvers. Senator, I think your concern is well founded,
and I think that it is well founded for the following reason:
If you ask the Federal Reserve to play this role, you are then
asking the Federal Reserve either to take on real power, as I
think Mr. Litan would like it to do, or the question becomes
what real abilities is this process going to have to achieve
the purpose, to actually constrain systemic risk and to act in
a crisis.
If we give the Federal Reserve real power, then the concern
outlined in my testimony comes to the fore, which is that the
Federal Reserve is not a fully public body. In particular, the
operational arm of the Federal Reserve and the arms of the
Federal Reserve in the financial markets, the regional Feds,
are both capitalized and governed in part by the very
institutions that they regulate. The result of the Federal
Reserve not being a completely public institution is that the
Federal Reserve is neither fully accountable or transparent to
the public.
That is not an appropriate structure in which to vest
either the kind of broad regulatory powers that are being
envisioned here by some of my colleagues on the panel nor is it
an appropriate structure to hand over the power to disburse
taxpayer funds which is a necessary component of systemic risk
regulation when a crisis hits. For that reason, if one wished
to vest the Federal Reserve with this type of power, you would
have to change its governance pretty significantly, and it is
not clear that is a good idea in relation to the Federal
Reserve's actual core mission which is monetary policy.
Furthermore, I am very influenced by two issues of
expertise and information sharing. My colleague, Mr. Pozen,
thinks it will be easily handled, but I think it will not. I
think if systemic risk management is not collective among the
agencies, that information will not be shared in an appropriate
way. I think that is just human nature and the nature of
matters in Washington.
And, second, I think that the expertise in the broader
capital markets that Mr. Pozen is convinced can be easily
acquired by the Federal Reserve is not actually that easily
acquired and, second, would be completely duplicative of
expertise resident in the SEC and the CFTC today.
Mr. Pozen is correct that the SEC's culture is not a risk
management culture. It is a disclosure and fiduciary duty-
related culture. But that is why you want to bring these
agencies together to conduct this function.
The punch line, I would say, though, is that we cannot turn
over this type of responsibility, either in terms of power to
regulate or in responsibility to regulate and in terms of the
ability to expend the taxpayer dollars to an institution that
in its ultimate functioning is self-regulatory and not
completely publicly accountable. It would be irresponsible to
do so.
Mr. Litan. We do not live in a perfect world. We have all
kinds of tradeoffs with these considerations.
So, to the point about their governance structure, I think
if you give more power to the Federal Reserve you may have to
change its structure. For example, if you told the Federal
Reserve that it has regulatory responsibility, you could say
that part of their activity is subject to the appropriations
process and is under congressional oversight.
You can leave monetary policy the way it is, where the
Federal Reserve gives the money back at the end of the day,
assuming it has any these days. But, in any event, you could
change the way the Federal Reserve's regulatory activities are
conducted. That is point one.
Point two, you could rebalance the concentration of power--
for example, by transferring the mortgage or the consumer
protection part of the Federal Reserve to other agencies.
At the end of the day, and I do not want to exaggerate
here, we have had the financial equivalent of a nuclear
meltdown. That is what it is. This is a horrific set of
circumstances. Frankly, it blows my mind. I would have never
expected this 2 years ago if somebody had told me this was
going to happen. And God forbid anything like this should
happen again.
So, at the end of the day, if that is the image that you
have in your mind, do you want a committee making the decisions
about this or do you want some one agency in charge?
I would feel more comfortable if someone was in charge, so
at the end of the day, after it all happened, we do not have
fingerpointing again, where the Federal Reserve Chairman comes
before you and says, I recommended X, Y, and Z to the CFTC and
the SEC and the Comptroller, but they did not listen to me. And
the Comptroller says, no, we have a difference in views. And
then we have fingerpointing.
At the end of the day, you, in Congress, want somebody to
be held responsible. So, if the magnitude of the problem
warrants it, you concentrate the power, and then you subject it
to oversight to solve the transparency problem. That is my
view.
Senator Tester. Can I keep going?
Chairman Lieberman. Go right ahead.
Senator Tester. All right.
The thought occurred to me as each of the three of you were
speaking that we have a Committee here of 17 members, and the
Banking Committee has the same kind of committee, and I
wondered if you three could get together and could come up with
a program that would work because it is going to be five times
more difficult for us, plus with a lot less expertise.
Consumer protection versus systemic regulation, are they
exclusive to one another?
For instance, good central systemic regulation, is that
good for consumers? Is that good for consumer protection? Does
one fit the other's needs and vice versa?
Mr. Silvers. Senator, I think there are many ironies built
into the answer to your question.
The first irony is that I think it is hard to read the
record of the Federal Reserve's oversight of the mortgage
markets and not conclude that the Federal Reserve felt that
consumer protection was an afterthought, and it turned out that
without effective consumer protection there was no effective
systemic risk management. Things ran exactly the opposite to
what the assumption was.
I think the lesson from this--I think Mr. Pozen talked
about this a few moments ago, and I absolutely agree with him--
is that there is a tension between not so much systemic risk
management properly construed but what it often turns into,
which is the desire to protect the safety and soundness of
particular institutions. There is a tension between that and
consumer protection in real life.
I think everyone who has been in this area knows that
typically bank regulators are safety and soundness focused, as
they should be. The safety and soundness mission is quite
important.
But the result when you put those two missions together is
that you get neither. You get neither effective consumer
protection nor effective safety and soundness regulation. For
that reason among others, the Congressional Oversight Panel
recommended a separate consumer protection regulator.
Now there are several options built into the report. I
would make clear my view is that consumer protection in the
financial markets needs to be separated from the safety and
soundness mission entirely.
Then the question is where does it go? It could be a
distinct agency. It could be the Federal Trade Commission which
has consumer protection responsibilities. It could be the SEC.
There is a caveat to the SEC. I am an extremely strong
supporter of that institution and believe it needs to be
revived and strengthened. However, its conception of its
mission is heavily oriented toward disclosure and toward
fiduciary duties. It is not a substantive regulator of the
fairness of the markets it regulates.
Consumer financial services--mortgages, insurance, insured
bank accounts, credit cards--are areas that I think pretty
obviously need substantive oversight. It is not clear that the
culture needed matches the SEC's culture and mission.
But the larger point that consumer protection and investor
protection need agencies focused on those missions is exactly
right, and I hope if we learn one lesson from this meltdown
that Mr. Litan described it is that if you do not get that
mission right, you are very likely to get these larger systemic
missions wrong as well.
Mr. Pozen. I think the short answer is that they are
related and that the breakdown of one can lead to a breakdown
of the other. However, as a matter of regulatory strategy, I
strongly agree with Mr. Silvers that we probably want to take
the consumer protection functions out of the Federal Reserve,
put them in an agency where that is the main focus, and then
the Federal Reserve will concentrate on solvency and other
aspects of systemic risk. That seems to be the way to go.
Mr. Litan. And I agree entirely with what Mr. Silvers said.
In an ideal world, or even less than an ideal world, I would
consolidate the SEC with something like a FTC to melt down
these cultures.
I just want to make one additional point. In my
professional life, I am sort of bicoastal. I live in Kansas
City, but I am also affiliated with the Brookings Institution.
So I am here on the East Coast a lot. Aside from the
disadvantage of traveling on airplanes, the advantage of being
bicoastal is that I get to live in the Heartland and hear real
people most of the week, and it has been good.
I will tell you one of the things I have heard from
traveling around the country, and I am sure that you too, when
you go back to your home districts, hear this. The public is
not only furious, the public has no confidence in our
regulatory system. When I talk to groups about how to try to
fix this and reorganize the government, at the end of the day,
I want to tell you that I think we have an unbelievably
skeptical public about the ability of regulation to fix the
financial system. So that whatever we do, wherever we lodge the
power, we have a huge uphill road to climb with the public.
And what really has sent people over the edge is the Bernie
Madoff affair. People all over America are asking: How could
something like this happen in the United States?
And so, in addition to your point about the culture of the
SEC being different from the others and how we have to change
the culture there, we also have to convince a very skeptical
public right now that there is a fix out there that will work.
Senator Tester. I will just tell you I hear the same exact
thing, and I, quite frankly, am just as frustrated and just as
furious as they are. Whether you are talking about Mr. Madoff
or whether you are talking about how some of those TARP funds
were used. We will just leave it at the fact that things are
not running smoothly at this point in time.
I think they will be fixed. I think it is just a matter of
time and getting some common-sense regulation. But what is good
for consumer protection, I heard you guys say, is also good for
systemic regulation, and that is important.
I do have some other questions, but I will wait for another
round. Thanks, Mr. Chairman.
Chairman Lieberman. Thanks, Senator Tester.
Senator Tester is one of, I think, two Members of this
Committee who is also on the Banking Committee. So that is an
important overlap.
I agree with you. I hear the same thing at home. Even
though the Madoff scandal is not, at its heart, relevant to or
the same as the housing bubble, the credit default swaps, etc.,
it does connect to the critical point of whether there was a
fiscal cop on the beat. How could this guy get away with this
Ponzi scheme particularly when we now have this gentleman who
seemed to have been trying to get the SEC to investigate for
years?
So this work is urgent. I know that the President hopes to
at least have an outline of a proposal before he goes to London
in early April. But it is critical now in terms of the
confidence without which the economy will not recover.
Senator Burris, thanks for being here. We turn to you now.
OPENING STATEMENT OF SENATOR BURRIS
Senator Burris. Thank you, Mr. Chairman.
I certainly have gone through the testimony of the
witnesses even though I was not here to listen to them.
Being an old banker and a part of some of that system
during my younger days, I am just wondering, where did we lose
control of this situation?
You have the FDIC, the Comptroller of the Currency, the
SEC, all of these regulators. Was it turf that started some of
this or nobody ending up with complete oversight and authority
for something like this to happen?
When we got rid of Glass-Steagall, the banks started using
all types of different instruments and insurance and all these
other things. Where did we lose control for the systemic
problem to come in?
Mr. Silvers. Senator, there are probably as many answers as
there are hours in the day to that question, but let me give
you a couple of thoughts that you may be surprised by.
One thing that is quite striking right now as we look at
the crisis of our mega-institutions is how few actual bankers
you find running them. When you start asking, well, who is in
charge here? Where are the people who know about underwriting
loans? The sort of old-fashioned bankers?
Senator Burris. Which I was, an old-fashioned banker.
Mr. Silvers. They are hard to find, and that, I think,
tells us something fairly deep.
I will take it one step further. We moved very dramatically
over the last 30 years, and you can see it in all kinds of
statistics about where financial assets are, away from banking
and institutions and toward markets, toward derivatives
markets, toward securitization markets and so forth.
There are a number of advantages to having done that, but
it is hard not to look at what has happened and also see that
there have been some profound disadvantages to that, including,
and I think the Chairman referred to this in his opening
remarks, the lack of skin in the game, in securitizations, for
example.
There is a deep belief among many academics that markets
are extraordinarily good at capturing information and making
decisions about things like risk. It is a little unclear to me,
looking at this landscape and this history, as to whether that
is really true in relationship to the old-fashioned kind of
banking activity that you were just describing.
Second, with respect to regulators and where did we lose
control on a regulatory basis, I think several big bad ideas
got going. One big bad idea that I refer to in my written
testimony goes back into the 1970s, which is the notion that
financial regulation is about protecting the weak, so that
basically we look very heavily at how essentially poor people
are treated and consumers are treated, but we do not look very
much at large, sophisticated actors because we figure they can
take care of themselves.
That idea, and I am not in any way at all against consumer
protection or against measures for the weak, but the idea that
we let the strong do whatever they want turns out to be exactly
what produces a systemic catastrophe. It also fed this notion
of regulatory loopholes, regulatory holes in our system.
Then, finally, I would just observe that it is very clear
that the place where the breakthrough really took off, the
moment in time when we really let our credit systems run loose
was in the very early part of this decade. It is what I would
call essentially idiot Keynesism. Policy decisions were made to
stimulate our economy through individual borrowing rather than
intelligent Keynesism which is what I think Congress and the
President are engaged in today.
That is an unsustainable move, idiot Keynesism. You cannot
stimulate an economy through lending money to people who cannot
pay it back.
I would finally note, and I think this will not surprise
you now, coming from an employee of the labor movement, that
ultimately the decision to try to have a high consumption, low
wage society was a prelude to disaster and that we tried to
make up the gap through credit, and it is not a sustainable
strategy.
Mr. Pozen. Let me just take up one aspect of what Mr.
Silvers said because it has not been focused on that much.
Senator Burris. Sure.
Mr. Pozen. I personally was recruited to serve as an
outside director of two large banking institutions, and I was
shocked by how little expertise there was on those boards. In
the end, regulators can only do so much. The day to day, month
to month work must be done by boards. But if you look at a lot
of bank boards, you really have to question whether they have
enough financial expertise to deal with these very complex
institutions.
You can argue that if somebody does not really know much
about banking, then they may be very independent. But is that
the type of director we want for large banks? In the end, I
could not be a permanent member of those boards because I had a
potential conflict of interest.
So we have a lot of very distinguished people on bank
boards, who spend one day every other month for a total of 6
days a year. They are not banking experts, and these are very
complex institutions. They do not seem to have known very much
about the significant risks taken by these institutions.
I would suggest that there is a different model of a board
of directors, which you see in companies that are owned by
private equity funds. These boards have five or six directors,
not 12 or 14. Almost all those directors are retired executives
from the relevant industries, and they spend 3 to 4 days a
month at the company.
Also, their compensation is structured differently--low
base salaries with significant stock options. Those directors
really care about what happens to that institution. They have
the time, the expertise, and the financial incentive.
So, in my view, we should consider a different model for
corporate governance. I cannot address all types of companies,
but for large and complex financial institutions, you really
need a different board structure. This is one of the subjects
that has not been focused on yet.
Look at the Citigroup board, filled with distinguished
people. But where was the audit committee when all these risky
deals and practices were happening?
The directors followed all the rules in the Sarbanes-Oxley
Act. They were all independent. So there are limits to a
procedural approach to governance.
But the directors of Citigroup, as opposed to a private
equity board, were not experts on financial institutions. They
did not spend a lot of time on company business, and they did
not have sufficient financial incentives aligned with the
shareholders.
We do not have to ask whether a chief executive officer
(CEO) from a company controlled by private equity received a
golden parachute when he or she was fired for doing a poor job.
It has never happened, and it probably never will happen. If we
had the right board of directors, it would not have happened at
these financial institutions.
Mr. Litan. Senator, just a few extra things because we
could go on, as Mr. Silvers said, forever.
You know lawyers frequently describe what are called but-
for-causes of accidents. But for X, Y, or Z, it would not have
happened. In all the tomes that are going to be written about
this financial crisis, there are lots of but-for-causes, and we
have heard just some examples. I am going to give you my top
three. All right?
If you look at the subprime numbers, they went off the
charts in 2004, 2005, and 2006.
Chairman Lieberman. What do you mean by subprime numbers?
You mean the number of subprime mortgages?
Mr. Litan. The number and the volume of securitizations,
they went through the roof in those years.
If we could have replayed history and notwithstanding that
we have State mortgage brokers--if we had minimum standards for
mortgage origination that would have prevented no documentation
loans, no income loans, and loans to people without any down
payment, a huge amount of the subprime explosion would have
never happened. That is point one.
Second, there was gasoline all over the floor of the
financial system in the form of excessive leverage. That was
what I think both Mr. Silvers and Mr. Pozen have talked about.
So that when the mortgages blew up, they ignited the fire, and
the fire was fed by the leverage.
Part of it was the SEC liberalized the rules on the
securities companies and, in particular, allowed them to fund
their assets with too much short-term money, which proved to be
highly destabilizing. The government-sponsored enterprises
(GSEs) also were way under-capitalized, and now we saw what
happened to them. So the second thing is that our key financial
institutions did not have enough skin in the game.
And the final point relates to credit default swaps. Part
of the reason investors thought subprime securities were safe
is that they were backed by bond insurance or you could buy a
credit default swap to cover risk of default.
As it turned out, however, the bond insurers were asleep.
The ratings agencies also were asleep because they all had
their models based on a few years, not on any long historical
period. And the credit default swap market is basically an
insurance market that was unregulated, and we allowed dealers
to write contracts with not enough money in the till to pay it
back when the bills came due. Now we, the taxpayers, are paying
all those bills.
I honestly believe even with all the other problems that
Mr. Pozen and Mr. Silvers have talked about I think we would
have escaped a good portion of this disaster if we had
addressed these three items.
Senator Burris. Mr. Chairman, we have to leave shortly. So
I have a lot more questions, but I will yield at this point,
and hopefully we can continue this at some other time.
Chairman Lieberman. Thanks, Senator.
This has been a great panel, both in your individual ideas
and in the back and forth between you. Maybe we will see if we
can do a final round if the three of us want to stay at 5
minutes each, and we will get out of here hopefully in time to
get to Prime Minister Brown.
You have all convinced me that we do need a systemic risk
regulator or a central risk regulator in some sense. Depending
on your model, it may not be a regulator. It is a kind of
financial system overseer in the sense of advance warning.
We are holding this hearing pursuant to the traditional
Governmental Affairs jurisdiction of this Committee. In the
last 5 years, we received a new jurisdiction, Homeland
Security.
And I go back to, Dr. Litan, your reference to what we are
experiencing now as a financial meltdown comparable to a
nuclear meltdown.
There are, to me, as I listen to your testimony, stunning
comparisons to the work we did after September 11, 2001, which
led to the creation of the Department of Homeland Security
(DHS) and, an even better example, the Director of National
Intelligence (DNI). Because what were we saying after September
11, 2001?
There was nowhere where the dots could be connected. If
this agency of the Federal Government had shared what it knew
with this agency and that agency, I tell you in the end I
concluded from all I have seen that we could have prevented
September 11, 2001. But they were not.
So, in a way, it is that, but it is also putting somebody
up on top, looking out over the horizon, constantly asking the
question: Are we seeing something here that is really
troublesome that could lead to a major economic crisis or
system failure?
You have convinced me of that, but there remain important
questions for all of us. Who does it? What are the kinds of
authorities that group has?
But now I come to the other part of this, and let's just go
to the final part of your last answer, Dr. Litan. We know that
there were certain kinds of economic activity that were
extremely consequential that were simply not regulated. Credit
default swaps are one. Hedge funds are another.
So I want to ask you for a quick answer. I have spoken too
long now.
A central risk regulator is not enough of a reform to avoid
a repeat of this mess we are in here. I presume we need to
regulate some of the activity, like the credit default swaps,
that brought the house down. And I want to ask you quickly if I
am right and just quickly, if so, who should do this? Who
should oversee credit default swaps or hedge funds or anything
else you think contributed to this?
Mr. Litan. So, shortly, I talk about credit default swaps
in my testimony.
Chairman Lieberman. Right.
Mr. Litan. As much as I want the Federal Reserve to be on
the front lines of the so-called SIFIs, I am not confident that
they are the best regulator of credit default swaps or any
derivatives market. I still see a role for the SEC or the CFTC
directly overseeing that.
People are talking about clearinghouses now being formed
which will reduce the risk, but you have to regulate the
clearinghouse. You have to make sure it is solvent.
Chairman Lieberman. Yes.
Mr. Litan. And then you have all these customized contracts
which will not be cleared. What do you do about them?
I think maybe one way to do this, and I am not necessarily
advocating it, is to have the Federal Reserve overseeing all
this, getting the relevant information from the agencies. But
to satisfy my desire that there be some teeth, you could give
the Federal Reserve the authority so that if it walked in and
said, look, Citigroup is not doing the right thing or there is
a section of the market that needs to be looked at or whatever,
the Federal Reserve could at least do something on its own
initiative and not just be stuck with calling on the phone and
saying, please will you do this? That worries me.
Mr. Silvers. Mr. Chairman.
Chairman Lieberman. Yes, I was going to ask the two of you,
quickly. What about derivatives markets that are unregulated,
hedge funds, etc.? Is that the SEC or the CFTC that we should
give that to by statute?
Mr. Silvers. Senator, my view is that what President Obama
said at Cooper Union during the campaign is the right answer,
conceptually. Things should be regulated for what they are, not
what they are called.
Those derivatives that are based on securities, where the
underlying instrument is a security, need to be under the
jurisdiction of the SEC or a merged SEC and CFTC.
Those derivatives that are effectively insurance need to be
regulated like insurance. It does not mean that they need to be
regulated exactly the same as an insurance policy but the same
capital requirements notions and the same review as to whether
they do what they say they do needs to be done.
With respect to hedge funds, it is clearly something that
ought to be under the SEC. A hedge fund is nothing but a money
manager, and it needs to be there. If the hedge fund is engaged
in activity that substantively is insurance, for example, by
selling a credit default swap, then it needs to be regulated as
if it is selling insurance--again, not exactly like an
insurance company but with those principles in mind.
And I think that is Mr. Pozen's point about somebody has to
be watching the safety and soundness of whoever is doing this.
Chairman Lieberman. That is helpful. Mr. Pozen, a last
word?
Mr. Pozen. I agree that the SEC should regulate hedge
funds, and the merged SEC and CFTC, which I agree should
happen, should regulate hedge funds and credit default swaps.
I just add one more point. One of the great accomplishments
of the 1975 Securities Act amendment was to merge the back
offices of all the securities exchanges into the Depository
Trust Company (DTC) and one clearing corporation. There was a
complicated tradeoff between antitrust considerations and
operating efficiencies in the public interest.
We have lots of groups now who want to be the central
clearing agency for credit default swaps, so many that there is
a lot of in-fighting. In my view, it would be great to have one
clearing agency for the whole world of swaps; or at least, one
for the United States and one for Europe. If we have a lot
more, we are losing a lot of the benefits of a clearing
corporation.
We should look at the national market legislation of 1975
and see whether we can pass a similar bill creating one central
clearing house for CDS. We do not really want people competing
on the back office.
Chairman Lieberman. Good. Thank you. Senator Tester.
Senator Tester. Thank you, Mr. Chairman.
The comments about the subprime and the no documentation
and the low documentation loans are something that is
interesting to me because I cannot imagine people lending money
with no documentation unless you can sell it to somebody who
does not know there is no documentation there, which is exactly
what happened.
Are there any provisions? You will have to be concise with
your answers because we just have a limited amount of time.
Are there any provisions with Gramm-Leach-Bliley that we
need to revisit? And if you can be as concise as possible, it
would be great.
Mr. Litan. I do not think so and this is where I disagree
with Mr. Silvers. I do not think Gramm-Leach-Bliley contributed
to this, Senator Tester.
And the very simple point that we had commercial banks and
investment banks that were not affiliated with each other that
went over the edge by themselves. It was not the fact that they
got merged together that allowed this. I think it would have
happened anyhow.
Senator Tester. We will get to that in another question
later.
Mr. Silvers. As my written testimony suggests, I think
there is a basic problem with the world Gramm-Leach-Bliley
created, which is that you have institutions that have large
regulated, insured businesses and large unregulated, uninsured
businesses, and they interact with each other unavoidably. That
is an unsustainable situation.
Senator Tester. So Gramm-Leach-Bliley needs to be changed
in that particular area?
Mr. Silvers. I think that we need to decide whether we wish
to basically really rein in our investment banks in a pretty
heavy way, recognizing that under Gramm-Leach-Bliley they have
all become bank holding companies, or that we want to have them
run pretty aggressively and separately from insured deposits.
Senator Tester. OK.
Mr. Pozen. I think that is a separate complex issue. To
eliminate no documentation loans sold to the secondary market,
Congress should amend the law that was passed last summer for
the registration of mortgage lenders. They are still left
mainly to the oversight of the States. We need a stronger
Federal presence in mortgage lending.
And we need a very simple rule: You cannot sell more than
90 percent of any loan into the secondary market.
Senator Tester. OK.
Mr. Pozen. If sellers were required to hold on to 10
percent of the loan, they would care more about the soundness
of that loan. Not just the documents; they would care whether
actually the borrower could pay.
Mr. Litan. All three of us agree on that issue.
Senator Tester. We have a situation right now where we
have--I do not know--I think there are 17 banks that are too
big to fail. Maybe more than that?
Mr. Pozen. Who knows?
Senator Tester. The question for me becomes if they are too
big to fail and at some point in time the money is going to run
out, what do we do about that, long-term?
Mr. Silvers. Senator, do you mean what do we do about the
fact that there are banks that are too big to fail or what do
we do about the fact that some of them are unstable right now?
Senator Tester. Well, both. I mean because I think anytime
you have a situation where you are too big to fail that means
you cannot fail. That means that is an inherent problem. If you
are too big to fail, you have a problem.
Mr. Silvers. Senator, in the Congressional Oversight
Panel's report, one of the reasons we recommended that you not
identify who is too big to fail and who is not is so that you
can have a continuous ratchet process around your capital
requirements and your insurance costs that make it more and
more expensive to be too big to fail. The result would be to
encourage less too big to fail institutions.
The question of what do we do with the ones that are sick
right now is that we need to take whatever steps are necessary
to get them back to life in a way that is responsible with the
taxpayers' money because we have a situation now where the four
largest banks have more than 50 percent of the lending ability
and they are paralyzed.
Senator Tester. Yes.
Mr. Litan. So I agree with Mr. Silvers that there ought to
be higher capital charges progressively for larger
institutions. Ditto for liquidity. That would introduce a
penalty, if you will, for getting too large, and is it
appropriately so because they visit costs on the rest of the
system so that they ought to pay for it.
The only area where I disagree, and I have said this
before, is that once you introduce that system, given the
disclosure requirements we have, everyone will know who these
institutions are and you will not be able to keep it secret.
Senator Tester. OK.
Mr. Pozen. Can I just add one more thing?
Senator Tester. Yes.
Mr. Pozen. You should realize that our merger and
acquisition policy now is creating more institutions that are
too big to fail. We have been encouraging mergers and
acquisitions among banks. Although Bank of America was too big
before, we have now made it even bigger with Merrill Lynch. If
Bank of America was too big to fail before, it is now much too
big to fail.
We are also guaranteeing the debt of most banks.
Senator Tester. Trust me. That is the whole problem. But
what do we need to do to stop it?
Mr. Pozen. I think the first thing we should do is start
guaranteeing only 90 percent of the debt of all these banks and
related institutions; investors should hang on to a little
risk. We want the big bond-holders at these banks, thrifts, and
holding companies to help us police the financial situation and
managerial quality of these institutions.
We tell any bank, you issue a billion dollars of debt and
whoever owns it, it is 100 percent insured by the Federal
Government, then the bond holders will not care who is running
the bank or how it is being run.
Mr. Litan. I just want to be clear on the debt. I think Mr.
Pozen and I agree on this, that it is really the long-term debt
where we want people to be on the hook. I think it is
impractical in my own view to say that for deposits.
Mr. Pozen. Yes, I agree.
Mr. Litan. So we are talking about long-term.
Mr. Pozen. We are now out to 10 years.
Senator Tester. I understand that.
Mr. Silvers. Senator, there is one final point about this,
though. If you say here are five banks or here are 20 banks,
and they are the systemically significant ones, what happens
when the one right outside the list fails?
In a situation like we have today, in a crisis, it will
turn out that somebody you thought was actually not
systemically significant is systemically significant. Witness
Bear Stearns and Lehman Brothers. You want to have a system
that everybody is in, where that bright line does not become so
important.
And, second, if you follow the logic of what my two co-
panelists said about who in the capital structure needs to be
held responsible when things go wrong, the clear implication of
that is that we obviously are insuring depositors. We have
effectively insured commercial paper and the money markets that
commercial paper backs up, but there are very powerful reasons
why we should not be insuring long-term debt holders and
particularly not equity holders. And there is absolutely no way
to square that with how we have actually treated the
stockholders and long-term bond holders of Citibank, Bank of
America, and others.
Senator Tester. Well, thank you all for being here. We
could have this discussion well into the evening. So, thank you
very much.
Chairman Lieberman. Thank you, Senator Tester. Great
questions.
You have been a wonderful panel. I am just thinking, going
to Prime Minister Brown now, you have basically said that it is
not time for another Bretton Woods series of agreements and we
cannot wait here in the United States. We have to take action
ourselves. There is too much at risk for us, for our economy,
and the truth is if we right ourselves it will help to right
the rest of the world.
Sometime we will have you back when we have more time to
ask what, if anything, you think the United States should be
doing to connect to the rest of the world since obviously part
of the reality we are living in is a remarkably global
financial system. But no time for that today.
In terms of time, we are going to keep the record of the
hearing open for 15 days if you want to supplement your
testimony in any way or if Members of the Committee who were
here or not here want to submit questions to you to be answered
for the record.
I thank you a lot. You have really helped, I say for
myself, educate me and clarify some questions. In the end,
Senator Collins and my hope is that we will make a
recommendation to our colleagues on the Banking Committee,
essentially a recommended reorganizational chart with some
descriptions underneath about what powers we think different
elements of the financial regulatory system need to have to
prevent a recurrence of what we are going through now.
With that, I thank you all very much, and the hearing is
adjourned.
[Whereupon, at 10:45 a.m., the Committee was adjourned.]
WHERE WERE THE WATCHDOGS?
FINANCIAL REGULATORY LESSONS
FROM ABROAD
----------
THURSDAY, MAY 21, 2009
U.S. Senate,
Committee on Homeland Security and
Governmental Affairs,
Washington, DC.
The Committee met, pursuant to notice, at 2:03 p.m., in
room SD-342, Dirksen Senate Office Building, Hon. Joseph I.
Lieberman, Chairman of the Committee, presiding.
Present: Senators Lieberman, McCaskill, and Collins.
OPENING STATEMENT OF CHAIRMAN LIEBERMAN
Chairman Lieberman. The hearing will come to order. Good
afternoon, and a special welcome to our guests, three of whom
have come from farther than normal to testify--and without
being summoned here by force of law, I might add. So we are
particularly grateful that you are here.
This is our Committee's third in a series of hearings
examining the structure of our financial regulatory system; how
that flawed structure contributed to the system's failure to
anticipate and prevent the current economic crisis; and, most
importantly, looking forward, what kind of structure is needed
to strengthen financial oversight. You will note that I used
the word ``structure'' at least three times here, and this is
because that is the unique function and jurisdiction that our
Committee has. We understand that the Banking Committee in
particular is leading the effort to review regulations in this
field, but we are charged with the responsibility to oversee
the organization of government, and we have tried to come at
this matter of financial regulatory reform with a focus on that
as opposed to the particular regulations.
We learned from our previous hearings that our current
regulatory system has evolved in a haphazard manner, not just
over the 10, 20, or 30 years some of us have been here, but
over the last 150 years, largely in response usually to
whatever the latest crisis was to hit our Nation and threaten
its financial stability.
As a result, we have here a financial regulatory system
that is both fragmented and outdated. Numerous Federal and
State agencies share responsibility for regulating financial
institutions and markets, creating both redundancies in some
ways and gaps in others--gaps particularly over significant
activities and businesses, and redundancies, too, such as
consumer protection enforcement, hedge funds, and credit
default swaps. Our current crisis has clearly exposed many of
these problems.
To strengthen our financial regulatory system, an array of
interested parties--academics, policymakers, even business
people--from across the political spectrum has called for
significant structural reorganization. So as we move forward
and consider this question, it seemed to Senator Collins and me
that it would be very helpful for us to examine the experiences
of other nations around the world, and that is the purpose of
today's hearing and why we are so grateful to the four of you.
Over the past few years, the United Kingdom, Australia, and
other countries have dramatically reformed their financial
regulatory systems. They have merged agencies, reconsidered
their fundamental approaches to regulation, and streamlined
their regulatory structures. Many people believe that these
reforms have resulted in a more efficient and effective use of
regulatory resources and certainly more clearly defined roles
for regulators.
The American economy is different in size, of course, and
in scope from all the others, but there is still much we can
learn by studying the examples of these free market partners of
ours. We really have an impressive panel of witnesses today,
each of whom has not only thought extensively about the
different ways in which a country can structure its financial
regulatory system, but also played a role in that system. And I
would imagine that you all bear some scars from trying to
change the regulatory status quo.
I would also imagine that you know what we have learned
here, that reorganizations are complicated and very difficult.
Our Committee learned this firsthand through its role in
creating and overseeing the Department of Homeland Security and
in reforming our Nation's intelligence community in response to
the terrorist attacks of September 11, 2001. But
reorganizations can also pay dividends and result in a more
effective, responsive, efficient, and transparent government,
and of course, that is what we hope for in the area of
financial regulation.
I am confident in the work that our colleagues on the
Senate Banking Committee are doing to address the financial
regulations, but as I said at the outset, we are focused here
on structure, and the two are clearly tightly interwoven. If we
want to minimize the likelihood of severe financial crises in
the future, we need to both reform our regulations and improve
the architecture of our financial regulators. As Treasury
Secretary Geithner and the Obama Administration prepare to
announce their own plan for comprehensive reform in the weeks
ahead, the testimony presented here today will help ensure that
we are cognizant of what has and has not worked abroad, and
that surely can help us guide our efforts and the
Administration's and clarify for us all which reforms,
regulatory and structural, will work best here in the United
States of America.
Senator Collins.
OPENING STATEMENT OF SENATOR COLLINS
Senator Collins. Thank you, Mr. Chairman.
Mr. Chairman, as you mentioned, this is the third in a
series of hearings held by our Committee to examine America's
financial crisis, and I commend you for your leadership in
convening this series of hearings because I believe that until
we reform our financial regulatory system, we are not going to
address some of the root causes of the current financial
crisis. Our prior hearings have reviewed the causes of the
crisis and whether a systemic risk regulator and other reforms
might have helped prevent it.
Testimony at these hearings has demonstrated that, for the
most part, financial regulators in our country failed to
foresee the coming financial meltdown. No one regulator was
responsible for the oversight of all the sectors of our
financial market, and none of our regulators alone could have
taken comprehensive, decisive action to prevent or mitigate the
impact of the collapse. These oversight gaps and the lack of
attention to systemic risk undermined our financial markets.
Congress, working with the Administration, must act to help put
in place regulatory reforms to help prevent future meltdowns
like this one.
Based on our prior hearings and after consulting with a
wide range of financial experts, in March, I introduced the
Financial System Stabilization and Reform Act. This bill would
establish a Financial Stability Council that would be charged
with identifying and taking action to prevent or mitigate
systemic threats to our financial markets. The council would
help to ensure that high-risk financial products and practices
could be detected in time to prevent their contagion from
spreading to otherwise healthy financial institutions and
markets.
This legislation would fundamentally restructure our
financial regulatory system, help restore stability to our
markets, and begin to rebuild the public confidence in our
economy. The concept of a council to assess overall systemic
risk has garnered support from within the financial regulatory
community. The National Association of Insurance Commissioners,
the Securities and Exchange Commission (SEC) Chair Mary
Schapiro, and the Federal Deposit Insurance Corporation (FDIC)
Chair Sheila Bair are among those who support creating some
form of a systemic risk council in order to avoid an excessive
concentration of power in any one financial regulator, yet take
advantage of the expertise of all the financial regulators.
As we continue to search for solutions to this economic
crisis, it is instructive for us to look outside our borders at
the financial systems of other nations.
The distinguished panel of witnesses that we will hear from
today will testify about the financial regulatory systems of
the United Kingdom, Canada, and Australia. They will also
provide a broader view of global financial structures. We can
learn some valuable lessons from studying their best practices.
Canada's banking system, for example, has been ranked as the
strongest in the world, while ours is ranked only as number 40.
I am very pleased that Edmund Clark has joined the other
experts at the panel. It was through a meeting in my office
when he started describing the differences between the Canadian
system of regulation, financial practices, and mortgage
practices versus our system that I became very interested in
having him share his expertise officially, and I am grateful
that he was able to change his schedule to be here on
relatively short notice. I am also looking forward to hearing
from the other experts that we have convened here today.
America's Main Street small businesses, homeowners,
employees, savers, and investors deserve the protection of an
effective regulatory system that modernizes regulatory
agencies, sets safety and soundness requirements for financial
institutions to prevent excessive risk taking, and improves
oversight, accountability, and transparency. This Committee's
ongoing investigation will continue to shed light on how the
current crisis evolved and focus attention on the reforms that
are needed in the structure and regulatory apparatus to restore
the confidence of the American people in our financial system.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator Collins. Thanks for
that thoughtful statement.
Let us go to the witnesses now. First we welcome David
Green, who was Head of International Policy at the United
Kingdom's Financial Services Authority (FSA) after having
previously spent three decades at the Bank of England. Mr.
Green currently works for England's Financial Reporting
Council. It is an honor to have you here, and we would invite
your testimony now.
TESTIMONY OF DAVID W. GREEN,\1\ FORMER HEAD OF INTERNATIONAL
POLICY, FINANCIAL SERVICES AUTHORITY, UNITED KINGDOM
Mr. Green. Thank you, Chairman. I give testimony, of
course, as a private individual, having worked in those
institutions you described. I also give testimony as a co-
author with Sir Howard Davies of a book on global financial
regulation which discusses a lot of the issues that are before
the Committee today. The views expressed here are entirely my
own, of course, and not those of any of the organizations I
have been associated with.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Green appears in the Appendix on
page 311.
---------------------------------------------------------------------------
There is remarkable biodiversity in arrangements for
financial regulation at a global level. There are essentially
four main types of structure to be found, with multiple
variants. There is the sectoral type, with separate regimes for
banking, securities, and insurance, which can be found in
France, Italy, or Spain. There is the so-called ``twin peaks''
type to be found in Australia or, in alternative versions, in
Canada and the Netherlands; the integrated type, which can be
found in Germany, Japan, Scandinavia, and, indeed, in the
United Kingdom. Then there is perhaps another fourth type,
where the United States might fit, with extraordinary
diversity.
When I was in the FSA, we thought we probably had over a
hundred counterpart regulatory bodies in the United States.
Then there is the role of the central bank, which may or
may not have responsibility for some, many, or, indeed, all
aspects of supervision, as it does in Singapore, for instance.
Probably the most advanced form of the integrated regulator
can be found in the FSA, where it was created remarkably
rapidly when the incoming Labour Government simply decided in
1997, without real debate, that at the same time as giving the
Bank of England independence in the implementation of monetary
policy, it would also create a single regulator for financial
services. That was set in train and eventually subsumed 11
prior agencies, and a single new piece of legislation was
drafted completely de novo with new objectives for regulation
and with a set of principles drafted to guide the regulators.
Not all of integrated regulators have that single piece of
legislation, and they carry on with sectoral legislation. That
is obviously an issue to be thought about when the Committee
addresses the legislative structure that is put in place.
The bodies were merged in a way which enabled prior
existing bodies simply not to be visible anymore. There was
full integration. You cannot find within the regulator the
bodies that were there before, and that was quite deliberate so
that no impression should be created of one of the prior
entities somehow taking over the others.
The rationale for integrated regulation was set out by the
FSA, and in my written testimony, I set out the main arguments,
but the core ones, as you know, are that financial
conglomerates, in particular, undertake a range of banking,
insurance, and investment business. The markets themselves have
instruments which mingle features of all those. And it was
difficult to carry on regulating on a purely functional basis
when that no longer matched the structures of either firms or
markets.
Integration makes it possible to align the regulatory
structure with the way the firms manage themselves so that this
should help with the proper understanding of the overall
business model and of overall risks. It also means that a
regulated firm only needs to deal with one agency for all its
regulatory business, ideally through relationship managers on
both sides.
An integrated regulator ought to be able to manage the
conflicts which inevitably arise between the different
objectives of regulation, and we will no doubt discuss that
later. The concept underlying a single regulator is that these
conflicts exist but need to be managed in one place or another,
and there have been in the United Kingdom adverse experiences
in the management of those conflicts in the past, which is one
of the reasons why the intention was to put them together.
As regards the role of the central bank, there are a number
of issues about the possible conflict of interest which might
take place with the independent conduct of monetary policy.
Monetary policy might be tempted to look more after the
regulated community than the wider interest. And those
arguments are a little bit more difficult to be certain about.
How has the model stood up? Previously, the model was very
widely praised. Since the crisis, like of regulators in many
places, there has been very wide criticism. But much of the
criticism can be pinned down to failures, if you like, at the
global level with the international capital rules regarded as
having fallen short. Markets were inadequately understood. The
way securitization would work and how markets would behave was
very widely misunderstood. That has been a common problem. The
FSA also made mistakes in not doing what it was supposed to do,
simple internal management mistakes.
There has been a lot of work done to go over the lessons of
the crisis. Both the FSA and the Bank of England have
undertaken work to see whether the structure of regulation has
identified any patterns of superior models as a result of the
crisis, and no patterns have been found. The Bank of England
did do some work--which I think I can make available to the
Committee--which finds no pattern at all as between integrated,
prudential, twin peaks regulator, and sectoral regulator. I
think the conclusion has been that the model itself is not
really seen to have been implicated in the way the crisis
unfolded, and, indeed, the fact that banking, securities, and
insurance were all interlinked in the crisis in some people's
minds has reinforced the underlying concept.
Obviously, I would be very happy to answer further
questions as the hearing proceeds. Thank you, Mr. Chairman.
Chairman Lieberman. Thank you. That was most interesting
and a good beginning. So at this state, we would say that, in
your opinion, which one of these regulatory systems was chosen
did not have much of an effect on the economic crisis that
occurred.
Mr. Green. That appears to be the case. You can find a
number of examples, if you take them in isolation, which
reinforce a particular argument. But if you look across the
board, you do not find a pattern. The Bank of England work that
I referred to, which I am sorry I do not have available here,
looked at, I think, about 40 or 50 different jurisdictions and
could find no pattern related to structure.
Chairman Lieberman. Yes.
Mr. Green. And the FSA work has shown that there have been
problems when supervision was inside the central bank and when
it was outside, and, again, no clear pattern can be found.
Chairman Lieberman. That is interesting. I normally would
hold the questions until after everyone testifies and then I
come back. That does not mean that there are not preferences
for one over the other form of regulation.
I also wanted to thank you for your graciousness in
describing the American system as ``diversified.'' That was
nicely done. [Laughter.]
Second we have Dr. Jeffrey Carmichael, the inaugural
chairman of the Australian Prudential Regulation Authority,
with responsibility for regulating and supervising banks,
insurance companies, and pension funds. Dr. Carmichael
currently works in Singapore as the Chief Executive Officer
(CEO) of Promontory Financial Group Australasia.
Thank you for being here.
TESTIMONY OF JEFFREY CARMICHAEL, PH.D.,\1\ CHIEF EXECUTIVE
OFFICER, PROMONTORY FINANCIAL GROUP AUSTRALASIA
Mr. Carmichael. Thank you, Chairman, and let me say what a
pleasure it is to be here.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Carmichael appears in the
Appendix on page 318.
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Our government implemented a new structure in the middle of
1998. Unlike the experience that Mr. Green just referred to
where the United Kingdom Government did it very quickly, ours
was the outcome of a committee that sat for almost 12 months
looking at the options, and it was a great privilege for me to
have been a member of that committee.
The new structure that was put in place realigned a
previous structure a little bit like your own. It was an
institutionally based structure. It was a hybrid structure of
bits and pieces. We had State regulation as well as Federal
regulation. What came out of the reorganization is what has
become known as an ``objectives-based'' or a twin peaks type
model. We do not like the term twin peaks because we actually
have four peaks, so we think that is undercounting.
But the four agencies that were put in place were:
First, a competition regulator that sat over the entire
system, not only the financial sector but the whole economy;
Second, a securities and investments commission, think of a
combination of your SEC and the futures regulator. They had
responsibility across all financial sectors for conduct,
including financial institutions, markets, and participants;
The third was the Australian Prudential Regulation
Authority (APRA), the one with which I was involved. We had
responsibility for the prudential soundness of all deposit
taking, insurance, and pensions;
And the fourth was the central bank, which was given, of
course, systemic responsibility for monetary policy, liquidity
support, and regulation of the payment system.
Over the top of that was a coordinating body, called the
Council of Financial Regulators, which includes the Department
of Treasury as well, and that is a very important add-on.
The defining characteristic of this architecture--and I
should add this is in some ways very similar to your plan that
was proposed by Former Treasury Secretary Henry Paulson earlier
in 2008, but with a couple of important differences, which we
can talk about later--is that it was unique in the world at the
time it was put in place in Australia, and so far as we know,
only one country--and that is the Netherlands--would claim to
have the same structure in totality. The Canadian structure is
similar, but a little bit less consistent.
The Australian banks under this structure, for example, are
subject to all four regulators. They have competition covered
by the Australian Competition and Consumer Commission (ACCC),
their conduct by the Australian Securities and Investments
Commission (ASIC), their prudence by APRA, and if there is a
liquidity support or payment system issue, they go to the
Reserve Bank. So that is the defining characteristic of this
model, that multiple agencies are responsible for each
institution, but for a different part of their behavior or
their activities. And there is a fairly clear dividing line
between those activities.
Some of the advantages that we see in this structure--and
some of these, of course, are shared by other models such as
the British one--include:
First, by assigning each regulatory agency to a single
objective--that is either competition or prudence--it avoids
the conflict of objectives that you face under virtually any
other system. So each regulator has just one thing to worry
about, and that avoids getting into some of the issues, for
example, that Northern Rock brought out, for the FSA.
Second, in bringing all regulators of a particular
objective together, you get synergies. We learned a lot when we
brought banking and insurance regulation together, and we were
able to develop an approach that took on the best of both of
those systems and to develop synergies out of that. Likewise,
ASIC, our conduct regulator, was one of the first in the world
to introduce a single licensing regime for market participants.
Third, this structure helped eliminate regulatory arbitrage
or jurisdiction shopping of the type that you have seen here.
Prior to the creation of APRA there were at least three
different types of institutions that could issue deposits in
Australia, and they were subject to nine different regulatory
agencies, depending on where they were located.
Following its creation, APRA introduced a fully harmonized
regime. We now have a single class of ``deposit-taking
institutions.'' We do not distinguish between banks, credit
unions, or thrifts. They can take on that separate identity,
but they are all regulated as deposit takers.
Fourth, by bringing together all of the prudentially
regulated institutions under the one regulatory roof, we have a
more consistent and effective approach to regulating financial
conglomerates, and along with countries like the United Kingdom
and Canada, Australia has been at the forefront of developing
the approach to conglomerate supervision.
Fifth, allocating a single objective to each regulator
minimizes the overlap between agencies and the inevitable turf
wars that are associated with that, which I am sure you are
very familiar with.
Interesting for us in our experience was that the gray
areas between the agencies have tended to diminish over time
rather than to increase, and I think that has been a little bit
of a surprise, but a very welcome surprise to those of us who
were involved with the design.
Sixth, the allocation of a single objective to each agency
minimizes cultural clashes, and one of the issues that we were
very conscious of in creating the distinction between
prudential and conduct regulation was that, while conduct
regulation tends to be carried out by lawyers, prudential
regulation tends to be carried out in general by accountants
and finance and economics experts--with the exception of the
United States, where lawyers tend to do it all. So, culturally,
we found it was very useful to separate these two types of
regulators so that we did not have those cultural battles.
Finally, by streamlining our old state-based, or partly
state-based, regulatory system, we got a lot of cost
efficiencies out of it, and we were able to facilitate strong
financial sector development and innovation without having to
reduce safety and soundness in the process.
In terms of outcomes, our architecture has weathered the
recent financial storm better than most. Indeed, I believe our
four major banks are still among the few AA-rated banks left in
the world.
The resilience of our system was helped by exceptionally
tough prudential standards, particularly in the areas of
capital and securitization. There was also inevitably some good
luck as well as good management. I am not going to claim it was
all brilliance.
In terms of crisis management, the coordination
arrangements worked exceptionally well and, I am told, in
speaking with each of the agencies recently, that they found
the singularity of objectives helped them enormously in terms
of coordination among the different agencies in the crisis.
On the less positive side, like everyone else, we have
learned that regulators and industry know much less about risk
than we thought we did. We have had to think about the way risk
is measured and regulated. Most importantly, we have learned
that financial stability regulation is a much bigger challenge
than we thought it was, and there is a lot still to be learned
there. And to borrow the Churchillian phrase, we regulators
have learned that ``we have much about which to be modest.''
In concluding, Mr. Chairman, I would like to offer two very
general observations. The first echoes a point you made in your
opening statement. There can be little dispute that regulatory
architecture matters. It is very important. There is no perfect
architecture. There is no one size fits all. But there are
certainly some architectures that are virtually guaranteed to
fail under sufficient pressure.
That said, architecture is only half the story. A sound
architecture is a necessary but not a sufficient condition for
effective regulation. The other component, which you mentioned,
is how you implement and enforce those regulations, and it is
very important that these two components are considered in
tandem and not in isolation.
Finally, it is easier to tinker with the architecture than
to do major reform. Major reform is largely about opportunity.
The window for reform is usually only open very briefly. You
have, arguably, the widest window for reform since the Great
Depression. This crisis provides you with the public support
and, I believe, the industry acquiescence to challenge the
vested interests and inertia that normally make major reform of
the type you have seen in some other countries all but
impossible. And I am sure I speak for many of my colleagues in
the international regulatory community, in hoping that this
opportunity is not lost. Thank you.
Chairman Lieberman. Thank you very much. Well said. I have
many concerns, but one clearly is that the result of this
crisis will be that we will change some regulations, some law,
but we will not change the regulatory structure very much
because of the resistance of those in the financial communities
but also, frankly, here in Congress to changing the status quo.
So your words are very much on target. I thank you.
Our third witness is Dr. Edmund Clark, President and CEO of
the TD Bank Financial Group in Canada. Mr. Clark has had a long
and distinguished career in both the Canadian Government and
private industry, and we are very grateful that you are here
today. Please proceed.
TESTIMONY OF W. EDMUND CLARK, PH.D.,\1\ PRESIDENT AND CHIEF
EXECUTIVE OFFICER, TD BANK FINANCIAL GROUP
Mr. Clark. Thank you, Mr. Chairman and Ranking Member
Collins, for inviting me, and thank you to the other Members. I
am obviously not here as a regulatory expert, but we have a
wonderful panel.
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\1\ The prepared statement of Mr. Clark appears in the Appendix on
page 326.
---------------------------------------------------------------------------
I am going to speak much more as a CEO who operates under
the regulatory regimes. We are a little unusual in the sense
that we operate on both sides of the border in Canada and the
United States. We have over 1,000 branches in the United States
from Maine to Florida, and we are a bank in the United States
that is continuing to lend, and lend aggressively. So we have
double-digit lending growth, and we are one of the few AAA-
rated banks left in the world. We exited the structured
products area in 2005, the source of most of the problems.
I thought I would comment on a couple of things, and one
was the actual management of the crisis from the beginning of
August 2007 until now, and I think what certainly distinguished
the Canadian system, which may not be duplicable in larger
countries, is that the six banks plus the Bank of Canada, the
Office of the Superintendent of Financial Institutions (OSFI),
and the Department of Finance essentially worked almost
continuously together and have a shared objective. There was a
very strong feeling among us that if any one of our banks ran
into trouble, we would all run into trouble. So there was no
attempt by one bank to, in a sense, game the system, and there
was also fairly quickly a view that we should try to have a
private sector solution to this problem, not a public sector
solution; and to the extent we involved the public sector, it
should be a profitable involvement on behalf of the taxpayers,
not a subsidy, and we were able to successfully do that.
In terms of the structure of the industry, I think it is
well known that there are some important differences. All the
major dealers are owned by the Canadian banks, and we did, in
fact, absorb $18 billion (CAD) of write-offs by these dealers.
TD Bank did not have any significant write-offs, but $18
billion (CAD) is a significant amount in the size of Canada,
but they were able to absorb that because they were tied to
large entities with very stable retail earnings.
Second, the mortgage market is completely different in
Canada. It is concentrated in the top banks, and we originate
mortgages to hold them. And so we have resisted attempts--
frankly, political attempts--to have us loosen standards
because we are going to bear the risks of those loosened
standards. So you did not get the development in Canada of what
you did in the United States.
Third, in terms of the capital requirements, our capital
requirements have always been above world standards, with a
particular emphasis on common equity. But it has also been
reinforced by the insistence of our regulation that we have our
own self-assessment of how much capital we need, and that in
all cases, it caused Canadian banks to hold more than
regulatory minimums, not at regulatory minimums.
I think the other difference would be that our regime's
binding constraint is risk-weighted assets, and that is a key
feature why we hold our mortgages rather than sell them. Where
you have total asset tests, you, in fact, encourage banks to
sell low-risk assets, and where we have a total asset test is
not the binding constraint.
In terms of the nature of the regulatory regime, it is a
principles regime, not a rule-based regime--it is rather light
in terms of the actual number of people employed in the
regulatory regime. There is a high focus on ensuring that
management and the board know and understand the risks that the
institution is taking and that, in fact, they are building the
infrastructure to monitor and manage that risk.
The way I put it internally in my organization is I am
actually on the side of the regulator, not on the side of the
bank. We have the same interest in ensuring that the bank does
not run into trouble, and do you have less of this conflict
situation because I see the regulator as helping me manage the
bank.
I think another important element that Canada moved to in
terms of compensation some time ago was to have low cash
bonuses. So in my case, 70 percent of my pay would be in the
form of equity which I hold. I am required to hold my economic
interests in the bank for 2 years after I retire, so I cannot
cut and run. And all my executives, whether in the wholesale
side of the bank or the retail side of the bank, are paid on
the whole bank's performance, including its ability to deliver
great customer satisfaction. We also have separation of the
chairman from the CEO, and all board and committee meetings
have meetings without management present to ensure that
independence.
Clearly, the issue, I think, you are addressing is the
issue of systemic risk, and I think it is the toughest issue to
deal with here. I think I would have to be in the camp to say
all the systemic risk issues were well known and well talked
about. It is not as if there was this mystery out there that
the U.S. mortgage system was, in fact, going way up the risk
curve and doing what most bankers would have regarded as crazy
lending. It is not as if there was not meeting after meeting
among bankers around the world about the risks that are
inherent in structured products. And I would say the under-
saving feature of the U.S. economy was a well-known fact. And
so I think you do have to sit back and say, well, if these
risks were well known, why were there no, in a sense, forces
against that?
I can comment on our own experience. As I indicated, we did
actually exit these products. We exited them because they were
hard to understand. They embedded tail risk and added a lot of
complexity to the organization. We also refused to, in fact,
distribute the asset-backed paper program that blew up in
Canada on the basis that if I would not sell it to my mother-
in-law, I should not sell it to my clients.
But the real issue is that in doing that, that was a very
unpopular thing to do. It was unpopular within my bank. It was
unpopular among my investors. It is very hard to run against
these tides, and so I think when you are talking about systemic
risk, you have to recognize that there is this odd confluence
of political, economic, and profit force actually always
propelling it. It is like a lot of the literature, what creates
boom. You have the same thing behind any forces of systemic
risk.
So what is my conclusion as a practicer in the field? Well,
I do not think there is one answer because, as I have said,
banks have failed under most regulatory regimes. But I do think
a strong regulator is important, and you certainly should not
allow regulatory shopping. I think that is obviously a very bad
thing.
And while rules are important, I actually think principles
do matter. It was clear throughout the industry that people
were in the process of using regulatory capital arbitrage, and
if you sat there from a principle point of view, I think you
might have stopped it.
Leadership matters enormously. I think boards should be
held accountable to ensure that they actually have a CEO with
the right value system. His job is to preserve the institution.
And I think it is clear to say while all regulatory regimes may
have known about systemic risk, they did not focus on systemic
risk. And I think we are lacking mechanisms where, if you did
come upon a view that existed, how would you, in fact,
coordinate action to bring it to an end?
I do think going forward, though, there is also a risk that
we could overreact, and one of the things I would plead is that
many elements of the regulatory reforms could drive
institutions to take more risk rather than less risk. And I
think you have to be careful in your rules to make sure that
low-risk strategies, such as the TD Bank one, are not, in fact,
negatively impacted by some of the rule changes. Thank you very
much.
Chairman Lieberman. Thank you very much. Refreshing. I must
say, I did not know how different the regulatory system and
some of the rules of behavior were, and it is striking that one
of the reasons that Canada did not get into some of the same
mortgage problems as we did was really because of regulation,
some of the things you were prohibited from doing.
Mr. Clark. Right. There was an element of regulation that
prohibited us, but also we had a capital regime that said we
could hold low-risk assets and not have large amounts of
capital. And that is a critical feature to the originate-and-
hold model.
Chairman Lieberman. Thank you.
Our final witness this morning is from closer to home.
David Nason was at the Treasury Department during March 2008
and before and was very active in the construction of the
Treasury Department's March 2008 ``Blueprint for a Modernized
Financial Regulatory Structure,'' previously known as ``the
Paulson plan.'' Mr. Nason is now the Managing Director for
Promontory Financial Group here in Washington, DC. We have two
of the four witnesses from the Promontory Group. That speaks
well for the group.
Mr. Nason, we welcome your testimony.
TESTIMONY OF DAVID G. NASON,\1\ MANAGING DIRECTOR, PROMONTORY
FINANCIAL GROUP, LLC
Mr. Nason. Thank you for having me. Chairman Lieberman,
Ranking Member Collins, and Members of the Committee, thank you
for inviting me to appear before you today on these important
matters. As the United States begins to evaluate its financial
regulatory framework, it is vital that it incorporate the
lessons and experience from other countries' reform efforts.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Nason appears in the Appendix on
page 334.
---------------------------------------------------------------------------
I recently, as you just mentioned, finished a 3-year stint
at the U.S. Department of the Treasury where I was honored to
serve former Secretaries Jon Snow and Henry Paulson. And as the
Assistant Secretary of the Treasury for Financial Institutions,
I worked hand in hand with the government as they tried to
respond to the financial crisis. More germane to this
particular hearing is I am particularly proud to have led the
team that researched and wrote the Treasury's ``Blueprint for a
Modernized Financial Regulatory Structure,'' which was
published in March 2008. And many of the issues that we
evaluated in the writing of the Blueprint are before the
Congress and the focus of this hearing.
What seems clear as we think about this issue is that
financial institutions play an essential role in a large part
of our U.S. economy, and given the economic significance of the
sector, it is important that we examine the structure of our
regulatory framework as we think about the content of
regulations. And this is all the more pressing as the United
States begins to emerge from the current financial crisis.
The root causes of the financial crisis are well
documented. Benign economic conditions and plentiful market
liquidity led to risk complacency, dramatic weakening of
underwriting standards for U.S. mortgages, especially subprime
mortgages, and a general loosening of credit terms of loans to
households and businesses.
The confluence of many events led to a significant credit
contraction and a dramatic repricing of risk. We are still
living through this process right now, and we have seen more
government intervention in the financial markets than we have
seen in decades.
The focus of this hearing today is prospective, however,
and the financial crisis has told us that regulatory structure
is not merely an academic issue and that topics like regulatory
arbitrage matter and have meaningful repercussions outside of
the province of academia. Indeed, if we look for something
positive in the aftermath of the crisis, it might be that it
will give us the courage to make the hard choices and reform
our financial regulatory architecture.
We have learned all too well that our regulators and
regulations were not well positioned to adapt to the rapid
financial innovation driven by capital mobility, deep
liquidity, and technology. Regulation alone and modernized
architecture could not have prevented all of the problems from
these developments. But we can do much better, and we can
position ourselves better.
Our current regulatory structure in the United States no
longer reflects the complexity of our markets. This complexity
and the severity of the financial crisis pressured the U.S.
regulatory structure, exposing regulatory gaps as well as
redundancies. Our system, much of it created over 70 years ago,
is grappling to keep pace with market evolutions and facing
increasing difficulties, at times, in preventing and
anticipating financial crises.
Largely incompatible with these market developments is our
current system of functional regulation, which maintains
separate regulatory agencies across segregated functional lines
of financial services, such as banking, insurance, securities,
and futures, with no single regulator possessing all of the
information and authority necessary to monitor systemic risk.
Moreover, our current system results in duplication of
certain common activities across regulators. Now, while some
degree of specialization might be important for the regulation
of financial institutions, many aspects of financial regulation
and consumer protection regulation have common themes.
So as we consider the future construct of our U.S.
financial regulation, we should first look to the experience of
other countries, especially those that have conducted a
thoughtful review recently, like we have heard today. As global
financial markets integrate and accounting standards converge,
it is only natural for regulatory practices to follow suit.
There are two dominant forms of financial regulatory regimes
that should be considered seriously in the United States as we
rethink our regulatory model. I would like to focus on the
consolidated regulator approach and the twin peaks approach.
Under a single consolidated regulator approach, one
regulator responsible for both financial and consumer
protection regulation would regulate all financial
institutions. The United Kingdom's consolidation of regulation
within the FSA exemplifies this approach, although other
countries such as Japan have moved in this direction. The
general consolidated regulator approach eliminates the role of
the central bank from financial institution regulation, but
preserves its role in determining monetary policy and
performing some functions related to overall financial market
stability.
A key advantage of the consolidated regulator approach that
we should consider is enhanced efficiency from combining common
functions undertaken by individual regulators into one entity.
A consolidated regulator approach should allow for a better
understanding of overall risks to the financial system.
While the consolidated regulator approach benefits are
clear, there are also potential problems that we should
consider. For example, housing all regulatory functions related
to financial and consumer regulation in one entity may lead to
varying degrees of focus on these key functions. Also, the
scale of operations necessary to establish a single
consolidated regulator in the United States could make the
model more difficult to implement in comparison to other
jurisdictions.
Another major approach, adopted mostly notably by our
colleagues at the table in Australia and in the Netherlands,
indeed, is the twin peaks model that emphasizes regulation by
objectives. One regulatory body is responsible for prudential
regulation of relevant financial institutions, and a separate
and distinct agency is responsible for business conduct and
consumer protection. The primary advantage of this model is
that it maximizes regulatory focus by concentrating
responsibility for correcting a single form of market failure--
one agency, one objective. This consolidation reduces
regulatory gaps, turf wars among regulators, and the
opportunities for regulatory arbitrage by financial
institutions, while unlocking natural synergies among agencies.
And perhaps more importantly, it reflects the financial
markets' extraordinary integration and complexity. It does pose
a key problem in that effective lines of communication between
the peaks are vital to success.
There are several ideas in circulation in the United
States. I would like to focus on some things that we focused on
in the Treasury Blueprint in 2008 and some other relevant
policymakers that are talking about other ideas.
The March 2008 Blueprint proposes that the United States
consider an objectives-based regulatory framework, similar to
what Dr. Carmichael discussed, with three objectives: Market
stability regulation, prudential regulation to address issues
of limited market discipline, and business conduct regulation.
Prudential regulation housed within one regulatory body in the
United States can focus on the common elements of risk
management across financial institutions, which is sorely
lacking in the United States. Regulators focused on specific
objectives can be more effective at enforcing market discipline
by targeting of financial institutions for which prudential
regulation is most appropriate.
Secretary of the Treasury Geithner and FDIC Chair Bair
addressed similar issues of importance in dealing with too-big-
to-fail institutions and the necessity of providing systemic
risk regulation. Senator Collins, you introduced legislation
that recognizes the key aspects that need to be addressed in
our system to deal with these difficult problems.
So while there is an emerging consensus in the United
States and among global financial regulators, market
participants, and policymakers that systemic risk regulation
and resolution authority must be a cornerstone of reform
financial regulation, the exact details of the proposals need
to be settled. These are very complicated and they require
thoughtful debate and deliberation.
One point, however, is clear: The U.S. regulatory system,
in its current form, needs to be modernized and evolved. We
should seize upon this opportunity to do this. To this end, the
future American regulatory framework must be directed towards
its proper objectives to maintain a stable, well-capitalized,
and responsible financial sector.
Thank you for inviting me.
Chairman Lieberman. Thanks, Mr. Nason. Very helpful.
A vote just went off, but I think we are going to try to do
a kind of tag team here, so Senator Collins will go over now,
and I will ask questions, and then we will go on from there.
The testimony has been very interesting.
While your testimony is in my mind, Mr. Nason, just take a
moment, and if we went to the twin peaks here--although as Dr.
Carmichael said, there are actually four in Australia--what
would be under the two peaks?
Mr. Nason. Well, I said the twin peaks model, but
essentially we would be asking for three peaks.
Chairman Lieberman. Three, really.
Mr. Nason. Three peaks in the United States.
Chairman Lieberman. One being the Federal Reserve.
Mr. Nason. One would be market stability regulation, which
we recommend in the Blueprint would be housed at the Federal
Reserve.
Chairman Lieberman. Right.
Mr. Nason. One would be prudential regulation of
institutions that require prudential regulation for your banks
and your insurance companies. And then business conduct
regulation, which is the type of consumer protection regulation
that we historically see in the consumer aspects of the Federal
Reserve and the banking agencies and most of what the
Securities and Exchange Commission does.
Chairman Lieberman. So you would split up some of the
existing regulatory agencies' functions, so it is not as simple
as asking which agencies would go under which, because you
would take pieces of each.
Mr. Nason. Yes, the model in the United States, it is a
difficult way to think about it, but if you take the consumer
elements of the banking agencies, put them under the business
conduct regulator, take the bulk of the responsibilities of the
SEC, put them under the business conduct regulator, and leave
the prudential or financial regulation in a separate regulatory
body, those are the two peaks. And then I think there is an
important role that is not demonstrated in those two peaks:
Someone taking the ownership of systemwide risks, and that is
the important role that we give to the Federal Reserve in our
Blueprint.
Chairman Lieberman. Incidentally, I like the Paulson plan's
use of the words ``market stability regulator'' because I think
it is more clear than systemic regulator, which always confuses
me at least.
Mr. Nason. We spent an enormous amount of time debating
that, and I am glad you noticed it. The one reason we called it
``market stability'' is to indicate to everyone that you are
going to have bouts of instability, and the goal is to try to
keep the markets as stable as possible. But you cannot prevent
it.
Chairman Lieberman. Right. Let me ask Mr. Green, Dr.
Carmichael, and Dr. Clark, from outside the United States
looking in--acknowledging that we have heard some mixed
testimony here on the question I am about to ask--and based on
your experience, obviously, what role do you think the
fragmented nature of our current structure played in the extent
of the current economic crisis here in the United States? Can
you make a judgment on that, Mr. Green?
Mr. Green. I think the most striking example--and there are
several--was the AIG affair, where, of course, there was no
Federal jurisdiction, as you know, which meant that although
there was a lead regulator in the New York State Insurance
Commission, nevertheless, that jurisdiction was shared with a
lot of other regulators. And the Office of Thrift Supervision
(OTS) also had a role, and I think it is fairly clear and
widely acknowledged that this meant there were gaps in terms of
looking at the whole picture for a global firm.
Chairman Lieberman. Right.
Mr. Green. The other example I think relates to the U.S.
investment banks, which almost uniquely at the global level
were not regulated along with the rest of the banking system.
And that led to gaps or inconsistencies. They were not--
although they did business that was very similar----
Chairman Lieberman. To banks.
Mr. Green [continuing]. To banks and, indeed, in the rest
of the world was done in banks. Nevertheless, they had a quite
different capital regime, and, indeed, curiously, their
consolidated capital regime was voluntary. That, of course,
came to an end very abruptly over a weekend. This was a risk
that a lot of people knew was waiting to be crystallized. But
those are two big examples, if you like.
Chairman Lieberman. So those are examples that suggest that
structure had some kind of causal effect, or at least enabling
effect on the crisis.
Dr. Carmichael, what would you say? And they are good
examples, I think.
Mr. Carmichael. I do not have a lot to add to that because
I think it is spot on. If one had to put rough percentages on
it--and this has got no science--I would say it was enabled 70
percent by the structure and 30 percent by bad regulation. So I
think the structure actually had more to do with the problem.
I will add one example to what Mr. Green said. I was
interested in one regulatory response to AIG--regulated, of
course, by the State regulator. The State regulator said, ``We
now want to regulate credit default swaps as an insurance
product,'' and immediately the impossibility of that became
apparent in that, unless the other 49 States agreed to do it,
the business would just move over the border. And this is not a
national border. It is just moving across the Hudson River, for
example.
So the insurance regulatory structure enables arbitrage,
enables gravitation to the lowest common denominator. Like Mr.
Green, we were amazed when we found that AIG was regulated by
OTS as a conglomerate. That just seems ludicrous. So I agree
entirely.
Chairman Lieberman. Thanks. Dr. Clark.
Mr. Clark. I guess what I would say I would not get
yourself trapped that if you cannot take a direct link back to
the great financial crisis, you should not clean it up. And so
I would say the U.S. system obviously has a lot of issues that,
even if they did not create the great financial crisis,
certainly do not make the system run any better. And so I think
whether you have 100 regulators or 50 does not matter. There is
clearly regulatory shopping that goes on constantly in the
United States, and that cannot be a good thing to have a sound
system.
Chairman Lieberman. That is a very important point. We are
focused on this now because of the current crisis, and there
are some clear linkages, as Mr. Green and Dr. Carmichael said.
But there are obviously other reasons beyond that to want to
alter our structure, and that is one of them--regulatory
shopping.
What else? You made a reference in your gracious and
diplomatic use of the term ``diversified.'' I presume that
underneath that was some sense that it was really pretty hard
to work together with the United States because of the way in
which the regulatory system was so dispersed?
Mr. Green. Certainly for regulators in the rest of the
world--and Mr. Carmichael will have a view on this as well.
Leave aside this AIG problem, even in the banking field there
was no single voice in the United States. Although a case can
be made for regulatory competition in this kind of area, it is
not very clear where the advantages came from regulatory
competition, and certainly in international discussions, it is
very difficult to have a completely coherent discussion when
there are three or four counterparties in some discussions even
about capital. And the SEC, if it was not there, should have
been there.
Chairman Lieberman. Right.
Mr. Green. It makes it very difficult to come to
international consensus.
Chairman Lieberman. Yes, and obviously we are in--to say
the obvious--a global economy, and there are times when we want
to have interactions globally that are not facilitated by the
way in which we are organized. So I take your point.
I am going to have to go in a minute, but, Mr. Nason, from
the U.S. perspective, are there any negative effects for
American business in a global economy that result--or even
domestically, but particularly globally--from this fractured
system we have now?
Mr. Nason. Sure. The clearest and easiest example--sorry to
beat it to death--is insurance. There are two things that are
clear. One, the international community does not understand and
appreciate the State regulatory system for insurance, so that
American industry is not well represented around the globe.
And, second, in periods of crisis like this, we learned all too
well at the Treasury that we would be benefited significantly
by having a Federal expert in insurance that you can draw upon
for expertise.
One of the big problems associated with dealing with the
AIG failure is there is no Federal person responsible for that
industry, so you cannot draw on Federal expertise. And that was
a very significant consequence of having this fractured system.
Another example we mentioned is the Office of Thrift
Supervision, which has oversight responsibilities for the
holding companies of a lot of these institutions, but does not
have the appropriate stature to represent the thrifts around
the world. So it is an inequality that hurts the institutions
that have thrifts in this structure.
Chairman Lieberman. Thank you.
I am going to ask that we stand in recess. As soon as
Senator Collins comes back, I will ask the staff to please
encourage her to begin her questioning.
The hearing is recessed.
[Recess.]
Senator Collins [presiding]. The hearing will come back to
order. Senator Lieberman has graciously allowed me to
temporarily assume the role of Chairman and reconvene the
hearing so that we can keep proceeding through this vote.
I want to thank each of you for your very interesting
testimony and bring up several issues in the hopes that I am
not repeating too much of what the Chairman may have already
asked you.
Mr. Carmichael, you talked about the four peaks, as you
described it, and that some of the advantages were that each
focuses on one aspect. You avoid conflict. You have essentially
a functional regulatory approach. And then you said there is
also a council of regulators. Does that council of regulators
have responsibility for identifying systemic risk?
Mr. Carmichael. In a short answer, yes. But, more
importantly, their role is to communicate and coordinate
between the agencies and to make sure that there is a regular
testing of issues. Sometimes the central bank, if it is
concerned about a systemic issue, has the power to send some of
its staff with the prudential people going on inspections, for
example, to learn more about what some of those issues might
be. The involvement of the Treasury is there for exactly the
systemic type reason.
So while it does not have any direct authority--there is no
charter that gives it the power to do anything--through
coordination they are able to focus the issues and decide, for
example, do we need more information about a particular area?
Do we need one of the agencies to collect that on behalf of the
systemic regulator?
Senator Collins. Mr. Nason, I know you were very involved
in the Paulson Blueprint for reform, and I very much
appreciated your insights. As I understand it, the Blueprint
that Secretary Paulson put out did call for a systemic risk
regulator, but it would be vested in, I believe, the Federal
Reserve. Is that correct?
Mr. Nason. Yes.
Senator Collins. When you were involved in drafting the
Blueprint, was consideration given to the council approach?
Mr. Nason. It was not labeled the ``council approach,'' but
one thing we did consider was providing more authority to the
President's Working Group on Financial Markets, which is very
similar to the council approach. We thought about it very
seriously because there is a lot of elements of attractiveness
to having a council because you are bringing a lot of different
sets of expertise to bear.
One of the things we got tripped up on is providing the
right amount of authority, and we were worried about clarity of
purpose and clarity of mission among a council. But it is
certainly something that we considered seriously.
Senator Collins. Mr. Clark, is there a system for
identifying systemic risk in Canada?
Mr. Clark. The system, I think, would be very similar, as I
understand from Dr. Carmichael, to the Australian system. There
is a group that meets regularly that is chaired by the Deputy
Minister of Finance and would have our regulator, OSFI, on it
and would have the Bank of Canada on it and the Canada Deposit
Insurance Corporation (CDIC), the equivalent to the FDIC, on
it. And, in fact, they have now created two committees--one
which is called the Financial Institutions Supervisory
Committee (FISC), which is designed more to deal with low-level
coordination issues, and then a second one that deals with more
explicitly strategic issues. And I think it is probably fair to
say that as a result of this crisis, the role of that committee
in making sure that they are debating what the systemic risk is
and who is doing what about it has been elevated as a result of
this.
Senator Collins. Mr. Green, what about in Great Britain?
How is systemic risk handled?
Mr. Green. There is a so-called tripartite committee which
brings together the Bank of England--the central bank--the FSA,
and the Treasury, which was intended to look at the functioning
of the system as a whole. And the Bank of England had a mandate
in relation to the stability of the system as a whole.
I think there was insufficient clarity about just what that
meant in the original drafting and what that meant in terms of
the role of the Bank of England--which, in fact, leaves a bit
of a question in my mind in relation to the so-called Paulson
Blueprint. The central bank has, as the monetary authority, the
capacity to lend and to change monetary policy. But then there
is an issue about what other tools does it have? Does it have
the capacity then to instruct the regulators to take action on
grounds of systemic risk?
I think, in fact, in the United Kingdom, the Bank of
England did not think that it had that authority. And the way
the system worked, the lack of clarity of objectives in
retrospect proved a bit of a disadvantage. And the Bank of
England spent its time talking about the economy, and the FSA
spent its time thinking about the individual firms. And one of
the main lessons that has been learnt from the crisis is that
the regulator needs to think more about what is happening in
the wider economy, and the central bank needs to remember that
monetary policy only has effect through the financial system.
So it is quite a subtle set of links that is difficult to
get precisely right.
Senator Collins. I think those are excellent points.
Mr. Nason, obviously one of the failures of our system was
a failure to identify high-risk products that escaped
regulation and yet ended up having a cascade of consequences
for the entire financial system. And I am thinking in
particular of credit default swaps, which in my mind were an
insurance product, but they were not regulated as an insurance
product. They were not regulated as a securities product. They
really were not regulated by anyone.
And as long as we have bright financial people, which we
always will, we are going to have innovation and the creation
of new derivatives, new products.
One of my goals is to try to prevent these what I call
``regulatory black holes'' from occurring where a high-risk
practice or product can emerge and no one regulator in our
system has clear authority over it. Without a council, there is
nobody to identify it and figure out who should be regulating
it.
What are your thoughts on preventing these regulatory gaps?
Mr. Nason. I think there is a lot to like about what you
are trying to achieve in your legislative proposal. I think
that identifying the fact that credit default swap (CDS) and
over-the-counter (OTC) derivative contracts are a source or a
potential source of systemic risk is very important, and I am
really happy to see you have identified it here and the
Administration is thinking about ideas like putting them on
exchanges and things like that, because OTC derivatives were
typically not regulated because they were viewed as bilateral
contracts between sophisticated parties. But they grew so big
and they are so significant in the U.S. system that they proved
to be two things: One, a source of great opaqueness in
financial institutions where you could not get a sense of how
important the derivative book was to a particular institution;
and, two, a real channel for the too-interconnected-to-fail
problem.
So I think that you are certainly right to identify them as
something that needs to be looked at carefully. I think that
they are certainly something that should be under the
supervision, oversight, and jurisdiction of a council or a
systemic risk regulator. And I think that I am happy that
things are moving along in that way.
Senator Collins. Mr. Clark, I admire your foresight in
deciding that some of these derivative products were simply not
well understood and were too high risk in getting out of that
market. In Canada, however, was there regulation of credit
default swaps and those kinds of exotic derivatives? Or did the
regulation only come about through safety and soundness
regulations? If you understand what I am saying.
Mr. Clark. I think so. In a sense, it was safety and
soundness, and I think it is fair to say as we were exiting the
business, Canadian banks were going into the business. So it
was not as if our regulator was saying do not do this.
Senator Collins. That is what I was wondering.
Mr. Clark. And as I pointed out earlier, Canadian banks
collectively took $18 billion (CAD) in writedowns. So in U.S.
terms, that is $180 billion, given the size of the country, so
it is not an insignificant amount. So we cannot stand here and
say there are no problems in Canada. I think that would be a
misnomer.
I think this is a very difficult area because I think the
reality is that people were aware of this and they were aware
that the products were getting bigger and more complex. But as
we were talking during the break, the reality is that people
were making a lot of money on it, and it looked like it was
very profitable. And I would say in its initial evolution,
credit derivatives were actually a positive factor, and so for
us as a bank, we were able to lay off a significant amount of
our risk by buying credit protection, and in that sense we saw
it as a good thing, not a bad thing. And it is only as a later
evolution that in a sense it ended up causing, I think, some of
the problems.
I think it underscores the capability issue, the one we
talked earlier about AIG, that in this war, if you will, or
race for knowledge, you have a very profitable and highly
sophisticated industry in the banking system around the world.
I think it does mean that you cannot afford to have three or
four regulators trying to go up the scale of knowledge. You do
have to have a concentrated knowledge in order to attract the
people to try to have a counter-push to these ideas.
Senator Collins. Mr. Carmichael, any thoughts on how to
prevent regulatory black holes as new products emerge?
Mr. Carmichael. Two things I would add to the comments made
so far. First of all, having banking and insurance under the
one regulator, as is the case in Canada, Australia, and the
United Kingdom, gives your regulator a much better chance to
pick up where those risks are being laid off. And you look at
the United States where you have 50 State insurance regulators,
picking that up as a problem for AIG was much more difficult
than it would have been under the other architectures.
The other side of it that I would add is that in a
structure where you have a clear conduct regulator and that
regulator has a responsibility for markets, that is where the
primary responsibility for new markets, which is where new
products tend to spring up. Regardless of how the market is
conducted, whether bilateral or on an organized exchange,
conduct should be the responsibility of that particular
regulator, provided they have the mandate and the skills to
pick that up and do with it what they need to. That is where
you would get the primary regulation, the disclosures, the
aggregation of information, and so on for those markets.
Senator Collins. Thank you. Senator McCaskill.
OPENING STATEMENT OF SENATOR MCCASKILL
Senator McCaskill. Thank you.
I do not know if you can help, Mr. Nason, but I have had a
hard time figuring out how we missed all this. And you were at
the Treasury Department for the 3 years prior to when we came
this close to a global meltdown as it relates to our credit
markets. And, I guess I am curious as to why you think no one
at Treasury--I mean, I was in a room with Secretary Paulson,
and I do not want to say that they were panicked, but there is
a reason why there was such bipartisan support 40 days before
our political election. If there was ever a time in this
building that the two sides cannot get along, it would be 40
days before our national presidential elections. And when you
had both major candidates for President voting in favor from
both ends of the political spectrum, that was because we all
had been given very detailed and accurate information about how
close we were to completely falling off the table as it related
to our credit markets.
I cannot get comfortable with how we are going to identify
risk going forward if the best and the brightest in our
country, supposedly the best financial minds in the world, did
not see this coming. Can you help me?
Mr. Nason. I can try to help you. I do not have the
answers, and we will be debating this for decades as to what
actually happened. But I think there were a couple things that
happened.
People saw individual things that they were worried about.
The regulators knew that underwriting criteria had gone down
for home mortgages. People had seen there was a very frothy
housing market. People had seen that the covenants in debt were
going down to a level that they were concerned with.
But I think what really was very surprising and what caught
people off guard was the severity with which things went from
being very frothy--people were not paying adequate attention to
risk, so the pendulum was nobody cared about risk at all,
people were just worried about making money--to people who were
not willing to take risk at all. So there was just a complete
and utter contraction of credit in the economy that caused an
enormous contraction.
The speed with which that happened was something that
people were not expecting. You got to a point where money
center banks would not lend to each other for 20 days or for 10
days without paying exorbitant interest rates. So you had a
complete breakdown in confidence. And I cannot give you comfort
that we are going to find it again. I can give you comfort that
this is that 1-in-100-year event. And you can try to manage it
better, you can try to prepare yourself better, but this is one
of those things where I do not think you can predict it. You
can just put yourself in a better position to try to deal with
it.
Senator McCaskill. Which of the three parts of your plan
would be responsible for identifying what happened?
Mr. Nason. Well, the three parts of the plan--first of all,
the plan was not created to deal with the financial crisis. It
was actually written before the financial crisis happened.
Senator McCaskill. You wrote it in March, right?
Mr. Nason. Well, we researched and wrote it the year going
up to March, and we released it right after Bear Stearns
failed, but it was not in response to those types of events.
Senator McCaskill. Right.
Mr. Nason. So the plan is not a lookback plan. But I think
generally speaking, you would have coordination among the three
parties to describe how to better position ourselves to deal
with this better.
Senator McCaskill. Let us assume that instead of your plan
being announced in March 2008--obviously, this is a fantasy--
that Congress passed it whole cloth and it was in existence.
Which is the body that you would expect under the plan that has
been drawn up would be the one to say things are nuts, people
are overleveraging, they have no idea what they are buying and
selling, they are chasing a number, and it is all about greed?
Mr. Nason. Sure. I would tell you that each of the three
would have a role, and here is what they would do. On the
prudential side, there would be tightened standards for capital
for financial institutions and more regulation on liquidity
management. On the conduct side, there would be stronger
regulations for mortgages and things like that. And on the
market stability side, there would be more focus on the
interconnectedness of these two institutions and also of things
like the derivatives markets. Those would be three ways that
each of the three pillars of the Paulson plan would respond to
this.
Senator McCaskill. Is it possible that the three pillars of
the Paulson plan, that each one of those pillars would have
said it was their job?
Mr. Nason. No. That is actually one of the premises of the
Paulson plan, is clarity of mission and clarity of objective.
See, one of the problems that we dealt with was that there was
a lot of finger pointing. There were battles between the State
regulators versus the Federal regulators on who was in charge
of mortgage origination. So there were concerns about who was
in charge of the holding company of Lehman Brothers. Was it the
OTS or the SEC?
So there is much less chance for finger pointing under an
objectives-based criteria like the Dutch and the Australians
have.
Senator McCaskill. Mr. Clark, I heard you say that you
originate mortgages to hold them, and I keep explaining that
one of my concerns about reverse mortgages that we are now
ramping up in this country is that they are very similar to
subprimes in that the people who are closing loans have no skin
in the game. Now, the scary thing about reverse mortgages is
that all of the skin is taxpayer skin. If those assets are sold
at term and they are not sufficient to cover the loan, the
Federal Government has to cover the loan. But in the subprime,
it was all of these exotic sliced and diced derivatives that
were spread out all over that we are trying, like Humpty-
Dumpty, to put back together again now.
I assume that in Canada the people who are holding the
mortgage are the same ones who made them and, therefore, they
continue to have skin in the game.
Mr. Clark. Absolutely. We originate all the mortgages. We
do not buy mortgages. We originate our own mortgages. And,
therefore, we are very concerned about the underwriting
standards because we are going to take the risks.
I do believe that the system of holding the mortgages does
a couple of things for you. One, it means you have the banking
system trying to make sure you have conservative risk, not wild
risk. But, second, it actually gives us an asset. The way I
always describe our bank is we are not an income statement that
generates a balance sheet. We are a balance sheet that
generates an income statement. And that means we have a
solidity of earnings that is there because we are not
originating mortgages, then selling them off, and then saying,
well, where am I getting next year's income if we originate
more and sell them off. We are actually holding them.
And so I think it produces tremendous stability in the
system, but it does require a regulatory regime that does not
penalize you for capital if, in fact, you hold a low-risk asset
like that.
Senator McCaskill. Do you think we should have regulations
that require people who close mortgages to assume some of the
risk?
Mr. Clark. I think some system where the people who
originate have skin in the game is quite important.
Senator McCaskill. Mr. Nason, what do you think?
Mr. Nason. I think that what we have seen is that our
securitization markets certainly got overheated, and there is
certainly some merit----
Senator McCaskill. I think a bonfire is more like it.
Mr. Nason. I am not going to quibble with that. I think a
bonfire is just fine. I do want to suggest, though, that the
securitization market, it is a bad word right now and it is an
ugly word, but it has a lot of value. It provides a lot of
credit to the economy. A lot of markets depend on it. It is
important to rebuild that market so we can get more credit in
the economy. Today, the auto industry relies on it; a lot of
industries rely on it. So it is important. Whether or not it
overheated like a bonfire, I think that is a fair
characterization.
Senator McCaskill. Would you mind if I ask one more
question?
Chairman Lieberman [presiding]. Go right ahead, Senator.
Senator McCaskill. I am a little uneasy about BlackRock. I
know that BlackRock was called in to manage at the New York
Federal Reserve in terms of some of the valuation of the
assets, and I know that there is some valuation of assets and
then there is going around to the other window and
participating--and I keep hearing that BlackRock is the only
game in town, and that is why they are getting all these
contracts. Their name came up again yesterday in connection
with the Pension Benefit Guaranty Corporation (PBGC), the
guaranty fund for pensions in this country. I keep hearing that
BlackRock is the only company that has the model and it is
proprietary, and therefore, they are the only game in town, and
we keep going back to BlackRock. In fact, I had somebody tell
me that the Secretary of the Treasury talked more often to the
head of BlackRock than probably a lot of other folks. And I do
not know if that is true or not, but it worries me because of
the--too big to fail aspect. Can I get you, without threat of
torture, to give me your take on why BlackRock is all of a
sudden everywhere and is involved in everything as it relates
to sorting out our financial mess?
Mr. Nason. A couple of things. I cannot imagine that the
comment that either Secretary of the Treasury spent more time
talking to BlackRock than anyone else is accurate.
Senator McCaskill. Hyperbole.
Mr. Nason. Hyperbole. That is one thing.
The second thing is the determination of hiring BlackRock
to manage the assets in the Maiden Lane/Bear Stearns situation,
I think that was a decision made by the Federal Reserve, so
that is not something I can speak about.
I think generally speaking what you are dealing with is a
large risk transfer of assets from financial institutions to a
variety of structures. And what the government is trying to do
is to protect the U.S. taxpayers' interest, hire someone who
has some experience in managing those particular assets.
BlackRock, Western Asset Management Company (WAMCO), and the
Pacific Investment Management Company (PIMCO)--there are a
couple of people who are very experienced in that.
I do not know the specifics of that particular situation,
but the only thing I can say is that there is a lot of
oversight and regulation for this process. There are the
procurement rules. There is the GAO and the TARP Inspector
General that are making sure that policies and procedures are
followed. So I think you can take comfort in the process
surrounding how these asset managers are retained and the
solicitations being made for them. That should give you
comfort. I think there is a lot of transparency in that as
well.
Senator McCaskill. Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator McCaskill. Thanks
for participating this afternoon.
We will do a second round insofar as Members want to be
here or can be here.
The Paulson plan, the Treasury Department's plan, issued
last March, as you probably know, envisioned a regulatory
system similar to Australia's, which was objectives based. The
report was controversial here, although, unfortunately, it got
overwhelmed by the growing crisis, so it did not receive the
discussion I think it deserved. But it called for consolidation
and dissolution of some existing agencies.
One controversial reform, which we have referred to briefly
here this morning, was the consolidation of the Securities and
Exchange Commission (SEC) and the Commodity Futures Trading
Commission (CFTC).
I wanted to ask our three witnesses from outside the United
States--I think I know the answer, but not totally--if any of
the three countries divide the regulation of securities and
futures the way we do here in the United States, or are they
regulated under one roof? Mr. Green, everything is under one
roof?
Mr. Green. Everyone is under one roof and, indeed, it was,
I think, always under one roof before the great merger into the
FSA.
Chairman Lieberman. Right.
Mr. Green. There was no real distinction between the
primary markets and the derivative markets. And I must say--and
I stand to be corrected by my colleagues here--I am not aware
of any other country where there is such a distinction.
Chairman Lieberman. Interesting. Correct, as far as you
know, Mr. Carmichael?
Mr. Carmichael. Yes, certainly in Australia, it has always
been under the one roof. What changed after we restructured was
that we also had brought it into one law. Prior to that, there
had been a separate law for derivatives and for securities, and
there were two separate exchanges. Once the law was merged, the
two exchanges also merged, and it was just simply a recognition
that there is no fundamental distinction there at all.
Chairman Lieberman. Right. How about Canada?
Mr. Clark. Well, unfortunately, we are the worst of all. We
have multiple security regulators in Canada.
Chairman Lieberman. Worse than the United States.
Mr. Clark. Worse than the United States in this----
Chairman Lieberman. That is very interesting.
Mr. Clark [continuing]. One respect, I would have to say.
So I think we are trying to get a national regulator.
Chairman Lieberman. So is it----
Mr. Clark. State level, essentially, and so this has been
an industry for 40 years to try to get this problem solved. I
think the current government is working very hard to see
whether they can get this reformed and have a national
regulator. But it has faced enormous political disagreement on
it because of state rights, essentially. And so I would say
that is, if we were looking for black holes in Canada, the fact
that we do not have a national regulator. And if you take a
look at the one major crisis Canada did have around asset-
backed paper, certainly a contributing factor was that there
was no federal regulation of this. This was all done at the
provincial level and so escaped--so it was--I think it
represents a black hole example.
Chairman Lieberman. Mr. Nason, I take it that historically
the reason we had both the SEC and the CFTC is that the CFTC
grew up from the trading in agricultural commodities and they
did not want to be mixed with the Wall Street regulators.
Mr. Nason. Historically, that is the genesis of the CFTC's
creation in the 1970s. But, interestingly enough, when the CFTC
was being created, Members of Congress and their staffs asked
the SEC if they wanted the jurisdiction for agricultural
commodities, and they declined because it was a specialized
market.
Chairman Lieberman. Right.
Mr. Nason. But now I think the volume of financial futures
on the futures exchanges is well over 90 percent; whereas, in
the 1970s it was significantly bifurcated between financial and
agriculture.
Chairman Lieberman. Yes. I think this has a lot of logic,
but it is going to be, for those historical reasons, difficult
here. And we can already see not just the regulated entities
but the Members of Congress fighting for the status quo; that
is, the Agriculture Committee fighting to keep a separate CFTC.
Of course, Senator Collins and I think that is why this
Committee has a unique role to play, because we have no vested
interest on either side--at least not in this matter. We may in
other matters.
Let me go on to ask Mr. Green, Dr. Carmichael, and Mr.
Clark about what I would call transition challenges. As we are
heading toward a time of reform, both regulatory and
structural, I wonder if you could give us any counsel about
transition problems that your countries faced, particularly the
two of you, during the transition to a more consolidated
regulatory system and any warnings you would give us as a
result.
Mr. Green. We had a Big Bang in the United Kingdom under
very unusual circumstances. It was not prepared by a great deal
of discussion, but it was accepted almost without subsequent
debate because so many parties thought that it solved a lot of
prior problems. So there was, if you like, a consensus that the
previous arrangements were unsatisfactory, and there were a lot
of attractions in what was being done then.
There was a big advantage, though, in that because there
was almost no warning, and the government was able to decide,
using its parliamentary majority, that this would happen. The
people just had to get on with it, and the organizations were
thrown together and told they had to come up with a solution.
There was not any alternative. You are not in that position in
the United States.
I suppose the lesson that one would draw from it is that if
it is at all possible to start with a structure that, rather as
I said in my earlier remarks, does not have one organization
clearly in the lead, but you are building a true merger and a
new structure out of that, there may be a greater chance of
success. But the historical circumstances were quite unusual in
that respect.
Chairman Lieberman. Dr. Carmichael, in addition to
responding to that, I wonder if you would talk just a little
bit about what the opinion is in Australia now about whether
this was a good move to go to the so-called twin peaks, in the
government, amongst the public, and I suppose in the regulated
community.
Mr. Carmichael. Anytime you have change, you are going to
have some difficulty, and I have been through this not only
twice in Australia with regulatory amalgamation, but in about
half a dozen countries where I have worked as well. So I have
seen some of the problems that can arise firsthand.
Two of the biggest ones are fear--and that is mainly among
staff--fear for jobs, and fear for where they will end up in
the new structure.
Chairman Lieberman. Right.
Mr. Carmichael. And the second is distraction. Regulators
have a job to do, a day job, which is regulation, but they are
distracted because of the reorganization and the rebuilding. So
those are two very big considerations that you have to deal
with in any change.
Chairman Lieberman. Did previous agencies disappear, as I
take it they did, in the United Kingdom?
Mr. Carmichael. Some did.
Chairman Lieberman. But some continued.
Mr. Carmichael. Yes.
Chairman Lieberman. They were just put into one of the
peaks.
Mr. Carmichael. We plucked parts of the central bank and
parts of some of the State regulators and put them together
into a national regulator. We only had one major institutional
rebuild. The others were sort of tinkered with at the edges. If
reform happened here it would be a much more extensive
rebuilding than that because of the sheer number of agencies
that you have.
But there are two things that in my experience have been
absolutely critical to getting to the end without falling over.
First is leadership--we have found that if you identify the
people who are going to be the leaders of the new
organizations, you have to do that early and you have to put
them in place to drive the changes because there are always
people who will resist the change and undermine the process.
You do not want them anywhere around when you are doing it. So
there is a need to make the big decisions early on and then to
get on with it.
The second one is communication--so that people understand
what is happening, and they get involved with it. The more you
can involve staff in the new structure, the more they will feel
ownership for it and be a part of it.
I should mention two other things. Mr. Green mentioned Big
Bang. In the United Kingdom, they did a Big Bang in terms of
making the decision very quickly. In terms of moving to a new
internal structure, the FSA moved in gradual steps over quite a
long period of time. We used a very different approach. We just
kept the agencies separate for a year. We brought them together
in name but people kept doing their old jobs for that year. We
redesigned how we wanted the agency to look at the end of that.
And at the end of the first year, we basically sacked everyone
and invited them to apply for new jobs in the new agency. And
for 2 weeks I did not sleep, not knowing whether we would
actually have an agency at the end of the process. I would not
recommend that approach. It worked, but I would not recommend
it for anyone else.
The last point I would make before getting to your comment
about whether it was a success is about legal elements, and I
speak here as a non-lawyer, but I have learned to respect law
much more over the last 10 or 15 years than I ever did. It was
a mistake in Australia to create the agency just with a piece
of enabling legislation that set it up, said what its powers
were, but left it to operate under each of the individual
industry acts that were already in place. So we still had a
banking act and a general insurance act and so on.
What we have done in a couple of other countries is take
each of those pieces of legislation and, before creating the
agency, take all of the regulatory powers out of those and move
them up into the agency's act. The power of that is just
incredible.
For example, when we first wanted to create a new
governance standard for all of our industries, my lawyers said,
``I am sorry, Chairman. You cannot do that. You have to issue
it under each of the different pieces of legislation, and some
of them do not even give you the power to do that.''
So the ability to create a harmonized approach in Australia
was severely handicapped by the law.
Now, the United Kingdom went about it another way--they
created an omnibus act. It was very painful, but the outcome
was very strong.
So legal elements are important. I would encourage you, if
you go this route, to get the legislation running ahead of the
agency, if you can. Get the legal side sorted out so that the
agency has the powers to do what it needs to do.
You asked whether it was a good move. The answer is
undoubtedly, yes. Our Prime Minister in Australia and our
Treasurer are out around the world crowing about how great our
system has been. If you wound the clock back 2 years ago, they
were still grumbling that the system belonged to their
predecessors, who were of a different party. The story has
changed enormously.
Chairman Lieberman. That is powerful testimony. Thank you.
Senator Collins.
Senator Collins. Thank you, Mr. Chairman.
Mr. Carmichael, let me take up where the Chairman left off.
Your four peaks or twin peaks approach has a lot of appeal to
me, but I am wondering, as someone who spent 5 years overseeing
financial regulation in the State of Maine, how it works for
the regulatory community. If you have separate regulators, do
you also have separate compliance audits? In other words, in
Maine, when we would send out our bank auditors to review the
State-chartered banks for compliance, they did the entire audit
because it was only that one agency plus there was a Federal
agency involved as well. But if you have separate regulators
for prudential regulation competition, are you having multiple
audits?
Mr. Carmichael. The answer is yes, but ``multiple'' is a
very small number in that our prudential regulator has the
primary responsibility for on-site inspections. And I should
say we are much more of a principles-based than a rules-based
country, so we do not do anything like as many audits and on-
site inspections as would be common under the U.S. approach.
Our conduct regulator, which is the pillar that looks at
mis-selling and mis-pricing of products, works on the basis of
responding to complaints. So they are not out there auditing
complaints as such. They will hear a complaint, and they are
really looking for misconduct of a type. Then they will do an
investigation. So it is very targeted. It is not a regular on-
site audit of that style.
So in the sense of overlap, it is really quite minimal.
Senator Collins. I also recall when I was head of the
Financial Department that we would have regulated entities say,
well, we are going to consider becoming federally chartered
unless you do X. So there is a real problem in our country with
shopping for the easiest regulator and playing the States off
against the Federal regulators and vice versa. And because that
is an income stream to the regulator, those threats matter to
State governments, particularly State governments that are
strapped for funds. So I think that is an issue as well.
Mr. Nason, in the United States we now recognize that a
large shadow banking sector can threaten the entire financial
sector, and I, for one, believe that it is not enough to
monitor just the safety and soundness of traditional banks, but
we need to extend safety and soundness regulation to investment
banks, for example, to subsidiaries of companies like AIG.
Bear Stearns, I am told, had an astonishing leverage ratio
of 30:1 when it failed. Do you think that we should be
extending some system of capital requirements across the
financial sector?
Mr. Nason. That is a great and very difficult question. If
you go back to Bear Stearns, Bear Stearns was under a
consolidated supervisory system that was administered by the
SEC, so they did have liquidity and capital requirements that
were different than the banking system, but they were under
some type of conglomerate supervision.
I think generally if you are a systemically important
institution, it is hard to argue that you should not be under
some type of systemic supervision to prevent hurting the
general economy.
What gets harder is where do you draw the line between
which types of institutions gets safety and soundness
supervision and which do not? For example, a very easy case is
some hedge funds, you can make an argument that they are
systemically important because of their size or concentration
in particular markets. They could probably be subjected to some
type of supervision. Should all hedge funds be subjected to
that type of supervision? The case is harder the smaller they
become.
So the way that we cut it in the Blueprint is that
institutions would all need to be licensed, chartered, and
under the supervision of our systemic regulator. But that type
of systemic regulation was different than traditional
prudential safety and soundness regulation.
Senator Collins. It, of course, gets very complicated very
quickly because if you designate certain financial institutions
as systemically important and, thus, make them subject to
safety and soundness regulation, you are also sending a message
that they are too big to fail--a very bad message to send
because then you are creating moral hazard.
This is so complicated to figure out the right answer here,
but I do think it is significant that the Canadian banks, with
their higher capital requirements and the ability to hold
lower-return assets, lower-risk assets, and lower leverage
ratios compared to American banks, were healthier. They did not
fail. So, clearly, there has got to be a lesson for us there.
Mr. Clark, I know we are running out of time, but I do want
to talk to you further about the lending practices. I
completely agree with my colleague from Missouri that part of
the problem with the American mortgage system was that risk and
responsibility were divorced, so you had a mortgage broker who
was making the loan, gets his or her cut, then sells it to the
bank, which gets its cut, which then sells it to the secondary
market. Everyone is getting a financial reward, but ultimately
no one is responsible for the mortgage if it goes bad. There is
no skin in the game, which I think is a big problem, although
difficult to solve because of the liquidity issues that Mr.
Nason raised.
But there are other key differences as well that you talked
to me about when we were in my office, and they had to do with
downpayment levels, mortgage insurance, and deductibility of
interest. Could you discuss some of the differences between
Canadian and American mortgage lending?
Mr. Clark. Maybe I should just mention one other feature
that I have not underscored but we found a tremendous
difference on the two sides of the border. In Canada, because
we hold all the mortgages, modifying the mortgages is easy to
do. We do not have to ask anyone's permission to modify the
mortgage. And it is not the government coming to us and saying,
``Would you start? Here is our modification program.'' We just
were instantly modifying the mortgages.
Last year, we represented about 20 percent of the mortgage
market in Canada. We only foreclosed on 1,000 homes in a whole
year, to give you an order of magnitude. And every one of those
thousand we regarded as a failure. And so the last thing we
would ever want to do is actually foreclose on a good customer.
And so we go out of our way to modify the mortgages, and that
is just natural practice for us because I do not have to ask
permission of some investor whether or not I want to do this or
can do it or what rules are governing it.
So I do think that has turned out in this crisis to be a
second feature that, frankly, none of us would have thought
about until the current crisis.
In terms of our specifics, we are required, if we, in fact,
lend more than 80 percent loan-to-value, to actually insure the
mortgage so that represents a constraint. It would not have
represented a constraint to the kind of no documentation
lending that was done in the United States because the actual
underwriting we are doing. But then again, because we actually
would be holding the mortgages, we insisted on full
documentation.
There is not interest deductibility. I think there is no
question that the feature of having interest deductibility in
the United States is a major factor for leveraging up. And
despite the fact that it is justified on the basis that it
encourages homeownership, historically homeownership has
actually been higher in Canada than it has been in the United
States. So there is no evidence that the two are linked at all.
All it does is inflate housing prices because, in fact, people
look at the after-tax cost in computing the value on which they
are to bid for the houses.
So I would say those are the main features. We do have
mortgage brokers, but they are originating mortgages which we
then hold. We do not sell them on. And I think that is the core
feature.
Senator Collins. And just to clarify, in most cases the
homebuyer is putting down 20 percent. Is that correct?
Mr. Clark. Yes. Although when I started my first house, I
bought the insurance and put down less than 20 percent. But you
can do it. But, again, we would not lend to that person unless
we were sure they were going to pay us back because we are
responsible for the collections, we are responsible for
managing that, and it is really our customer relationship,
which is how we regard it.
Senator Collins. I think it is fascinating that
homeownership levels are actually higher in Canada than in the
United States, because the justification for all these policies
that encouraged the subprime mortgage market was to increase
homeownership. And, in fact, it has caused a lot of people to
lose homes that they could not afford in the first place, and
the Canadian experience is very instructive.
Mr. Green, last question to you. In the United Kingdom,
what are the lending policies? Are they more similar to the
Canadian practices or to the American practices?
Mr. Green. A mixture. There is also no interest
deductibility in the United Kingdom, though that has not
stopped a boom in house prices. There has been no regulation of
the terms of lending, and one of the issues that has arisen in
the review that the FSA has undertaken of what went wrong and
what might need to change--which I commend to you, it is a very
detailed review covering many of the issues we have talked
about today--is whether there should be some kind of mandatory
loan-to-value ratios or loan-to-income ratios. So they were not
in place, but that is seriously being considered.
What has now been agreed at the European level is that
there will be skin in the game and that the originator in
securitization will have to maintain 5 percent. And I think I
am right in saying that has now been legislated across the
European Union because of a rather widespread perception that
this was a problem that needed fixing. You may say 5 percent is
only symbolic, but, of course, it will concentrate the minds of
the management to all the issues that Dr. Clark has mentioned.
Senator Collins. Thank you. Thank you, Mr. Chairman.
Chairman Lieberman. Thanks very much, Senator Collins.
Thanks to our four witnesses. Thanks for the trouble you
took to come here, for the time you spent with us, and, most of
all, for sharing your experiences and opinions. I found this to
be a very helpful hearing. Even you, Mr. Nason, who did not
come that far. [Laughter.]
We appreciate your testimony. And at the risk of
simplifying it, I think in various ways your testimony has
shown us that structure matters, obviously regulation does,
too, that you need a healthy combination of both, and that none
is a cure-all. You cannot assume that a good regulatory
structure will solve all the problems. But it will solve some
of them, and it will prevent others from occurring or make it
harder for others to occur. I think you have helped clarify
opinions up here, so we thank you very much.
It is our normal course to keep the record of the hearing
open for 15 days for any additional questions or statements. If
you have any second thoughts you want to add to the printed
record--all your prepared statements, which were excellent,
will be printed in the record in full. It may be that some
Members of the Committee, those who were here and those who
were not, would file some questions with you, and if you have
the chance, it would be appreciated if you would answer them
for the record. But, really, our thanks, and I hope you will
both watch with interest as we proceed to attempt to reform and
say a prayer for us as well.
The hearing is adjourned. Thank you.
[Whereupon, at 4:01 p.m., the Committee was adjourned.]
A P P E N D I X
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