[Senate Hearing 111-42]
[From the U.S. Government Publishing Office]








            MODERNIZING THE U.S. FINANCIAL REGULATORY SYSTEM

                                                         S. Hrg. 111-42

                    MODERNIZING THE U.S. FINANCIAL 
                           REGULATORY SYSTEM

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

                                HEARING

                               before the

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

    THE GOVERNMENT ACCOUNTABILITY OFFICE'S FRAMEWORK FOR ASSESSING 
  PROPOSALS TO MODERNIZE THE U.S. FINANCIAL REGULATORY SYSTEM AND THE 
   GROUP OF 30's RECENT REPORT ON CREATING A FRAMEWORK FOR FINANCIAL 
                               STABILITY

                               ----------                              

                            FEBRUARY 4, 2009

                               ----------                              

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

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50-564 PDF

                                 ______

2009

                                                         S. Hrg. 111-42


                     MODERNIZING THE U.S. FINANCIAL
                           REGULATORY SYSTEM

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

                                HEARING

                               before the

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

    THE GOVERNMENT ACCOUNTABILITY OFFICE'S FRAMEWORK FOR ASSESSING 
  PROPOSALS TO MODERNIZE THE U.S. FINANCIAL REGULATORY SYSTEM AND THE 
   GROUP OF 30's RECENT REPORT ON CREATING A FRAMEWORK FOR FINANCIAL 
                               STABILITY

                               __________

                            FEBRUARY 4, 2009

                               __________

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


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

?

            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  JIM DeMINT, South Carolina
JON TESTER, Montana                  DAVID VITTER, Louisiana
HERB KOHL, Wisconsin                 MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                 Colin McGinnis, Acting Staff Director

     William D. Duhnke, Republican Staff Director and Chief Counsel

                      Dean V. Shahinian,  Counsel

             Jonathan Miller, Committee Professional Staff

                       Deborah Katz, OCC Detailee

                Julie Chon, Senior International Adviser

                   Lisa Frumin, Legislative Assistant

                  Drew Colbert,  Legislative Assistant

                  Didem Nisanci, Legislative Assistant

                        Robert Lee, GAO Detailee

                 David Stoopler, Legislative Assistant

                   Emma Palmer, Legislative Assistant

                 Matthew Pippin, Legislative Assistant

                Jonathan Davidson, Legislative Assistant

                  Tamara Fucile, Legislative Assistant

                   Mary Perko, Legislative Assistant

            Mark Oesterle, Republican Deputy Staff Director

                   Andrew Olmem,  Republican Counsel

            Mark Calabria,  Senior Professional Staff Member

                  Mike Nielsen, Legislative Assistant

                  Gregg Richard, Legislative Assistant

                 Sarah Novascone, Legislative Assistant

                       Dawn Ratliff, Chief Clerk

                      Devin Hartlet, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                      WEDNESDAY, FEBRUARY 4, 2009

                                                                   Page

Opening statement of Senator Dodd................................     1
Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     4
    Senator Schumer
        Prepared Statement.......................................    48

                               WITNESSES

Paul A. Volcker, Chairman, Steering Committee of the Group of 30.     7
    Prepared statement...........................................    49
    Response to written questions of Senator Johnson.............   262
Gene L. Dodaro, Acting Comptroller General, U.S. Government 
  Accountability Office; accompanied by Orice M. Williams and 
  Richard J. Hillman.............................................    35
    Prepared statement...........................................   126
    Response to written questions of Senator Johnson.............   263

              Additional Material Supplied for the Record

GAO Report to Congressional Requesters; Corporate Shareholder 
  Meetings: Issues Relating to Firms That Advise Institutional 
  Investors on Proxy Voting......................................   267
GAO Report to the Ranking Minority Member, Committee on Health, 
  Education, Labor, and Pensions, U.S. Senate; ``Pension Plans: 
  Additional Transparency and Other Actions Needed in Connection 
  With Proxy Voting''............................................   295
Testimony of Yvonne D. Jones, GAO, before the Subcommittee on 
  Oversight of Government Management, the Federal Workforce, and 
  the District of Columbia, Committee on Homeland Security and 
  Governmental Affairs, U.S. Senate; ``Financial Literacy and 
  Education Commission: Further Progress Needed To Ensure an 
  Effective National Strategy''..................................   340
Letter submitted by Derek B. Stewart, GAO, to the Subcommittee on 
  Oversight of Government Management, the Federal Workforce, and 
  the District of Columbia, Committee on Governmental Affairs; 
  ``Military Personnel: Bankruptcy Filings Among Active Duty 
  Service Members''..............................................   360
Testimony of Valerie C. Melvin, GAO, before the Subcommittee on 
  Oversight and Investigations, Committee on Financial Services, 
  House of Representatives; ``Military Personnel: DOD Has Taken 
  Steps To Address Servicemember's Financial Needs, but 
  Additional Effort Is Warranted''...............................   369

                                 (iii)

 
            MODERNIZING THE U.S. FINANCIAL REGULATORY SYSTEM

                              ----------                              


                      WEDNESDAY, FEBRUARY 4, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 3:05 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.

               OPENING STATEMENT OF CHAIRMAN DODD

    Chairman Dodd. The Committee will come to order.
    Let me thank all of my colleagues, and I think you all 
understood we intended, obviously, at some time earlier to have 
this hearing a little earlier. But as I think all of you may 
know, we had an interesting session on our side of the aisle, 
gathering today to listen to some of our new economic team 
under President Obama, as well as the President himself and 
others, talk about many of the issues that are confronting the 
country, not the least of which was the issue of the subject 
matter of this hearing, the modernization of the U.S. financial 
regulatory system. I am particularly honored and delighted to 
have Paul Volcker here with us, who has been a friend for many 
years, someone I have admired immensely for his contribution to 
our country.
    How we will proceed is, because we are getting underway 
much later than normal for the conducting of Senate hearings, 
with the indulgence of my colleagues, I will make some opening 
comments myself, turn to Senator Shelby, and then we will go 
right to you, if we could, Chairman Volcker. Then I will invite 
my colleagues and tell them that any opening comments that they 
do not make for themselves, we will include them in the record 
as if given. And since there are not many of us here, we can 
move along pretty quickly, I hope, as well. So, with that 
understanding, we will get underway and, again, I thank all of 
you for joining us here today.
    Today, we continue the Senate Banking Committee's 
examination of how to modernize our outdated financial 
regulatory system. We undertake this examination in the midst 
of a deepening recession and the worst financial crisis since 
the Great Depression in the 20th century. We must chart a 
course forward to restore confidence in our Nation's financial 
system upon which our economy relies.
    Our mission is to craft a framework for 21st century 
financial regulation, informed by the lessons we have learned 
from the current crisis and designed to prevent the excesses 
that have wreaked havoc with homeowners and consumers, felled 
financial giants, and plunged our economy into a recession.
    This will not be easy, as we all know. We must act 
deliberately and thoughtfully to get it right. We may have to 
act in phases given the current crisis. But inaction is not an 
option at all, and time is not neutral. We must move forcefully 
and aggressively to protect consumers, investors, and others 
within a revamped regulatory system.
    Last Congress, this Banking Committee built a solid 
foundation upon which we will base our work today, and I want 
to once again thank Dick Shelby, former Chairman of this 
Committee, and my colleagues, both Democrats and Republicans, 
who played a very, very constructive role in the conduct of 
this Committee that allowed us to proceed as we did.
    Subcommittees and Committees held 30 hearings to identify 
the causes and consequences of this crisis, from predatory 
lending and foreclosures, to the collapse of Bear Stearns, the 
role of the credit rating agencies, the risks of derivatives, 
the regulation of investment banks and the insurance industry, 
and the role and condition of banks and thrifts.
    The lessons we have learned thus far have been rather 
clear, and let me share some of them with you.
    Lesson number one: consumer protection matters. The current 
crisis started with brokers and lenders making subprime and 
exotic loans to borrowers unable to meet their terms. As a 
former bank regulator recently remarked to me, ``Quite simply, 
consumers were cheated.'' Some lenders were so quick to make a 
buck and so certain they could pass the risk on to the next 
guy, they ignored all standards of prudent underwriting. The 
consumer was the canary in the coal mine, but no one seemed to 
notice.
    Lesson number two: regulation is fundamental. Many of the 
predatory lenders were not regulated. No one was charged with 
minding the store. But soon the actions of these unregulated 
companies infected regulated institutions. Banks and their 
affiliates purchased loans made by mortgage brokers or the 
securities or derivatives backed by these loans, relying on 
credit ratings that turned out to be wildly optimistic. So we 
find that far from being the enemy of well-functioning markets, 
reasonable regulation is fundamental to sound and efficient 
markets, and necessary to restore the shaken confidence in our 
system at home and around the globe.
    Lesson number three: regulators must be focused, 
aggressive, and energetic cops on the beat. Although banks and 
thrifts made fewer subprime and exotic loans than their 
unregulated competitors, they did so with impunity. Their 
regulators were so focused on banks' profitability, they failed 
to recognize that loans so clearly unsafe for consumers were 
also a threat to the banks' bottom line. If any single 
regulator recognized the abusiveness of these loans, no one was 
willing to stand up and say so. And with the Fed choosing not 
to use its authority to ban abusive home mortgages, which some 
of us have been calling for, for years, the regulators were 
asleep at the switch.
    Lesson number four: risks must be understood in order to be 
managed. Complex instruments, collateralized debt obligations, 
credit default swaps designed to manage the risks of the fault 
loans that backed them turned out to magnify that risk. The 
proliferation of these products spread the risk of subprime and 
Alt-A loans like an aggressive cancer through the financial 
system. Institutions and regulators alike failed to appreciate 
the hidden threat of these opaque instruments, and the current 
system of regulators acting in discrete silos did not equip any 
single regulator with the tools to identify or address 
enterprise or systemwide risks. On top of that, CEOs had little 
incentive to ferret out risks to the long-term health of their 
companies because too often they were compensated for short-
term profits.
    I believe these lessons should form the foundation of our 
effort to shape a new, modernized, and, above all, transparent 
structure that recognizes consumer protection and the health of 
our financial system are inextricably linked. And so in our 
hearing today and those to come--and there will be many--I will 
be looking for answers to these questions. What structure best 
protects the consumer? What additional regulations are needed 
to protect consumers from abusive practices? We will explore 
whether to enhance the consumer protection mission of the 
prudential regulators or create a regulator whose sole job is 
protecting the American consumer.
    How do we identify and supervise the institutions and 
products on which the health of our financial system depends? 
Financial products must be more transparent for consumers and 
institutional investors alike. But heightened supervision must 
not stifle innovation of financial actors and markets.
    Third, how do we ensure that financial institution 
regulators are independent and effective? We cannot afford a 
system where regulators withhold bold and necessary action for 
fear that institutions will switch charters to avoid stricter 
supervision. We should consider whether a single prudential 
regulator is preferable to the alphabet soup of regulators that 
we have today.
    Fourth, how should we regulate companies that pose a risk 
to our system as a whole? Here we must consider whether to 
empower a single agency to be the systemic risk regulator. If 
that agency is the Federal Reserve Board, we must be mindful of 
ensuring the independence and integrity of the Fed's monetary 
policy function. Some have expressed a concern--which I share, 
by the way--about overextending the Fed when they have not 
properly managed their existing authority, particularly in the 
area of protecting consumers.
    Fifth, how should we ensure that corporate governance 
fosters more responsible risk taking by employees? We will seek 
to ensure that executives' incentives are better aligned with 
the long-term health of their companies, not simply short-term 
profits.
    Of course, my colleagues and our witnesses today may 
suggest other areas. I do not mean to suggest this is the 
beginning and end-all of the questions that need to be asked, 
and I welcome today's witnesses' as well as our colleagues' 
contributions to this discussion and the questions that ought 
to be addressed.
    I look forward to moving forward collaboratively in this 
historic endeavor to create an enduring regulatory framework 
that builds on the lessons of the past, restores confidence in 
our financial system, and recognizes that our markets and our 
economy will only be as strong as those who regulate them and 
the laws by which they abide. That is the responsibility of 
this Committee. It is the Republican of this Congress. It is 
the responsibility of the administration.
    I will recognize Senator Shelby for an opening comment and 
ask my colleagues if they might withhold statements, at least 
at the outset, so we can get to our witnesses.
    With that, I turn to Senator Shelby.

                  STATEMENT OF SENATOR SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    Today, the Committee will hear from one of this Nation's 
most respected economists and veteran policymakers. Dr. Volcker 
is no stranger to this Committee. Senator Dodd and I remember 
many years ago when he would come here as Chairman of the 
Federal Reserve Board. During the financial crisis in the late 
1970s, it was Paul Volcker who helped put our economic house 
back in order, and, Dr. Volcker, I welcome you back to the 
Committee again.
    While I am very interested in the views of our witnesses on 
regulatory modernization, I think the hearing could be a little 
bit premature. Let me explain.
    As I have said many times and will continue to say, I 
believe that before we discuss how to modernize our regulatory 
structure, or even before we consider how to address the 
current financial crisis, we need to first understand its 
underlying causes. If we do not have a comprehensive 
understanding of what went wrong, we will not be able to 
determine with any degree of certainty whether our regulatory 
structure was sufficient and failed or was insufficient and 
must change.
    I understand that next week Chairman Dodd plans to hold a 
hearing on the origins of the financial crisis, for which I 
commend him. I welcome that hearing, but I believe that one 
hearing, or even a handful of hearings, falls well short of 
what these exceptional times will demand. Instead, this 
Committee should, I believe, and must conduct a full and 
thorough investigation of the market practices, regulatory 
actions, and economic conditions that led to this crisis.
    The Committee should hear testimony from all relevant 
parties and produce a written report of its findings. This work 
is crucial, I believe, if we are to develop policies that will 
help end this crisis and prevent it from occurring again.
    While I understand many people have their own views of what 
happened, this Committee has yet to make that determination in 
a comprehensive and organized manner. As a result, nearly a 
year and a half later, we still have not documented what 
started the crisis and why it became so severe. The uncertainty 
about its origins has not only exacerbated our economic 
downturn by undermining confidence in our entire financial 
system, but it has left us without a clear understanding of 
what needs to be done. We need to remedy that. Thus far, the 
efforts of the Treasury Department and the Congress have been 
ad hoc at best.
    When this all began, I strongly opposed the TARP bailout 
legislation because I believed Congress jumped right to a 
legislative solution without first identifying the problem it 
was trying to solve. Since we never developed a consensus about 
what caused this crisis, neither Congress nor the Treasury 
Department can devise a targeted solution. And as a result, 
TARP has drifted rudderless since it was passed 4 months ago, 
wasting taxpayer dollars while the crisis rages on without an 
end in sight.
    It is well past time that we investigate the origins of the 
financial crisis so that we can begin to lay the groundwork for 
a bipartisan, effective, and durable solution. In the absence 
of such effort, there is now talk of creating a commission to 
examine the origin of the financial crisis and to make 
recommendations for further action. At this time, I would 
oppose the creation of such a commission because a thorough 
investigation is something that this Committee can do and must 
do. The American people rightly expect their elects 
representatives, the Senators here, not unaccountable 
commissions to do the work necessary to solve the problems 
facing the country.
    This Committee is uniquely positioned to conduct a 
transparent investigation that could build the necessary 
political consensus around the appropriate legislative remedy 
that we must seek. This particular Committee has a long history 
of conducting such investigations. The best precedent, I 
believe, for this type of investigation that our current 
economic situation demands is the year-long investigation of 
stock market abuses the Committee conducted during the Great 
Depression. The so-called Pecora hearings produced a detailed 
report exposing a wide range of abuses on Wall Street. The 
Committee heard testimony from hundreds of witnesses, producing 
nearly 12,000 pages of transcripts from over 100 hearings. The 
investigative staff was made up of dozens of individuals and 
included attorneys, accountants, and statisticians. They 
conducted scores of interviews and sworn depositions. The 
Committee subpoenaed corporate records and heard testimony from 
the heads of Wall Street and industry, including 3 days of 
testimony, I have been told, from Mr. Morgan himself. The 
Committee's investigative record comprises 171 boxes in the 
National Archives.
    The record that the Pecora hearings established ultimately 
laid the groundwork for the passage of the Securities Act and 
the creation of the Securities and Exchange Commission. 
Recently, renowned economic historian Ron Chernow wrote an 
editorial in the New York Times calling for Congress to 
initiate an investigation in the tradition of the Pecora 
hearings. He stated the importance of such an investigation to 
resolving the current crisis by pointing out, and I will quote 
him:

        If history is any guide, legislators can perform a signal 
        service by moving beyond the myriad details of the rescue plans 
        to provide a coherent account of the origins of the current 
        crisis. The moment calls for nothing less than a sweeping 
        inquest into the twin housing and stock market crashes to 
        create both the intellectual context and the political 
        constituency for change.

I believe that he is correct.
    The hearings this Committee has held to date on the credit 
crisis have been helpful, but I think they have lacked the 
focus and purpose displayed during the Pecora hearings, partly 
due to the Committee's lack of resources up to this time. To 
remedy this problem, Senator Dodd and I have already submitted 
an initial request for additional funding and office space for 
the Committee. We were recently informed that the Committee is 
going to receive additional funding, although not what is 
necessary, I believe, to conduct a thorough and fair 
investigation.
    I am hoping that our colleagues on the Rules Committee 
would agree that this type of effort here in the Banking 
Committee right now is not only necessary but deserving of 
their support. I believe the investigation should start by 
calling before the Committee all of the regulators from the 
past decade or more who were appointed to make sure this crisis 
did not happen, but it did.
    The Committee has heard from regulators on their views on 
how to solve the crisis, but it has yet to hear from present 
and former regulators on what caused the crisis and whether 
steps could have been taken to prevent it. The Committee, I 
believe, should supplement this testimony with an exhaustive 
review of the records of the regulators from that period. Once 
again, there will be a time to discuss what needs to be done, 
but before we entrust any new or existing regulator with 
additional responsibilities or authorities, I believe we need 
to know if and how our present regulatory structure failed us.
    After we complete a thorough review of the role of the 
regulators, we should then call the CEOs of the largest banks, 
insurance companies, brokerage firms, home builders, realtors, 
and other financial services companies of the past 10 years to 
testify. This, of course, would be preceded by an extensive 
staff effort to examine the activities of each institution or 
industry.
    Since the crisis began, the Committee has not yet heard 
from Wall Street CEOs on their role in creating the toxic 
assets that have spread through our financial system like a 
cancer. Nor have they publicly explained why their risk 
management systems failed or why they operated with such 
dangerous levels of leverage. Because many of these firms have 
either failed, received public money, or sought some type of 
Federal assistance, I believe they owe it to the American 
people to explain how this crisis started and what role they 
played in it.
    Last year, I called for a hearing to examine the role of 
underwriters in spawning the crisis. The Committee announced 
that it would hold a hearing to examine underwriting practices, 
but it was postponed and is yet to be scheduled. That hearing 
could now be part of this effort.
    Mr. Chairman, I am willing to work with you, as I have, and 
I believe this Committee is uniquely positioned, as you do, to 
perform this important service at this time for the American 
people. I pledge my full support should you choose to undertake 
your own version of the Pecora hearings, as long as they are 
comprehensive.
    Chairman Dodd. Well, I thank you, Senator, very, very much. 
I would just note for the record that there have already been 
some proposals, including one from Senator Isakson and Senator 
Conrad, for sort of a 9/11 Commission--some of my colleagues 
may be aware of this already--to be done outside of this 
Committee to go back and examine that, and that has, obviously, 
some appeal as well. Certainly we want to examine what 
happened, but also we need to go forward.
    With that, I thank you very much, Chairman Volcker, for 
being with us, and for those are unfamiliar with our first 
witness, Chairman Volcker is the Chair of the President's 
Economic Recovery Advisory Board, Chairman of the Board of 
Trustees of the Group of 30, and former Chairman of the Board 
of Governors of the Federal Reserve System. Chairman Volcker 
worked in the Federal Government for almost 30 years, including 
positions at the Federal Reserve Bank of New York, the Treasury 
Department, and Chase Manhattan--he has a wealth of experience.
    We thank you for coming and welcome you to the Committee.

 STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, STEERING COMMITTEE OF 
                        THE GROUP OF 30

    Mr. Volcker. Thank you, Mr. Chairman, Mr. Shelby, Members 
of the Committee. I am delighted to be here. I want to make 
clear that I am appearing as Chairman of the Steering Committee 
of the Group of 30 and not as Chairman of the President's 
Economic Recovery Advisory Board this morning.
    Chairman Dodd. It is so noted. We will make that 
distinction here.
    Mr. Volcker. People accuse me of liking the title 
``Chairman,'' but I want to make sure Chairman of what.
    [Laughter.]
    Mr. Volcker. The Group of 30 is a group of people drawn 
from the private and public sectors with experience in finance, 
and I emphasize that it is international, and this report was 
directed not just toward the United States, although it is 
perhaps most relevant to the United States. But it is directed 
toward authorities in any country that has extensive financial 
operations around the world.
    It does not discuss all the origins of the crisis. It does 
touch upon it, but that is not my purpose in appearing before 
you this morning. What is evident is, whatever the cause is--
and we could go into that. What is evident is that we do meet 
at a time, as you have emphasized, of acute distress in 
financial markets. Strongly adverse effects on the economy more 
broadly are apparent. There is a clear need, I think, for early 
and effective governmental programs. They cannot wait a year 
for attacking the immediate problems to support economic 
activity and to ease the flow of credit. But I think it is also 
evident that more fundamental changes are needed in the 
financial system, and they will take some time to work out.
    But to the extent that we have some sense of the direction 
of those reform efforts, I think it will help the more 
immediate problem. The important thing is that we do not and 
should not want to contemplate a repetition of this experience, 
and that is what this report is aimed at, and I am sure will be 
your concerns over time.
    I understand that President Obama and his people are going 
to be placing before you some more immediate measures. They are 
not the subject of our report. But when we look further ahead, 
I do think the more we have a sense of the longer-term future, 
the better place you will be for appraising the immediate 
actions to make sure they are consistent with what we would 
like to see in the longer run.
    The basic thrust of the G-30 report is to distinguish among 
the basic functions of any financial system. First, there is a 
need for strong and stable institutions that serve the needs of 
individuals, of businesses, of governments, and others for a 
safe and sound repository of funds, providing a reliable source 
of credit, and maintaining a robust financial infrastructure 
able to withstand and diffuse shocks and volatility that are 
inevitable in the future. I think of that as the service-
oriented part of the financial system. It deals primarily with 
customer relationships. It is characterized mainly by 
commercial banks that have long been supported and protected by 
deposit insurance, by access to the Federal Reserve credit, and 
by other elements of the so-called Federal safety net.
    Now, what has become apparent during this period of crisis 
is increasing concentration in banking and the importance of 
official support for what is known as systemically important 
institutions when they become at risk of failure. What is 
apparent is that a sudden breakdown or discontinuity in the 
functioning of those institutions risks widespread 
repercussions on markets, on closely interconnected financial 
institutions, and at the end of the day, on the broader 
economy.
    The design of any financial system raises large questions 
about the appropriate criteria for, and the ways and means of, 
providing official support for these systemically important 
institutions.
    In common ground with virtually all official and private 
analysts, the G-30 Report calls for ``particularly close 
regulation and supervision, meeting high and common 
international standards'' for such institutions deemed 
systemically critical. It also explicitly calls for 
restrictions on ``proprietary activities that present 
particularly high risks and serious conflicts of interest'' 
deemed inconsistent with the primary responsibilities, I would 
say the primary fiduciary responsibilities, of those 
institutions to its customers. Of relevance in the light of 
recent efforts of some commercial enterprises to recast 
financial affiliates as bank holding companies, the report 
strongly urges continuing past U.S. practice of prohibiting 
ownership or control of Government-insured, deposit-taking 
institutions by non-financial firms.
    Second, the report implicitly assumes that while regulated 
banking institutions will be dominant providers of financial 
services, a variety of capital market institutions will remain 
active. Organized markets and private pools of capital will be 
engaging in trading, transformation of credit instruments, and 
developing derivatives and hedging strategies. They will take 
place in other innovative activities, potentially adding to 
market efficiency and flexibility.
    Now, these institutions do not directly serve the general 
public; individually, they are less likely to be of systemic 
significance. Nonetheless, experience strongly points to the 
need for greater transparency. Specifically beyond some minimum 
size, registration of hedge and equity funds should be 
required, and if substantial use of borrowed funds takes place, 
an appropriate regulator should be able to require periodic 
reporting and appropriate disclosure.
    Furthermore, in those exceptional cases when size, 
leverage, or other characteristics pose potential systemic 
concerns, the regulator should be able to establish appropriate 
standards for capital, liquidity, and risk management.
    Now, the report does not deal with important and sensitive 
questions of the appropriate administrative arrangements for 
the regulatory and supervisory functions, which agency will 
supervise which institutions. These are in any case likely to 
be influenced by particular national traditions and concerns. 
What is emphasized is that the quality and effectiveness of 
prudential regulation and supervision must be improved. 
Insulation from political and private special interests is a 
key, along with adequate and highly competent staffing. That 
implies adequate funding.
    The precise role and extent of the central bank with 
respect to regulation and supervision is not defined in the 
report. It is likely to vary country by country. There is, 
however, a strong consensus that central banks should accept a 
continuing role in promoting and maintaining financial 
stability, not just in times of crisis, but in anticipating and 
dealing with points of vulnerability and risk.
    The report also deals with many more specific issues 
cutting across all institutions and financial markets. These 
include institutional and regulatory standards for governance 
and risk management, an appropriate accounting framework 
(including common international standards), reform of credit 
rating agencies, and appropriate disclosure and transparency 
standards for derivatives and securitized credits. 
Specifically, the report calls for ending the hybrid private/
public nature of the two very large Government-sponsored 
mortgage enterprises in the United States. Under the pressure 
of financial crisis, they have not been able to serve either 
their public purposes or their private stockholders 
successfully. To the extent that the Government wishes to 
provide support for the residential mortgage market, it should 
do so by means of clearly designated Government agencies.
    Finally, I want to emphasize that success in the reform 
effort, in the context of global markets and global 
institutions, will require consistency in approach among 
countries participating significantly in international markets. 
There are established fora for working toward such 
coordination. I also trust that the forthcoming G-20 meeting, 
bringing together leaders of so many relevant nations, can 
provide impetus for thoughtful and lasting reform.
    Thank you, Mr. Chairman. I am delighted to have any 
comments or questions.
    Chairman Dodd. Well, thank you very much, Mr. Chairman as 
well. And what I am going to do is ask the clerk here to put 
the clock on at 8 minutes, and we will try to adhere to that so 
we can get around to everybody, since we have not had opening 
statements be made. And I will begin, then turn to Senator 
Shelby.
    Let me, if I can, begin with a couple of--sort of a broad 
question, if I can. The GAO report states--and I am quoting it 
here. It says, ``Mechanisms should be included for identifying, 
monitoring, and managing risks to the financial system, 
regardless of the source of the risk.''
    What was the source of the risk in the current crisis, in 
your view?
    Mr. Volcker. Well, that is a complicated question that goes 
to some of Senator Shelby's concerns about what caused the 
crisis. If I were analyzing this crisis in a substantial way, 
you have to go back to the imbalances in the economy, not just 
in financial markets. But as you know, the United States has 
been consuming more than it has been producing for some years, 
and its savings have practically disappeared, and that was made 
possible by, among other things, a very fluid flow of savings 
from abroad, low interest rates--very easy market conditions, 
low interest rates, which in turn incited the great world of 
financial engineering to develop all kinds of complex 
instruments to afford a financing for businesses, and 
particularly in this case for individuals, homebuyers, that 
went on to exceed basically their capacity to pay. And it was 
all held up by rising house prices for a while, as you know, 
and everybody felt better when the house prices were rising, 
but that could not happen forever. And when house prices 
stopped rising, the basic fragility in that system was exposed.
    So you had an underlying economic problem, but on top of 
that, you had a very fragile, as it turned, highly engineered 
financial system that collapsed under the pressure. I think of 
it as we built up kind of a Potemkin Village with very fancy 
structures, but they were not very solid.
    Chairman Dodd. Let me draw upon your experience as the 
Chairman of the Federal Reserve System, and you correct me if 
my facts are wrong about this thing. But as I understand it, 
there are about 1,800 economists that work for the various 
Federal Reserve banks across the country.
    Mr. Volcker. How many?
    Chairman Dodd. I am told about 1,800. I do not know if that 
is true or not, but someone mentioned that number to me. But a 
very high number, whether it is 1,800 or not, but a significant 
number of people who do research all the time in the various 
banks. Can someone explain to me why there was not someone 
sounding the alarms out of the Federal Reserve System as people 
who monitor and watch what is happening economically that would 
have sent a signal to us back in the days of, I think, in 2005 
or 2006 even, that this was a problem emerging in a glaring 
way? Why didn't we hear?
    Mr. Volcker. Well, I have to say I do not think economists 
are very good at this kind of analysis. In a macro world, I am 
sorry to say that, but I am not sure there has been much 
improvement over the years. But I think if there are 1,800 
economists, I am sure some of them were concerned and did in 
their own way raise some questions.
    But, you know, when things are going well--this is the bane 
of regulation. When things are going well, nobody wants to hear 
about regulation and restraints.
    Senator Shelby. Absolutely right.
    Mr. Volcker. And so it is very hard to have your voice 
heard. When things are going poorly, everybody wants to 
regulate everything. And somehow we have to find a balance 
between too little and too much.
    This was an extreme case, but it is not unusual for 
imbalances to go along for a while without anybody really 
wanting to stand up and take strong action.
    Chairman Dodd. Well, I would love to at some point further 
pursue the discussion about the Federal Reserve System and how 
it is working.
    Let me ask you, if I can as well, about the consumer 
protection issue. Your report describes the need to establish 
standards for capital liquidity and risk management for 
financial institutions. But do you also believe that strong 
consumer protections play an integral part in financial 
stability? I am sure you do, by the way. And if so, what 
regulatory structure would best protect consumers? A separate 
consumer protection agency, as has been suggested by some? 
Elizabeth Warren, who will be before us tomorrow, has made a 
recommendation along those lines. Distinct consumer protection 
missions of the prudential regulator? Which of those two 
options do you find----
    Mr. Volcker. Well, let me say, first of all, our report 
does not deal with that question.
    Chairman Dodd. You do not. I realize that.
    Mr. Volcker. Quite deliberately. But there is--obviously, 
this administrative question you raise is relevant. We were 
dealing with what we think of as safety and soundness of the 
system. We were not dealing with protection of consumers, 
protection of investors, business practices--which are related 
but a different function. And one of the questions--which we 
did not deal with, but I think the Congress has to deal with it 
and the administration has to deal with it--do you adopt a 
separate agency and a separate administrative structure for 
what I will call ``business practices,'' including consumer 
protection, separate from the prudential regulator--which is a 
development which is true in some countries now, and it is 
along the lines that Secretary Paulson proposed in his thinking 
about the long run.
    I think that is a serious issue. I do not want to express 
an opinion now, but I have certain sympathy for exploring it, 
at least, personally.
    Chairman Dodd. Well, I would welcome that as you give it 
more thought.
    Last, let me address the issue of systemic risk regulation 
again. And I realize I am not specifically referring to the 
report in some cases. I am drawing upon your knowledge and 
expertise in these areas.
    The G-30 report describes one of the lessons from the 
current crisis as follows, and let me quote it. It says:

        Unanticipated and unsustainably large losses in proprietary 
        trading, heavy exposure to structured credit products and 
        credit default swaps, and sponsorship of hedge funds have 
        placed at risk the viability of the entire enterprise and its 
        ability to meet its responsibilities to its clients, 
        counterparties, and investors.

    Three questions: Should we allow financial institutions to 
become large and systemically significant? Should there be a 
single systemic risk regulator or should that substantial be 
shared among different agencies? Should the systemic risk 
responsibility be given to the Federal Reserve, in your view? 
And are you concerned that it would also be a burden on the 
Federal Reserve with numerous divergent tasks which you and I 
have discussed? And I will not elaborate here. You know the 
point I am trying to make. And, third, are you concerned that 
extensive involvement by the Fed in so many aspects of day-to-
day operations of the economy and the financial system might 
jeopardize its independence?
    Mr. Volcker. Again, these are questions we did not deal 
with in the report. We dealt with the structural question that 
we felt these basic, systemically important institutions and 
banking institutions that are protected by the Government and 
are dealing in a fiduciary way with customers should not engage 
in the kind of activities that you read from the report, these 
highly risky proprietary activities, because it undermines 
potentially their basic function.
    When it gets to who regulates it, it is just simply not in 
the report. But I tell you, the kind of considerations that you 
raise for the Federal Reserve, or without the Federal Reserve, 
I think are very relevant to that decision. You will have a 
different Federal Reserve if the Federal Reserve is going to do 
the main regulation or all the regulation from the prudential 
standpoint. And you have to consider whether that is a wise 
thing to do given their primary--what is considered now their 
primary responsibilities for monetary policy.
    They obviously have important regulatory functions now, and 
maybe those functions have not been pursued with sufficient 
avidity all the time. But if you are going to give them the 
whole responsibility, for which there are arguments, I do think 
you have to consider whether that is consistent with the degree 
of independence that they have and focus on monetary policy.
    Chairman Dodd. I hope I am not over-reading you there. I 
hear that tone suggesting that that kind of a super-regulatory 
function would, I think, put into question the very issues that 
are raised by it. A systemic risk regulator might have less of 
a problem, in your view.
    Mr. Volcker. That is true. Then you have to consider how 
the systemic risk regulator matches up with the other 
prudential regulators. There are very interesting questions 
here.
    The G-30 issued a report, a rather detailed report, a year 
or so ago or 9 months ago, on different regulatory practices 
around the world, which raised the questions that you are 
raising, and almost all countries are struggling with these 
questions now.
    Chairman Dodd. I thank you.
    Senator Shelby.
    Senator Shelby. I want to pick up, Chairman Volcker, on 
some of the area that Senator Dodd is getting into. I think it 
is very important.
    Do you have any concerns, Dr. Volcker, that if the Fed 
assumes too many responsibilities, its ability to conduct 
monetary policy could be undermined?
    Mr. Volcker. Yes.
    Senator Shelby. And what are your views on the separation 
of monetary policy from banking policy along the lines of the 
reforms that were enacted in the United Kingdom in the late 
1990s that gave banking regulation to the FSA and monetary 
policy to the Bank of England?
    Mr. Volcker. Well, that is an interesting experience. That 
was rather widely acclaimed, and other countries attempted to 
or did follow that pattern. But then when they had a crisis, 
they found out it did not work so well.
    Senator Shelby. It did not work.
    Mr. Volcker. And whether that was some idiosyncratic 
reasons in the U.K. or whether it is a more general reason, I 
do not know. But the underlying problem----
    Senator Shelby. Why didn't it work, if you could----
    Mr. Volcker. Well, I----
    Senator Shelby. I know it did not work.
    Mr. Volcker. It seemed to be a lack of coordination between 
three agencies involved--the U.K. Treasury, the Bank of 
England, and the FSA, the regulatory agency--even though they 
had overlapping personnel to some extent. But it seems clear 
that coordination was not close enough.
    But I would make one point in connection with your 
observation. Supervision regulation has implications for the 
performance of the financial system and the economy, and it can 
work in support of monetary policy or it can work contrary to 
monetary policy. And that is one reason for giving the Federal 
Reserve responsibility for both.
    Senator Shelby. Dr. Volcker, as you keep up with all this, 
and as a former Chairman of the Federal Reserve, you know the 
Fed has had a dramatic expansion of its liquidity facilities 
over the past year, and it has raised concerns that the Fed has 
moved out of the realm of monetary policy and into the realm of 
fiscal policy.
    The Group of 30 Report, as I understand it, recommends that 
central bank liquidity support operations should not involve 
lending against or outright purchases of high-risk assets. 
Instead, your report, as I understand it, recommends that those 
forms of support should be handled by directly accountable 
Government entities.
    In your view, what role should be given to the President or 
the Treasury Secretary in approving Government bailouts or 
other support for institutions that will likely involve 
taxpayer dollars?
    Mr. Volcker. Well, in cases where they do involve risk and 
the use of taxpayers' dollars, we are pretty clear that the 
administration, particularly the Treasury, ought to be involved 
in that decision, and the Federal Reserve should not undertake 
those kinds of actions, if they do it at all, without the 
concurrence of the administration.
    Senator Shelby. Is this in the line under our 
constitutional system that it would be inappropriate for 
unelected central bankers to determine whether a company or 
industry receives a taxpayer-funded bailout? Shouldn't those 
decisions be made by the President and the Congress, who are 
accountable to the people? Is that----
    Mr. Volcker. Well, Congress can provide a framework for 
making those decisions, but I think they do involve political 
questions that the President and the administration should be 
involved in. I think just to clarify, my own understanding from 
outside is when the Federal Reserve has done this recently, 
they have worked closely with the Treasury. They have not gone 
off on their own and undertaken these measures.
    Senator Shelby. It seems like a new role for the Fed than 
when you were Chairman.
    Mr. Volcker. Yes, it is a non-traditional role.
    Senator Shelby. Non-traditional role. You are very----
    Mr. Volcker. The report takes a traditional view of the 
functions of the Federal Reserve.
    Senator Shelby. Dr. Volcker, recently Stanford economist 
and, somebody you know, a former Under Secretary of the 
Treasury, John Taylor, argued that excessively loose monetary 
policy during the first part of this decade caused the 
financial crisis.
    Mr. Volcker. Well, I do not think I am going to get into 
that question this afternoon. I do think that conditions in 
financial markets which were related to the large balance of 
payments deficit, large current account deficit, and the free 
flow of money from abroad laid the groundwork for many of the 
excesses in the market.
    Senator Shelby. Now, this is in your report, as I 
understand it. One of the key recommendations of the G-30 
Report is creating a failure resolution regime that imposes 
discipline--that is, actual losses--not only on managers and 
shareholders but also on sophisticated creditors.
    I believe one of the primary failings of the recent 
bailouts of the GSEs, AIG, and Bear Stearns was the intent of 
protecting any creditors from losses.
    Dr. Volcker, in terms of who qualifies as a ``sophisticated 
creditor,'' do you believe that both financial institutions 
such as investment banks and foreign central banks would count 
as sophisticated creditors? Or should?
    Mr. Volcker. Well, they individually are sophisticated, 
yes. Whether they need to be protected in some particular 
occasions is another question.
    Senator Shelby. Given that the large creditors of the GSEs, 
AIG, and Bear had no legal claim to being bailed out--which 
they did not--what specific mechanisms would you suggest that 
we think up here to put in place to assure that such 
sophisticated creditors take losses in the future, which helps 
bring discipline to the market?
    Mr. Volcker. The premise of your question included the 
GSEs?
    Senator Shelby. Yes.
    Mr. Volcker. Well, the GSEs, I think, if I may say so, with 
the connivance of the Congress, were considered to be something 
special and they would be protected. And there was a general 
understanding, rightly or wrongly, while officially they did 
not have the full legal requirement of a guarantee, through the 
years----
    Senator Shelby. But they had the implicit guarantee, didn't 
they?
    Mr. Volcker. Pardon me?
    Senator Shelby. The implicit guarantee.
    Mr. Volcker. Yes, they had an implicit guarantee and that 
was----
    Senator Shelby. Was that because they were hybrid----
    Mr. Volcker.----I think, generally understood.
    Senator Shelby.----you know, stock owned and Government 
sponsored?
    Mr. Volcker. We are very clear on one recommendation in 
this report. We should not have that kind of hybrid institution 
anymore.
    Senator Shelby. I totally agree with you.
    Mr. Volcker. You know, you cannot change it overnight, but 
I think as we design a new financial system, we ought to avoid 
that kind of compromise that is going to get you in trouble.
    That does not mean that Congress or the Government cannot 
support the mortgage market if they want to.
    Senator Shelby. Right.
    Mr. Volcker. But they ought to do it directly.
    Senator Shelby. Yes, sir. Thank you.
    Thank you, Chairman Dodd.
    Chairman Dodd. Thank you very much.
    Senator Warner.
    Senator Warner. Thank you, Mr. Chairman.
    Dr. Volcker, I have got three questions, and I think they 
follow up on both the Chairman's and Senator Shelby's approach. 
It seems from the report a clear understanding that there needs 
to be some level of regulation of some of these institutions 
that fell between the cracks. Yet it seems that even though 
major money center banks that clearly were regulated followed 
the market to start putting out these same kind of complex new 
instruments, your term of ``over the top financial 
engineering.''
    I guess on a going-forward basis, as we move forward to 
some new structure, even with regulation and transparency, is 
that going to be enough or should there be some point of an 
evaluation, almost a societal value evaluation, of some of 
these instruments, whether the extra ability to price that risk 
down to the last decimal point is worth all of the side risks 
that we have seen taking place by some of these instruments?
    Mr. Volcker. Well, we do a lot of talking about the 
importance of risk management and so forth, but, in essence, 
the conclusion that we have is that some of these innovations 
and some of these very risky activities are almost inevitably 
going to get ahead of the regulators, and these basic 
institutions--the big commercial banks, in particular--are of 
systemic importance, therefore should not get involved in those 
activities. They are too risky, and I think it is clearly 
demonstrable they involve conflicts of interest that add to the 
uncertainty and risk.
    Senator Warner. So you would see some system whereby there 
might be bright-line prohibitions----
    Mr. Volcker. Yes, I see--we suggest some bright-line 
prohibitions for hedge funds and equity funds, and you asked me 
about proprietary trading--you did ask me about proprietary 
trading. I think these big financial institutions probably have 
to have some capacity, do need some capacity for trading. But 
if they have very aggressive trading in very large amounts, 
where it is not quite such a bright line, you probably need 
special attention, and we suggest special attention via special 
capital requirements if they are going to engage in those 
activities.
    Senator Warner. And as you said, sometimes these 
instruments get ahead of the regulators, and how do you----
    Mr. Volcker. No question about that.
    Senator Warner. You do not want to stifle innovation, but 
it seems to me that some of these instruments recently were 
more about fee generation than they were about appropriately 
pricing risk?
    Mr. Volcker. Well, I think that is true, but there is 
plenty of room for innovation outside of the basic banking 
system, and that is a distinction we make. All kinds of 
sophisticated capital market techniques, a derivative explosion 
which may have gone too far, but the whole idea of 
securitization could be developed outside the banking system. 
To the extent it is inside the banking system, we say, well, 
the bank should hold onto what they securitize. That is a 
traditional function. But outside, they can engage in all kinds 
of trading and----
    Senator Warner. But wouldn't you say some of these outside 
functions now need to have some kind of regulatory----
    Mr. Volcker. Yes, well, I guess we are trying to say we 
want to go relatively lightly, if they are relatively small 
institutions without systemic significance. But if they get big 
enough--and some of the hedge funds have, and we had the 
experience of Long Term Capital Management in the past where, 
rightly or wrongly, people thought it had systemic 
implications. Then you have to think about leverage 
requirements and capital requirements and liquidity 
requirements.
    I myself think that would just be a handful of those 
institutions, and most of them--we do call for reporting and 
registration, but I do not think they would take heavy 
regulation.
    Senator Warner. Well, let me follow up on Chairman Dodd's 
question as well, one of the points he raised. A lot of your 
focus is on systemic risk. We have heard the comment a lot in 
the popular press, you know, certainly these institutions are 
``too big to fail.'' On a going-forward basis to try to 
alleviate that systemic risk, should there be some examination 
of sizing of some of these institutions?
    Mr. Volcker. Yes, well, we make a fleeting reference to 
that actually in the report. There is now more concentration 
than you ever had in the United States. The degree of 
concentration is not as great as many foreign countries have, 
but it is very large from our history. And I think that is a 
question you want to ponder. It has got political, obviously, 
as well as economic circumstances, whether there is such a 
thing as not only ``too big to fail,'' ``too big to exist.''
    Senator Warner. Right.
    Mr. Volcker. And it has got--we certainly have seen how 
difficult it is to manage these institutions given the variety 
of functions they have been performing. Now, we suggest that 
their functions be simplified. That would be easier to manage. 
But, still, there is in present law, as you know, a limit on 
deposit-taking. I think it is 10 percent. You cannot go beyond 
10 percent. Back when I was Chairman, we once suggested 5 
percent, which some people thought was too big. Now it is 10 
percent.
    You know, it raises a question at some point. When is 
enough enough?
    Senator Warner. Right.
    Mr. Volcker. And I think you ought to look at it.
    Senator Warner. One last question. Over the last decade, as 
somebody who spent some time in the financial markets, there 
has always been the argument, oftentimes from our friends in 
the U.K., you know, to come over to their markets. Wall Street 
was complaining that if there was additional regulation, we 
would see a flight of all these firms abroad, development of 
new money centers all around the world with not as stringent a 
regulatory structure.
    In light of this complete worldwide collapse, do you think 
there will be an ability to come up with some strong 
international standards? Or are we going to be able to patch 
this over and still have a few 2-years later, 5-years later, a 
rush to the bottom as firms try to go around the world to find 
the least regulatory----
    Mr. Volcker. I think we have had a real wake-up call, here 
and elsewhere, in Europe, Japan, China. And this wake-up call I 
hope is strong enough so that we will emerge from this with 
consistency and the basic regulatory and supervisory framework. 
If it does not, I would still do what we think is appropriate 
here and let them go if they want to be in----
    Senator Warner. Even if we have a regulated system, you 
could make the argument that might be the safer system.
    Mr. Volcker. Yes, and I think in the long run--suppose we 
now had a strong regulatory system, and it was Europe and Japan 
and elsewhere that was in worse shape. All the money would be 
flowing into us because it was the strongest system.
    Now, unfortunately, that is not the case right now. But it 
should be the case. What should be the case is we have a high 
degree of uniformity. And I do not think that is impossible. 
You already have that pretty much in the capital area. Now, 
that is just one area. You have got a lot of other areas--the 
hedge fund regulation, rating agency regulation, accounting is 
one place where I am sure--I have a special background here, 
but I think we should have uniform accounting around the world.
    Senator Warner. If I just follow where you are headed, you 
would actually say a strong regulatory system with appropriate 
oversight in this country would not be counterproductive to the 
continued growth of capital markets in the United States. It 
might still be a long-term benefit to our country.
    Mr. Volcker. Yes. That does not mean you want unproductive 
regulation. Good regulation we ought to have, regardless of 
what the rest of the world does.
    Senator Warner. All right. Thank you, sir.
    Chairman Dodd. Thank you very much, Senator. I asked 
someone once, ``Why do you think it is that the world comes 
here?''--talking about, obviously, not the present day, but a 
little time ago. ``Why does the world come here and bring its 
wealth?'' The answer I was given, two reasons: one, we are very 
good at making money, and as importantly or more importantly, 
it was a safe place to be. You might make a bad bet, but you 
were not going to lose your money because the system was 
corrupt or did not work. And I think that is the point that 
Senator Warner is making, and I think if you have a strong, 
sensible, balanced regulatory system, the world could also 
follow us. They may not join us, but they will move in that 
direction.
    Mr. Volcker. I have hopes that, given what has happened, 
you will get some uniformity. You know, the argument always was 
we will lose all this business to London. Well, London has got 
the problem at least as much as we have, and I think that is 
generally recognized at this point.
    Chairman Dodd. Senator Johanns.
    Senator Johanns. Thank you, Mr. Chairman.
    In reference to your last comment, I will offer an 
observation, and that is that the financial crisis is bad 
enough; where I do think there is a good chance of uniformity, 
just as you suggest, I think over time it is hard to sustain 
that. Why? Just simply because one country is going to look at 
this and, you know, when things stabilize--and hopefully they 
will stabilize--that country is going to say, you know, we 
could get more banking business here if we tweaked this a 
little bit and tweaked that a little bit. So you almost need to 
think about what mechanism you have in place to deal with that 
economic phenomenon. Countries want business, and they are 
going to do things. Sometimes over time we see it is bad 
judgment, but I would just offer that observation.
    A couple more observations, and then I would like to ask 
you a question. It seems to me--and this is so complicated. It 
is hard to say there are a couple of reasons for what is going 
on, but it seems to me that there are two really, really 
important things that really have led in a substantial way to 
this financial crisis.
    Number one is whatever mechanism was in place to evaluate 
risk accurately just failed. Highly compensated, enormously 
bright people being advised by the best in the business simply 
lost their way when it came to evaluating risk.
    The second thing was that, for whatever reason, as 
regulatory agencies or departments tried to get a handle on 
this, it was very difficult for them or they dropped the ball, 
or whatever, in terms of themselves blowing the whistle on 
unreasonable risk being taken.
    Those two things strike me as really fundamental to what we 
are dealing with here. If you agree with that statement, I 
would really be interested, Dr. Volcker, in your educating us 
on how your recommendations would deal with that, number one, 
the failure to accurately evaluate risk and, number two, the 
failure, for whatever reason, to blow the whistle on that risk.
    Mr. Volcker. Well, we have got a lot of rhetoric in this 
report about the importance of risk management and trying to 
deal with the problem you have and the failures of risk 
management in our leading financial institutions--partly, and 
importantly, because the complexity became so great that we 
lost sight of how to measure the risk.
    Now, I have got a point of view on this, but the markets 
were taken over by financial engineers. They were 
mathematicians. They were not market people. They somehow 
thought that financial markets would follow the laws of physics 
or some natural law and everybody had a nice, normal 
distribution curve. And they kept being surprised by outlying 
events. Well, they seemed outlying if you thought of the world 
of a normal distribution curve, but that is not the world of 
finance that I know. Financial markets are affected today by 
what happened yesterday, and what is happening right now 
affects thinking and affects what happens tomorrow. So you get 
people going to extremes in both directions. And these 
financial engineers kind of thought that they had the answer to 
how to measure risk and take care of it.
    Things were very complex. When you mixed together these 
enormous compensation practices, the enormous gains possible, 
with obscure financial engineering, you had a recipe for 
extremes, I think, that kind of came back to haunt us.
    Senator Johanns. If I might just----
    Mr. Volcker. That will be addressed by what is happening, 
but so much of the best talent in the United States is going 
off into financial markets. I wish more of it would go building 
bridges instead of financial markets.
    Senator Johanns. If I might just offer another observation, 
and your thoughts on compensation, I think, really warrant this 
Committee kind of digging deep on that issue. But there is 
another piece to it, too. There was a point in time where 
someone was compensated based upon the quality of the loan that 
they wrote. You know, when I bought my first house, you didn't 
get that loan unless you had a reasonable chance of continued 
employment, you had 20 percent down in the bank, et cetera. 
However, the compensation structure turned to how many loans 
you could write and bundle and then sell, and like I said, 
nobody was figuring out how to evaluate the risk, or if they 
did, they threw all the rules out the window.
    Mr. Volcker. Well, I think that is a good example. In the 
old days, you had a customer. You evaluated his ability to pay, 
the value of the house, and so forth. But then they came along 
and said, well, look. If we put 80,000 of these loans together, 
our statistical analysis says 85 percent of them will be OK and 
the result was you put poorer and poorer loans in the package. 
It turned out that 85 percent were no longer good, and that is 
where we are.
    Senator Johanns. And the frustrating thing about that, and 
I will wrap this up, for the average citizen out there is that 
15 percent now has been labeled toxic assets and somehow the 
taxpayer feels like they are being imposed upon to own that 
risk today and they are saying, ``why me?''
    Mr. Volcker. I don't know how you want me to respond to 
that----
    Senator Johanns. You don't have to respond, Doctor. You 
are----
    Mr. Volcker. There comes a time when you have to support 
these institutions in the interest of the greater good and the 
stability of the markets. But one of the difficulties in this 
whole business is very much commented on today, is how you 
price those assets when the taxpayer takes them over.
    It is possible you could think of a scenario where if the 
taxpayer has to take them over and the markets are stabilized, 
the taxpayer may actually make money. But you certainly don't 
want to go into it with the taxpayer unnecessarily losing a lot 
of money. But it is a very--this is all complex enough so it is 
very hard to unscramble all this stuff.
    Senator Johanns. Thank you very much.
    Chairman Dodd. Thank you, Senator. Very good questions.
    Senator Reed?
    Senator Reed. Thank you, Mr. Chairman, and thank you, 
Chairman Volcker, for not only your testimony, but for your 
service on this G-30 Commission as well as so many other 
commissions.
    We have been confronted with a long to-do list by the G-30 
report, but our capacity is limited. I wonder, could you focus 
on what you consider to be the top two or three systemic risks 
that should be dealt with immediately? A sense of priority, I 
think, would help--I will speak for myself--would help.
    Mr. Volcker. Well, when you say immediately----
    Senator Reed. Well, immediately in the----
    Mr. Volcker. First of all, we are going to have--I am not 
sure this is what you meant in asking the question--it is going 
to cost more money to deal with this financial crisis. There 
shouldn't be any mistake in your mind about that, that this has 
deteriorated to the point where it is going to take Government 
support in the interest of overall economic stability and 
recovery, and it is going to be lots more billions of dollars. 
I don't know how many. But that is necessarily a priority, 
which I hope and believe the administration will face you with 
shortly.
    Now, looking ahead, I think we rather put the priority in 
what I put in my statement as our first point, that you have 
got to take these big protected institutions, particularly the 
large ones, but all the banks are going to be protected to some 
extent, and you have got to develop apparatus for protecting, 
but you have also got to limit what they can do, and you want 
to do that as intelligently as you can, because you want them 
to compete. You want them to be innovative in providing 
services. But you don't want them taking a kind of risk that is 
inconsistent with the fact that at the end of the day, 
Government support is in the background. Now it is in the 
foreground. But ordinarily, it is in the background. And I 
think that is the, I think, the most fundamental thing.
    But there are so many things that need attention that it is 
hard for me to rank them in priority. The accounting problem is 
a real one. And apart from the fact of the desirability of 
uniformity, and there has been a lot of progress in that area. 
That is one area I think we are going to get uniformity, and we 
should get uniformity. But then uniformity is one thing, but 
uniformity according to what standard? And there, there is a 
problem with all this mark to market business and fair value 
accounting. When should that be applied? When should it not be 
applied? If it is not mark to market, what else do you do?
    My own feeling is that is something that has to be thought 
about by the regulators themselves and they ought to have a 
voice in the accounting for the basics, banking anyway, 
banking, insurance companies. But intellectually, that is a 
very tough problem.
    Senator Reed. Let me ask this related question. We are 
debating a significant recovery package at the moment. That, I 
would think, would complement any efforts we make to further 
aid the financial institutions, because without this recovery 
package, then the potential hole has got to be much bigger. Is 
that your view, also?
    Mr. Volcker. That is right. No, you have got kind of a 
three-legged stool. You have got the stimulus package to help 
provide direct support to the economy. You have got to have the 
financial package to unleash the flow of credit. And then 
related to both those things, I think you have got the 
individual mortgage problem, which nobody has figured out how 
to deal with very effectively, but it is an important part of 
the problem. So you have got to advance on all those fronts.
    Senator Reed. Let me----
    Mr. Volcker. Let me just point out----
    Senator Reed. Yes, sir?
    Mr. Volcker.----the obvious. If you didn't have the 
stimulus package, let us say, the worse the economy gets, the 
more problems you are going to have in the banking system. That 
is obvious.
    Senator Reed. And the bigger the hole that has to be 
filled.
    Mr. Volcker. The hole gets bigger.
    Senator Reed. In the G-30 report, the reported noted that 
credit rating agencies are not held legally accountable for 
their ratings. Do you believe that has to change?
    Mr. Volcker. I believe this is an area that has to be 
reviewed. We made a few suggestions in the report, including 
the one that you mentioned. I don't feel that that is the last 
word, frankly, what we say in this report. The whole 
compensation structure is important and we allude to it, but we 
don't say what the answer is. I am not prepared now to say I 
think I know the answer to that, but it is not an unimportant 
question, obviously.
    Senator Reed. Let me ask you a final sort of set of 
questions. The Chairman raised the issue of 1,800 economists at 
the Federal Reserve. Did anyone sort of notice the implications 
of the housing bubble building up and other problems? The 
Ranking Member has talked about sort of looking into the 
regulatory practices of the Federal Reserve, particularly 
regulating these large institutions.
    My assumption is that on a daily basis, the Federal Reserve 
would have hundreds, perhaps, of examiners within these 
institutions. Why wasn't anyone aware of some of these off-
balance sheet devices, liquidity puts? Was it an area of 
concern? Was this an issue they were aware or, or were they 
completely blindsided? I think it goes to the point of trying 
to discover who knew what when so we have an idea of how we can 
restructure the----
    Mr. Volcker. I do not know the answer to your question. A 
perfectly reasonable question. I was not there. I can't answer 
the question.
    Senator Reed. That is a perfectly reasonable response.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you.
    Senator Bennett?
    Senator Bennett. Thank you, Mr. Chairman.
    Dr. Volcker, welcome. We have had three simultaneous 
bubbles. They haven't burst simultaneously, but they were going 
on simultaneously. We have had the housing bubble. We had the 
oil bubble. And then we had a credit bubble. The oil bubble, 
everyone who pumps gas is delighted that it has burst. Everyone 
who produces gas and oil is probably a little sorry that it has 
burst. But all of the dire consequences that we heard predicted 
with respect to the oil bubble are now no longer on the front 
page and we no longer talk about the oil shock and its impact 
on the economy and the rest of us because the price----
    Mr. Volcker. What about the opposite? The price isn't high 
enough to stimulate the----
    Senator Bennett. That is right. It has gone from $145 a 
barrel to $35 a barrel and then bounced around. But that is a 
bubble that burst and a collapse that happened very rapidly and 
the American motorist is delighted.
    The housing bubble has burst and we don't know where the 
bottom is. It is uneven across the country, and that is why I 
am a little suspect of the Case-Shiller number, because that 
takes the worst parts. There are some places in the country 
where housing prices have actually risen, but the mortgage 
problem remains very much a difficulty because nobody knows 
what the securities are worth. They don't know how much toxic 
paper they have, and so on.
    Let us talk about the credit bubble. It is different from 
the classic bubbles of the housing bubble and the oil bubble, 
but we still don't have a firm handle on what is happening with 
respect to credit. We don't have any kind of normalcy. There 
was a time when credit was enormously available. Now, it is 
almost not available at all, except again, like the housing 
thing, there are some parts of the country where it is 
available, or there are some markets where it is available and 
others where it is not.
    Look into your crystal ball and tell me, or tell us what it 
is going to take for the credit bubble to resolve itself and 
how long you think that might be.
    Mr. Volcker. Well, I won't profess to know the answer to 
that question with any reliability. It is going to take some 
time. We are not at the end of this business. And I think the 
immediate challenge is to provide some basis for greater 
confidence in the banking system and in lending. You know, it 
is kind of a spiraling process. The worse the economy gets, the 
less confidence there is, and the less confidence there is, the 
more difficult creditors and the worse the economy gets.
    So we have got to break into that cycle, and I think that 
is why I emphasized earlier the importance of dealing with the 
banking situation. It is going to cost some money. And if we do 
that effectively, then I think we could begin seeing the end of 
this. But it is, I don't know how many months, but it is not 
going to be overnight.
    Senator Bennett. It is not going to be soon----
    Mr. Volcker. We have had a great shock to confidence and 
trust in markets and these markets depend upon confidence and 
trust and it is going to take a while to restore that.
    Senator Bennett. It is not going to be soon and it is not 
going to be cheap.
    Mr. Volcker. And it is not going to be cheap.
    Senator Bennett. Now, since you have put your finger, I 
think, on the real core of all of this, which is confidence, 
you talk about a three-legged stool, a stimulus package, 
something, for want of a better summary term, I will call more 
TARP to deal with the financial institutions, and then 
resolving the mortgage crisis. I am perfectly willing to go 
down all three roads, but what happens if we pass a stimulus 
package that is not stimulative? Doesn't that produce a greater 
hit to the confidence circumstance than if we did nothing?
    That is what I think the debate is all about. I don't 
subscribe to those who say, well, we want the economy to fail 
because then Obama will fail and then the Republicans will come 
back. This is one Republican who rejects that, absolutely, and 
for the good of the country.
    But it is one thing to say, let us pass a stimulus package. 
It is another to be sure it is going to be stimulative. It is 
one thing to say, well, let us shore up the financial 
institutions. Then it is another thing to be sure that the way 
we do that is going to be helpful, and so on. Can you give us 
your advice as an economist as to what you think is the most 
stimulative?
    Mr. Volcker. Well, I want a stimulus package that 
stimulates.
    Senator Bennett. Well, we all stipulate to that.
    Mr. Volcker. To the extent--you know the dilemma here--to 
the extent you can take action that not only stimulates but is 
in accordance with some longer-term needs of the economy, 
obviously you are sympathetic toward that. I am sympathetic 
toward that, and that, among other things, leads you to 
infrastructure.
    Senator Bennett. Right.
    Mr. Volcker. The problem is, that takes time. So what do 
you do in the immediate future? There are things that are very 
compelling in the short run in terms of helping people that are 
out of work in terms of unemployment compensation and other 
things where there is the pressure of immediate money in their 
hands. But when you take those two different kind of extremes, 
both useful, put it together in as good a package as you can 
and get it passed, would be my advice. I am not an expert on 
all the particulars of this program. I haven't looked at it. 
But I am aware of the debate. But I hope that gets resolved in 
a constructive way as quick as you can.
    Senator Bennett. I have talked to some bankers who say, 
well, the injection of capital that has come as a result of 
TARP is not only welcome, but essential, but we still do not 
have sufficient capital to make any loans. We have sufficient 
capital to sustain our present balance sheet, which we didn't 
have before. But we are unable to attract any private capital 
and we are unlikely to get any more public capital. Do you have 
any prescription for us as to what we should be doing there 
with respect to----
    Mr. Volcker. Well, I don't know what the administration is 
going to propose, but I suspect there is going to need to be 
some public capital----
    Senator Bennett. And then----
    Mr. Volcker.----maybe quite a lot of it.
    Senator Bennett. Then the question arises, in what form? 
The first TARP, for which I voted, contrary to my friend, 
Senator Shelby, was sold to us on the basis that it was going 
to acquire the toxic assets and clean up the balance sheets of 
the bank, and then it changed toward a program of buying 
preferred stock or making some other kinds of loans, warrants, 
and so on. Along with Senator Dodd, I agreed we ought to give 
the Secretary of the Treasury full authority to do whatever he 
thought was best, but the track record, at least coming from 
somebody's analysis, has been a little bit spotty as to whether 
that is----
    Mr. Volcker. Well, I think it is fair to say, if you look 
back over the last 6 months or so, that they were kind of 
repeatedly firefighting, on some crucial weekends in 
particular, and it may have been successful or unsuccessful in 
particular cases, I think mostly successful in putting out a 
particular fire, but it didn't come across as being very 
consistent and very credible in terms of what comes next and I 
think we have suffered from that. And what we need now is, I 
think, a kind of comprehensive program that recognizes the 
breadth of the problem--it is not just one or two 
institutions--and provides a framework for dealing with this in 
a consistent way. I think that is essential to get confidence 
back in this situation. I hope that is what is going to happen 
in the next couple of weeks.
    Senator Bennett. Thank you very much.
    Chairman Dodd. Thank you, Senator Bennett.
    Just a quick question before I turn to Senator Schumer. In 
your view, Doctor, looking back, did we do the right thing in 
early October in supporting that TARP program or not?
    Mr. Volcker. You know, it is very hard to sit on the 
outside and say what should have been done in particular 
circumstances. All I know is something had to be done. Whether 
it was perfect foresight or whatever, we could have done it 
differently, you mentioned the TARP program, which was designed 
in the first instance--I had actually written something about 
it before it happened and suggested that we get rid of some--
buy up some of these so-called toxic assets, and that was the 
original intention and then they switched, maybe for good 
reason. But the whole thing wasn't as persuasive as it might 
have been.
    Now understand, as time goes past, these loans are getting 
worse. They are not getting better because the economy is 
worse, so that makes it more difficult.
    Chairman Dodd. So the answer----
    Mr. Volcker. Well, the answer, as I say, I think you need, 
apart from the stimulus program, you need a program that looks 
big enough, powerful enough, across the board enough, not that 
it necessarily has to be applied, but you have something there 
that can be applied in terms of further deterioration of the 
market or individual institutions. You hope that by the mere 
fact of being there, confidence might begin to be restored. The 
better looking the program, the less you have to use it.
    Chairman Dodd. So I think I hear you saying, yes, you agree 
that it should have been done. How it was executed is another 
matter. Is that a fair characterization?
    Mr. Volcker. I think--yes, I think so.
    Chairman Dodd. Senator Schumer?
    Senator Schumer. Thank you, Mr. Chairman, and thank you, 
Mr. Chairman. It is good to see you. I have been on Banking 
Committees for 28 years and I think you have been testifying 
before them for about 28 years.
    Mr. Volcker. Just about.
    Senator Schumer. So it is good to see you. I have an 
opening statement, Mr. Chairman. I am going to forego reading 
it. It outlines my general views on regulatory reform, 
including a much more unitary--well, controlling systematic 
risk, ensuring stability--I have always thought all holding 
companies should be regulated by one regulator, maybe the Fed, 
maybe not, but one regulator, and I know you have been asked 
about that--unifying our regulatory structure--we have too many 
regulators, too many holes between the cracks, too many 
conflicting organizations. Third, regulating the currently 
unregulated part of the markets, both instruments and entities, 
hedge funds and others. We need to do that. Fourth, to 
recognize that we are in a global financial world, global 
solutions, and increase transparency. Those have been my five 
principles. I wrote an op-ed about this about a year ago and I 
have been sticking with them. It hasn't changed. So I ask 
unanimous consent that that be put in the record.
    Senator Schumer. I would like to focus on the international 
part first, because to me, the biggest challenge we face when 
we set up a new system of regulation is not what we do here. I 
think there is sort of a consensus. I mean, I have heard 
Chairman Dodd has said, Chairman Frank, the administration, 
they are very similar to the five things that I have outlined 
here. But how in this international financial world, with a 
national system of regulation, don't you always flee--doesn't 
money always flee to the lowest common denominator? And if we 
regulate swaps here or regulate hedge funds here, they just 
migrate to a place where they are not regulated because the 
individual operators, regulation is a common good.
    Mr. Volcker. Well, I expressed some optimism on this point 
earlier, before you came in----
    Senator Schumer. Good. Well, I welcome hearing again, 
because there isn't much----
    Mr. Volcker. I have optimism only because this crisis is so 
serious. We here in this country, in the U.K., in Japan, 
potentially in China, have never seen anything like this, and 
so this kind of focuses the mind. I think the leaders in Europe 
and the United States, Canada, Latin America, they are all 
interested in this subject.
    You have a forum in the G-30. I don't think it is an ideal 
forum for this purpose, frankly, for getting into the detail, 
but it is a good forum for making sure that somebody else does 
it. And we do have some international bodies that are making 
progress.
    In many of the areas that you would be concerned with, take 
hedge funds, the Europeans are more concerned about regulating 
hedge funds than we are.
    Senator Schumer. You know, I am not so worried--I mean, 
although the details, look how long it took to get some 
agreement on Basel and the capital accords.
    Mr. Volcker. Right.
    Senator Schumer. Everyone had general agreement and it took 
five or 10 years to get this done.
    Mr. Volcker. Now wait a minute, I was largely, or 
importantly responsible for the first so-called Basel 
Agreement. It only took 2 years.
    Senator Schumer. Right, but Basel II took much longer.
    Mr. Volcker. The revision took much longer because we did 
such a good job the first time.
    [Laughter.]
    Senator Schumer. But, you know, in this new global world, 
Hong Kong could decide that they don't want the Western 
consensus. They will go for the short-term hit of having----
    Mr. Volcker. I----
    Senator Schumer. You know, it is just difficult.
    Mr. Volcker. Look, one area where this is front and center 
is in accounting----
    Senator Schumer. Yes.
    Mr. Volcker. and I have a special interest in this because 
I used to be the Chairman of the International Accounting 
Standards Committee.
    Senator Schumer. Right.
    Mr. Volcker. And there, the suspicion in the United States 
has been our U.S. GAAP is better than anything else and that we 
have international accounting standards and we ought to adopt 
U.S. GAAP. Well, I think that has been proven to be a bit of an 
illusion. U.S. GAAP is not God, either----
    Senator Schumer. Right.
    Mr. Volcker. and there are lots of problems, and I see no 
reason--I do not believe that the international standards are 
in any sense weaker than GAAP. They are more principle-based--
--
    Senator Schumer. Yes.
    Mr. Volcker.----but in terms of the substance, they are no 
weaker, and there has been a lot of progress.
    Now, there are political pressures on the international 
standard setters and we ought to be alert to that and those 
pressures, frankly, are--well, they are in the United States, 
too, but they are particularly strong in Europe, and I think we 
all have an interest in maintaining the independence of the 
standard setters and we want to put pressure on them to do a 
good job.
    Senator Schumer. Yes.
    Mr. Volcker. But I think that is a promising area and a 
very difficult area.
    Senator Schumer. Yes, it has been difficult, the most 
difficult. My worry is a year from now, when we begin to see 
the light at the end of the tunnel here, say China will decide 
they want to gain the immediate advantage and just set up 
rather sophisticated----
    Mr. Volcker. No, but we----
    Senator Schumer.----trading operations, and it just----
    Mr. Volcker. We said----
    Senator Schumer. My experience----
    Mr. Volcker. We said earlier, if we have got good 
regulation, and good is not synonymous with a lot of regulation 
necessarily, but if we have intelligent regulation and the rest 
of the world doesn't follow us, well, that is too bad, because 
I think in the end, it will be recognized that we have the best 
and the business will come here.
    I am tempted to say, because this is not the first time I 
have been before this Committee and this problem arising in the 
United States, where when you talk about--the Senator talked 
about everybody wants to tweak the regulation to their 
advantage.
    Senator Schumer. Yes.
    Mr. Volcker. That is true of American States. They are 
always trying to tweak----
    Senator Schumer. Of course.
    Mr. Volcker.----financial regulation to the advantage of 
particular States. So we have had a certain experience there.
    But all I can say is if we can't deal with this now, given 
the extent of the problem not just in the United States----
    Senator Schumer. Around the world.
    Mr. Volcker.----but around the world, we have an 
opportunity to do it.
    Senator Schumer. Yes. I agree, it is a unique opportunity. 
It is just my experience has shown everyone agrees 10,000 feet 
up, and you start getting into the details and they don't, and 
then there are new instruments that come along and new 
opportunities for one country to gain on the other and they 
trade that short-term benefit to everyone's long-term 
detriment. But good. I am glad you are optimistic.
    Mr. Volcker. One thing I would say in that connection, 
maybe I am optimistic and out of it and don't know what is 
going on, but there are bodies----
    Senator Schumer. I doubt that.
    Mr. Volcker.----internationally to deal with this, and to 
the extent it can be left to these more or less expert bodies, 
and accounting is one example, but the Basel Committee is 
another example----
    Senator Schumer. Yes.
    Mr. Volcker.----and there are several other examples, the 
political leaders ought to put pressure on those expert groups. 
When they try to do it themselves----
    Senator Schumer. I understand.
    Mr. Volcker.----I think you get a problem.
    Senator Schumer. All you need is one significant outlier to 
throw off the--to toss up the apple cart.
    One other question, because my time is running out, credit 
rating agencies, where there has been real trouble. Do you 
think the model ought to change, that we ought to----
    Mr. Volcker. I mean, I can answer that question yes. But if 
you ask the next question, how----
    Senator Schumer. Yes.
    Mr. Volcker.----I will tell you, I am not ready to make a 
pronouncement. I think that----
    Senator Schumer. Well, what about the old model, where 
instead of the issuer paying for it, it was the investor that 
did?
    Mr. Volcker. Well, I was surprised to learn, or I had 
forgotten, because ever since I have been compos mentis and an 
adult, I think the AAA ratings or AA or whatever they were, but 
20 or 30 years ago, they were paid by the investor.
    Senator Schumer. Exactly. Yes, and it worked.
    Mr. Volcker. And it worked. It seemed to work. So why can't 
it work again? I don't know the answer.
    Senator Schumer. The one--and this will be my last, because 
my time is expiring--the one thing people say is that when the 
investor pays, the investor doesn't want to make it public and 
there is sort of a public good.
    Mr. Volcker. Yes.
    Senator Schumer. What would you think of some quasi-
governmental intervention here?
    Mr. Volcker. I can't see the governmental agency making the 
credit rating. The potential political pressures that will come 
on, everybody----
    Senator Schumer. Well, that is why I said quasi. Don't you 
think the Fed is pretty well removed from political pressures?
    Mr. Volcker. Well, I think the Fed is more removed, 
properly so----
    Senator Schumer. Yes, it should be.
    Mr. Volcker.----than any other agency, and I like to think 
it has earned that in part over time by competence in the way 
it acts. But I don't think you just want to pile everything on 
the Federal Reserve. At some point----
    Senator Schumer. Yes.
    Mr. Volcker.----it breaks.
    Senator Schumer. Well, to clarify, my view would be to go 
back to the investor-paid initially. We have got to do 
something to change it.
    Mr. Volcker. Well, I agree with that.
    Senator Schumer. Thank you. Thank you, Mr. Chairman.
    Chairman Dodd. I won't ask you to comment on this, but 
since your knowledge and background in accounting, the FASB 
model, and I realize they are very different functions we are 
talking about here, but a FASB model has worked fairly well in 
accounting standards, particularly when we got away from the 
industry supporting it and financially underwriting it.
    Mr. Volcker. Well, that is--the IASB is the FASB model writ 
large internationally.
    Chairman Dodd. So there is a value in maybe talking about 
that model, as well.
    Senator Crapo has been, of all the members of this 
Committee, probably has worked as hard on Government 
regulation, reform regulation as any member, so we welcome your 
continuing participation in the Committee, Mike. Thank you.
    Senator Crapo. Thank you, Mr. Chairman.
    Chairman Volcker, I want to go back to the Group of 30 
report just to kind of try to understand maybe in a little more 
detail with you what was intended by it. I am going to first 
focus on one of the concepts that Senator Schumer mentioned--I 
apologize for my voice, I might lose it during the questions--
and that is the principle of unifying our regulatory system.
    For some time even before we ran into this crisis, I have 
been arguing that we need to unify our regulatory system and 
really make sure that we had the right regulatory system for 
our financial system and for our capital markets. In that 
context, as I look at what we have today, it seems to me we 
have a lot of overlap that is unnecessary. We have gaps where 
there is no regulation where there should be. And we have 
weaknesses in some parts of our system. And what we need to do, 
as I think you said earlier, we need to get good regulation, 
not necessarily a lot of it. We have got to be thorough. We 
have got to cover everything, and in my opinion, eliminate 
overlaps.
    As I look at the first principle of the Group of 30's 
report, it talks about dealing with gaps and weaknesses and so 
forth in the system. But one of your first points is that the 
activities of banks should be subject to prudential regulation 
and supervision by a single consolidated regulator. Do I 
understand you or the report at that point to be talking about 
something like merging the functions of the OCC and the OTS and 
perhaps other regulators?
    Mr. Volcker. Well, we deliberately did not get into the 
specifics. We were at a high level of generality when it came 
to the administrative arrangements. But we do recognize the 
problem that you just described and that you had to have some 
kind of a unified system, at least for banks.
    Senator Crapo. And when you say at least for banks, I 
noticed one of your other points was that the activities of 
large insurance, investment banks and broker dealers require 
consolidated supervision. Are you not saying essentially the 
same thing there in other contexts?
    Mr. Volcker. Well, I can't say, speaking in the report, we 
were saying the same thing, because we deliberately didn't want 
to get into the detail. I think it is an important subject, but 
we were concentrating on what the substance of the regulation 
should be. At some points, we said it should be consistent. But 
we didn't opine about who should do what.
    Senator Crapo. Well, let me try to take you there, and you 
don't have to speak for the report right now. A lot of 
discussion has been made about whether we should have a single 
regulator like they have in England, whether we should have 
three regulators, one for the systemic, one prudential, and one 
consumer protection----
    Mr. Volcker. Well, one of----
    Senator Crapo. Do you agree with those approaches or that 
idea of consolidating?
    Mr. Volcker. I think you should at least explore the idea 
of two regulators, which was raised by Secretary Paulson's 
report a year or so ago, that you have one on so-called 
business practices and consumer protection and investor 
protection and one on prudential safety and soundness concerns. 
They overlap. They are not entirely separate, but there is 
substantial difference between those two approaches. In fact, 
there is enough difference in approaches you will get a clash 
between those agencies. But maybe that is healthy----
    Senator Crapo. Right.
    Mr. Volcker.----instead of just having one. Now, you take 
the English pattern, they went all one way and away from the 
Central Bank. Now, that didn't work so well in terms of crisis. 
So how do you get----what we did say very clearly is whatever 
system you have, you had better get the Central Bank involved 
enough so they can respond effectively to a crisis.
    Senator Crapo. And that is consistent also with Secretary 
Paulson's blueprint----
    Mr. Volcker. Yes.
    Senator Crapo.----in terms of the suggestions made there?
    Mr. Volcker. Yes.
    Senator Crapo. One other point that was made in the report 
is that the money market mutual funds that were wanting to 
continue to offer bank-like services should be required to be 
reorganized as special purpose banks. Could you expand on that 
a little bit? What was intended by that?
    Mr. Volcker. Well, what was intended by that--you go back 
in history a little bit. Money market funds developed because--
to escape regulation, effectively. This is a way to provide a 
banking service outside of banks, and they had some competitive 
advantages because they weren't banks and they didn't subject 
to banking regulations. So when a crisis came along, the 
framework was not adequate. In some cases, they were owned by 
rich parents and it was OK. When they weren't owned by a rich 
parent, you had a collapse with widespread repercussions.
    We said, you should not essentially say we should not have 
institutions out there that promise to act like a bank, but 
they are not regulated and protected like a bank. And if they 
are going to be protected de facto, which is what happened 
here, in effect, they got a free ride, and they shouldn't have 
gotten a free ride. So if they are going to act--if they are 
going to talk like a bank and squawk like a bank, they ought to 
be regulated like a bank.
    Senator Crapo. Well, one of the principles that I tend to 
follow as I approach this issue is that similar products or 
similar functions should be regulated with the same rules or by 
the same regulators. Would you agree with that principle?
    Mr. Volcker. Well, I think if you adopted that regulation 
on money market mutual funds, the natural thing would be to 
have the same regulator as the banking regulator.
    Senator Crapo. Thank you. One more thing I would like to 
ask a little clarification on and that is your comment and the 
report's comments about the way we should handle our GSEs, 
Fannie and Freddie. You indicate that a clear separation of 
Government financial support from the private profit-seeking 
sector of this should be done. It is not clear again whether 
you are saying that we should nationalize the Fannie and 
Freddie functions or whether we should withdraw the Federal 
guarantees or accomplish the Federal guarantees in some other 
way. What exactly are you saying?
    Mr. Volcker. We are saying that is your choice. You ought 
to do one or the other.
    [Laughter.]
    Senator Crapo. All right.
    Mr. Volcker. You shouldn't leave them hung up in between, 
because it is confusing and when you got into trouble, were 
they public agencies or were they not? And if they were acting 
in the public interest, were they doing right for their 
fiduciary responsibility to the stockholder? I think they got 
placed in an impossible position. They were supposed to be 
important constructive factors in the mortgage market. The 
crisis came along and they were so over-extended in pursuit of 
their stockholder interests that they couldn't perform the 
public function. And if they performed the public function, 
their stockholders would squawk. And you shouldn't permit that 
to happen.
    Senator Crapo. Thank you very much. Just one last question, 
and really, this is sort of a summary to go back to what we 
have already talked about and that you have already expressed a 
comment on, but I would just like to explore it a little 
further with you, and that is it seems to me that right now, 
depending on whether you count the FDIC, there are six or seven 
Federal regulators with overlapping responsibilities in some 
cases, and as I said earlier, gaps in some places and so forth.
    It seems to me that regardless of the specifics, that 
Secretary Paulson's blueprint, the Group of 30 report, even 
though it didn't get into the details, and a number of the 
other reports that have dealt with this same issue have all 
concluded that we have too complex a system that needs unifying 
and simplification. Now, whether we go to a single regulator or 
whether we go to a smaller number than the seven that we have 
now, that we need to simplify and reduce the number of 
regulators and clearly identify the functions they are 
regulating and then move forward from there. Is that general 
statement something you could agree with?
    Mr. Volcker. Yes, I agree with that, but I guess what I 
would say is when you get to that stage, that stage ought to be 
second. I don't mean it should be way off, but you ought to 
have some feeling about the substance of the regulation and 
then decide who should do it rather than decide who should do 
it and worry about the substance afterwards.
    Senator Crapo. Agreed, and in that context, just to help me 
in my mind, I am starting to think of that substance part of it 
as something focusing on systemic risk, prudential regulation, 
and then consumer protection, and there may have to be some 
other insurance aspects or whatever.
    Mr. Volcker. Yes.
    Senator Crapo. But would that tend to be the kind of thing 
you were talking about?
    Mr. Volcker. I think it is one of the possibilities, yes. A 
good possibility.
    Senator Crapo. Thank you very much.
    Mr. Volcker. The report doesn't say so, but----
    Senator Crapo. I understand. I understand.
    Chairman Dodd. No, and let me just say, too, I appreciate 
Senator Crapo's longstanding involvement in this and I think we 
are sort of heading in the same direction on a lot of this. 
Obviously, the devil is in the details, a lot of it, but you 
are getting sort of a consensus emerging up here and some ideas 
and thoughts in this direction. That is why your testimony is 
so tremendously helpful.
    I can't--first of all, I don't disagree at all about the 
conflicting missions of the GSEs of protecting your shareholder 
interests and the public policy notion of housing. I am struck 
by the notion that we are sort of doing--aren't we doing the 
same thing now? When I look at Citi and Bank of America and 
Goldman Sachs and the infusions of massive amounts of taxpayer 
money, once again, now you have got the exact same situation we 
talked about with the GSEs. In effect, we have a massive amount 
of public money going in, so that we are setting public 
criteria on private institutions. What is the difference?
    Mr. Volcker. Well, the difference, I hope, is that this is 
a reaction to a particular emergency and it is transitional and 
nobody is thinking you are keeping it that way.
    Chairman Dodd. All right. I hope so.
    Senator Crapo. You are right, and I hope so, too.
    Chairman Dodd. Let me just also, and Senator Shelby had to 
go on to another meeting, let me just in a sense respond and 
ask, as well. I mean, look, we obviously know that we have got 
to go back. We are reviewing all the time how we get here. We 
are asking everyone what their thoughts were on how this 
happened and it is a very important question. None of us 
disagree with it.
    As the Chairman of a committee here, and all my members 
serve on other committees, as well, and we have obviously got a 
very important agenda to deal with, not the least of which is 
the modernization of the regulatory structure and some sense of 
urgency, I happen to believe, and I think you have implied 
this, if there is any silver lining in all of this right now, 
it is that I think there is a willingness and an understanding 
that we have to move. In the absence of this moment, if this 
were, quote, ``normal'' times, I think we would have a hard 
time engaging in this debate and discussion because of the 
vested interests that don't want anything to change at all. So 
we have been given a moment, unfortunately, here, tragically, I 
might add. But it is a moment.
    Now, what do we do with the moment, and my fear is that if 
I end up squandering a year going back and reviewing for the 
next number of months how we got here--not an illegitimate 
question--that I may miss the moment, and I will look back and 
this Committee will look back and say, we had an opportunity. 
Recognizing the moment, we need to do something about this.
    And so I respect immensely the idea that we ought to spend 
time, and I want to move carefully, obviously, and 
deliberately. But my concern is if we miss the moment, we will 
find ourselves in a deeper hole for a good many years to come.
    So let me ask you, Doctor, if I can, do you sense that, as 
well? Should this Committee and the others responsible, 
obviously the House and the President, the executive branch, 
move? And again, as I sensed it, your priority would be to deal 
with systemic risk up front and soon. Is that correct?
    Mr. Volcker. Yes, you know, with all deliberate speed.
    Chairman Dodd. I agree.
    Mr. Volcker. I am not enchanted by, you know, talking about 
combining the SEC and the CFTC. It is an important issue, but 
do that as part of the whole thing. Just don't pick out 
particular issues like that, in my view, but I----
    Chairman Dodd. Deal with the totality of it. And an issue 
that Senator Crapo brought, and I care about, as well, is sort 
of the forum shopping that went on by the major interests that 
restructure themselves in order to pick out a regulator. It is 
all backwards, in a sense. We should be determining who is 
going to be regulated, not you choosing who you are going to be 
regulated by, and that has been a constant problem, as well.
    So as I hear you say it, the systemic risk would be the 
area you think we ought to be aggressively pursuing, carefully 
but aggressively pursuing. Am I correct?
    Mr. Volcker. Yes.
    Chairman Dodd. Do my colleagues have any additional 
questions? Senator Warner?
    Senator Warner. One quick question. Thank you, Mr. 
Chairman, and I had to step out for a moment, so if Senator 
Crapo asked this question, I apologize.
    One of my questions earlier was about the argument over the 
last decade, if we added more regulation, how the capital 
markets would migrate elsewhere, and it seemed like, and I was 
one of those folks who held up what looked like the model in 
the U.K. as maybe one to go after. Clearly, it has not proven 
to be all it was made out to be. Is there some other--as we 
think through this, is there some other nation around the world 
that has got a regulatory structure that you say, hey, as you 
think through this in America, look at country X or country Y?
    Mr. Volcker. I hate to make an advertisement for the Group 
of 30, but we just issued a big report on that subject. We 
described, I don't know, what, two dozen countries, different 
systems. We refrained from saying which is best, but we did 
pronounce a lot of pros and cons, what looked more promising 
and the advantages, disadvantages of different systems.
    There seems to be some intellectual and other movement 
toward what the Senator was describing of two agencies, one for 
business practices and one for prudential. I can't claim that 
that is widespread, but there are two or three countries, or 
four or five countries that now follow that. For a while, this 
business of putting everything in one agency seemed to attract 
a following. That enthusiasm has been a bit dampened by the 
fact it didn't solve all the problems in the U.K.
    But those are the two alternatives that need to be looked 
at. The United States is big enough and complicated enough, we 
may have a system like nobody else's, but I don't think anybody 
is very happy with the system we have and it takes this kind of 
a crisis to change it.
    Senator Warner. Well, you could, Dr. Volcker, maybe you 
could share with the Chairman at some point which of those 
countries you think might be models or might give us some 
guidelines or lessons we could learn from.
    Mr. Volcker. We do have--your staff can, I am sure, look at 
the report we have on that subject because it does try to 
describe the strengths and weakness of different approaches. 
And there is a pretty strong feeling, which is not the case in 
the United States historically, that similar functions should 
be subject to the same regulator and the same regulations, 
which is----
    Senator Warner. So focused on function rather than on 
institution?
    Mr. Volcker. Than by institution, yes.
    Senator Warner. Thank you, Dr. Volcker.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, and Doctor, we thank 
you immensely. Let me just recommend, as well, and I am sure 
you will agree based on your last comment, why don't we make 
available the staff of the Group of 30, and for any interested 
members and their staffs, we will try and set something up and 
have a session where they can go through and do exactly that, 
get into more details and the questions back and forth as part 
of our ongoing effort here. It might be very worthwhile and we 
will arrange that to occur, as well.
    And I should have said at the outset, by the way, and I 
apologize, Doctor, you and the Group of 30, the people who are 
involved in this, I know the names are listed in the report 
itself, but I want the record to reflect how much we appreciate 
that effort. This was a very comprehensive effort made to 
examine this----
    Mr. Volcker. Thank you.
    Chairman Dodd.----and it is appropriate that our first 
witness in a series of hearings we are going to be having on 
this subject matter comes from this very group that brings a 
wealth of knowledge and expertise to this subject matter. We 
are going to hear from the GAO and staff, who have also been 
involved in this. I am going to bring them up here shortly, but 
I want the record to reflect how much we appreciate that 
effort.
    You have begun a very important discussion, obviously not a 
completely comprehensive one, but one that touches on the very 
major issues we will have to address in the coming days if we 
are going to effectively respond to the challenge of 
modernizing our regulatory structure, so I thank you.
    Mr. Volcker. Well, I think I can speak for my colleagues 
that engaged in the study that we appreciate your interest. We 
feel it was worthwhile, so----
    Chairman Dodd. Well, this is the moment. This is the 
moment. We have been given, unfortunately, a moment.
    Mr. Volcker. And just in terms of all this competition 
between countries and so forth, this is an international 
report.
    Chairman Dodd. I know that.
    Mr. Volcker. There is no sharp cleavage between people from 
different nationalities.
    Chairman Dodd. Thank you very much.
    We will leave the record open a little bit. There may be 
others who couldn't be here today who would like to maybe 
submit some ideas and questions to you, as well, and if you 
have a chance to respond to those. We thank you.
    Mr. Volcker. Thank you.
    Chairman Dodd. I will invite our second witness up, our 
second panel. Welcome to Dr. Gene Dodaro, who is the Acting 
Comptroller General of the U.S. Government Accountability 
Office, the GAO. Mr. Dodaro has worked for over 30 years in a 
number of key positions at GAO, including Chief Operating 
Officer. He will also be testifying tomorrow before the 
Committee on the Troubled Asset Relief Program, so he is a busy 
man with being here today and tomorrow.
    Mr. Dodaro will be accompanied by two GAO staff members, 
Rick Hillman and Ms. Orice Williams. We thank you for joining 
us, as well.
    Why don't you come on up and sit with--have both of you 
come up and sit there, because I know you worked very closely 
on the details of all of this and I know Mr. Dodaro would 
appreciate having you sit there with him, as well, and respond 
to some of this.
    Again, we thank you very, very much. I am sorry about the 
delay, but obviously a lot of questions for Dr. Volcker. So we 
welcome your comments, and again, congratulations on this. All 
of us have great respect for the GAO and the work you do, but 
this is a very important effort you have put forward and sort 
of a template for us to begin this very important discussion of 
regulation modernization.

 STATEMENT OF GENE L. DODARO, ACTING COMPTROLLER GENERAL, U.S. 
                GOVERNMENT ACCOUNTABILITY OFFICE

      ACCOMPANIED BY RICHARD J. HILLMAN, U.S. GOVERNMENT 
 ACCOUNTABILITY OFFICE; AND ORICE M. WILLIAMS, U.S. GOVERNMENT 
                     ACCOUNTABILITY OFFICE

    Mr. Dodaro. Thank you very much, Mr. Chairman. I appreciate 
the opportunity to appear before you and the members of the 
Committee this afternoon to assist your deliberations on the 
financial regulatory system.
    As you mentioned, we in this report embarked on an effort 
to assist this Committee and the Congress in tracing the 
evolution of the financial regulatory system over the last 150 
years, how it has evolved; to talk, second, about some of the 
developments in the market that has really challenged that 
regulatory system; and to put forth a framework to help guide 
decisions on how to craft and evaluate proposals to change the 
system going forward.
    Our bottom line conclusion is that the current system is 
outdated, it is fragmented, and it is ill suited to meet the 
21st century needs of our nation. There are many reasons for 
this. Three I would point out, trends that we identified in the 
report.
    First is that the regulators have struggled and often 
failed to mitigate the systemic risks of large interconnected 
financial conglomerates or to adequately ensure that they have 
managed their own risks. There is no one single regulator 
charged with looking at risk across the financial system. This, 
as mentioned in the earlier discussions today, is a problem 
that needs to be addressed.
    Second, regulators have been confronted with some large 
market participants that are less regulated. Non-bank mortgage 
lenders, credit rating agencies have been mentioned here. They 
are two that we point out in our report, as well.
    Third, both the regulators, consumers, investors have all 
been challenged by the emergence and growth of complex 
financial instruments, whether it is collateralized debt 
obligations, credit default swaps, over-the-counter 
derivatives. All these products have really evolved and 
introduced new dimensions into the system that really outpace 
the regulators' ability to be able to handle that.
    Now, going forward, we think that action needs to be taken. 
It needs to be deliberative, as pointed out here in the 
discussion so far. And in order to assist this, we outline nine 
characteristics in our report which we think are good 
touchstones.
    First is that the regulatory goals need to be clear and 
articulated in statute, and the goals really ought to drive the 
substance of the organization, as Dr. Volcker mentioned 
earlier, and they ought to be in statute so that they can be 
used to hold the regulators accountable going forward and can 
provide consistency over a period of time and ensure that there 
is consistency in the regulation going forward.
    Next, it has to be--reform has to be comprehensive. The 
current institutions and products that, where there are gaps, 
the gaps need to be closed and it needs to be looked at in an 
interrelated set of, as has been mentioned, in a unified basis 
going forward.
    System-wide risk needs to be addressed. Somebody needs to 
be in charge of making sure that the system-wide risks are 
monitored going forward.
    It needs to be flexible and adaptable, and by that we mean 
it has to allow for innovation, but somebody has to be staying 
abreast of risks that are emerging going forward. We know where 
the risks are now. What shape they will take in the future is 
really anybody's guess at this point, but we need to have a 
monitoring system in place that can triage those risks, make 
determination, not be totally reactive to the situations going 
forward.
    It needs to be efficient and effective. By this we mean 
there is overlapping jurisdictions right now that can be 
consolidated or looked to to consolidate so we have an 
efficient system going forward.
    Consumer protection has to be also a paramount 
consideration here. Every time we have evaluated an activity 
for this Committee or another committee in Congress in terms of 
whether it is credit card fees or whether it is mutual fund 
fees, the disclosures invariably aren't adequate enough going 
forward, and I believe there also needs to be more attention to 
financial literacy concerns. The Federal Government has a 
commission on this, but it hasn't been--had a strategic plan, 
been resourced properly. That needs to be part of the package, 
as well.
    The regulators have to have the right authorities. They 
have to have proper independence, and that involves the funding 
sources that they draw upon to ensure that independence going 
forward.
    And last, taxpayer exposure has to be minimized. We believe 
that whatever structure is put in place, that future failures 
are borne by the cost of the market participants and not by 
taxpayers going forward. An example here is what is set up 
currently in the Bank Insurance Fund, where fees are paid and 
then institutions, if they fail or are taken over, then the 
fund is recapitalized by the participants in the fund and not 
by taxpayers going forward.
    Now, to your point about seizing the moment, one of the 
things that we did in order to highlight attention to dealing 
with this issue was add the need to modernize the financial 
regulatory system to our most recent update for the High-Risk 
List that we keep for the Congress and unveil at the beginning 
of each new Congress, and this is important because we have 
added areas in need of broad-based transformation as one of the 
criteria to be put on the High-Risk List. We think it was 
important to do that, to feature this as the attention of need 
of change both by the executive branch and importantly by the 
Congress, in this case, through legislative initiatives.
    So that sort of concludes my opening statement. My 
colleagues and I would be happy to answer any questions that 
you have.
    Chairman Dodd. I must say, you are always a spectacular 
witness. That was his testimony given without reading, and your 
comprehensive knowledge of your own report is pretty 
impressive. You have testified before us on numerous occasions 
and you always do an excellent, excellent job, and so I command 
you and your staff for your depth of understanding and 
appreciation of the issue.
    Am I to understand, by the way, when you listed the list, 
the list is not necessarily in the order of importance, because 
consumer protection comes sort of at the mid-point in that list 
and I don't interpret that to mean that that is less important 
than the first issue you raised.
    Mr. Dodaro. That is correct. Basically, these nine 
characteristics all have equal value. The only thing I would 
say is we list the regulatory goals articulation up front, 
which could include--and should include--consumer protection as 
sort of an overarching starting point. But other than that, 
they are all of equal importance.
    Chairman Dodd. And the last comment you made is I 
understand to be that you believe this ought to be a high-
priority item for this Congress, the 111th Congress.
    Mr. Dodaro. Definitely.
    Chairman Dodd. Yes. Let me, if I can, begin with the first 
question I asked Dr. Volcker, because again, while obviously we 
are looking forward here, Senator Shelby's point, whether you 
want to have this Committee do it or someone else do it or 
however, and I think you can walk and chew gum, that we can 
actually do both functions maybe simultaneously, that is 
analyze how we got here as we decide what steps to take going 
forward, is an important question.
    And so the question I asked Dr. Volcker was, I will repeat, 
and that is your, in fact, the report here states, and I quote 
here:

        Mechanisms should be included for identifying, monitoring, and 
        managing risk to the financial system regardless of the source 
        of the risk.

What was the source of the risk?
    Mr. Dodaro. I think, you know, basically the three areas 
that I pointed out in terms of these developments that have 
occurred that have outpaced the ability of the financial 
regulatory system. It depends on how you want to frame it. Our 
report frames it in terms of market developments compared with 
the regulatory system. Our report is not a comprehensive 
inventory of every, perhaps, poor decision that was made by 
individual regulators or by companies or by other institutions 
going forward. Clearly, that is worthy of investigation.
    But our point was that there are these broad trends, and 
these trends, you know, we have seen emerge over a period of 
time. In 1994, we issued a report on the problems that were 
emerging in derivatives. In 2004, at the request of this 
Committee, we issued a report talking about the need to 
modernize the financial regulatory system. So a lot of the need 
to change the system, I believe has been emerging over a period 
of time. It was definitely brought to the forefront over this 
past year in the scope and dimensions of the problem. But I 
think there is enough basis of study being done that could 
begin to build the record that Senator Shelby was talking 
about.
    But until action is taken, we continue to have these 
exposures and vulnerabilities, and I don't think, you know, 
some of this can proceed on a parallel path.
    Chairman Dodd. I agree with you, as well.
    Let me--the structure of the financial regulation. Again, 
we have heard a lot of different ideas today. I keep sensing 
some commonality among members up here and I would like to 
raise, if I can, in order to address the problem, should we 
consolidate regulatory agencies? If so, which agencies should 
be consolidated and what public policy goals would such 
consolidation achieve? Is there a role for maintaining a State-
Federal system of optional bank charters, for instance, in your 
view? What are the advantages and disadvantages of creating a 
Federal insurance regulator?
    We are debating up here, and this subject has been before 
us, on the Optional Federal Charter. A lot of people think 
there is not much debate over life issues. There is a 
significant debate over property casualty issues of how we go. 
What are your thoughts on those questions?
    Mr. Dodaro. I will ask Mr. Hillman to comment on the 
insurance industry. He has done a lot of work on that area. But 
in terms of your first question about consolidation, some of 
our work in the past, in the banking regulators agency, we 
raised the issue of the potential benefits of merging OTS and 
OCC and perhaps the supervisory responsibilities of the FDIC as 
a potential area that ought to be examined going forward. 
Obviously, many people have mentioned the SEC-CFTC potential 
issue going forward.
    But my point would be, at this juncture, those decisions 
need to be made in concert with identifying who the systemic 
regulator would be, because the relationship between that 
regulator and the other regulators that may have more specific 
prudential responsibilities, I think needs to be thought of in 
a holistic fashion. Otherwise, we are going to put in place 
another potentially fragmented system to replace a fragmented 
system that we already have.
    Chairman Dodd. So get to the systemic risk issue first?
    Mr. Dodaro. First, and then in parallel with that decide 
how to make the other system support that, and it will also 
help the systemic risk regulator because they won't be having 
to deal with as many other entities going forward and it does 
address the issue of regulatory arbitrage that you mentioned 
earlier, Mr. Chairman.
    But Rick can comment on the insurance area.
    Chairman Dodd. Yes.
    Mr. Hillman. The notion of an alternative national 
insurance regulator is something that is deserving of 
significant merit, that we need to best understand the 
tradeoffs associated with that. But in recent years, the 
preponderance of evidence, particularly amongst the larger 
insurance companies, suggests that they are at a disadvantage 
compared to the banking and security sectors in that the 
banking and security sectors can bring new products to the 
market more swiftly that are similar to products that are also 
being sold by the insurance industry. However, the insurance 
industry, rather than having one or a small number of 
regulators to get product approval, has 54 separate regulators 
from the 50 different States and four different Territories. So 
the idea of having some commonality associated with the 
introduction of products of similar nature in the marketplace 
is something that deserves close attention.
    Chairman Dodd. Yes. Well, it does and this Committee cares 
a lot about it. What about the State-chartered versus federally 
chartered institutions?
    Mr. Dodaro. I think what we have seen and observed over 
time, the State function, particularly as it relates to 
consumer protection, has provided an important safeguard and we 
think the benefits of that need to be preserved going forward. 
There needs to be obvious coordination in this area. There 
are--it is important always to have some checks and balances in 
the system, and I think the Federal-State issue is one of the 
important checks and balances that needs to be maintained in a 
revised system. Most of our work is focused on the Federal 
level, of course.
    Chairman Dodd. Let me jump, if I can, to the issue of 
failing institutions. The GAO report suggests that a regulatory 
system should have adequate safeguards that allow financial 
institution failures to occur while limiting taxpayers' 
exposure. Can you give us an example of some of those 
safeguards?
    Mr. Dodaro. I mentioned, alluded to one in my opening 
statement. The Bank Insurance Fund, I think, is the model that 
we have in mind going forward here extended across the system 
whereby the banks pay fees into the system. The fund is then 
capitalized. There is a statutory ratio that is set, and if the 
fund falls below that ratio, FDIC has a number of years in 
order to recapitalize the fund----
    Chairman Dodd. Right.
    Mr. Dodaro.----but that is done by the financial 
institutions in the system and not supported by taxpayer funds. 
I mean, that was something that was modernized during the 
savings and loan and banking crisis we had in the 1990s.
    Chairman Dodd. Yes.
    Mr. Dodaro. We think there ought to be something like that 
more broadly speaking in this system so that the taxpayers 
aren't turned to to provide anywhere near the level of 
investment that we are being asked to provide today.
    Chairman Dodd. The former SEC Chairman, Bill Donaldson, 
once warned against executive compensation plans that 
emphasized rewards for short-term financial targets, and I 
quote him here. He says, ``People with targets and jobs 
dependent on meeting them will probably meet the targets, even 
if they have to destroy the enterprise to do it,'' end of 
quote.
    I wonder if you might explain the relationship of 
compensation to risk taking, particularly when oriented toward 
short-term goals and discuss how they should be addressed.
    Mr. Dodaro. This is an area that we haven't studied 
extensively going forward, but clearly the role of incentives 
here are important going forward and you are seeing some of 
that. We point some of that out in our report in terms of the 
number of mortgages lent, for example, and the incentives 
systems build into it. So I think that is an area that needs a 
lot more study and attention, but clearly, the incentives in 
the corporate governance aspects of this can't be overlooked 
going forward.
    Chairman Dodd. So the issue of proxy voting and so forth on 
compensation issues, it has been discussed a little bit in the 
past, but to what extent shareholders at what level have a 
right to participate in making--first of all, they find out 
invariably a lot of these contracts are entered into and you 
don't discover all the details of them until someone is 
leaving.
    Mr. Dodaro. Mr. Chairman, let me go back and look at what 
we have done in the past. I don't have a ready answer for you 
on that today and we will provide one.
    Chairman Dodd. I appreciate it. I thought you might, but it 
was one I wanted to raise.
    Let me turn to Senator Johanns.
    Senator Johanns. Thank you, Mr. Chairman.
    A couple of thoughts. Having run a State government from 
the Governor's office and having a Director of Insurance which 
I appointed and regulating insurance at the State level, I will 
tell you, and we were a fairly small State population-wise, at 
least, that there was a closeness of regulation there that 
never got very far away from you.
    Now, I compare that with having run a Federal department, 
very large, 110,000 employees in 75 foreign countries. We 
regulated a whole bunch of things. These regulatory enterprises 
can be so big and the diversity so enormous around the country 
that what happens is exactly what your report points out. It 
just breaks down.
    And so when you start comparing State charter versus 
Federal charter, et cetera, I think we have to keep that in 
mind. I really do. Having run both, I can tell you, a 
department that regulates on a national basis is always going 
to fight that battle. That is my observation.
    My question, though, deals with kind of a follow-up on this 
whole issue of risk analysis. How do you figure out that this 
basketful of assets has value and what is its value and what 
exposure do you want to take to that risk? I would like to hear 
your thoughts on that. Is this something where you would 
suggest that our regulatory framework have kind of a pre-
approval feature to it, because once the investments are made, 
the horse has pretty well galloped out of the barn, if you know 
what I am saying. I would just like to hear your thoughts about 
that.
    Mr. Dodaro. Yes. Clearly, the risk management failed at 
several levels in this situation. It failed at an institution 
level. It failed at an industry level. It failed at the 
national level and at an international level. I think the 
breadth in which this moved across the globe, I think really 
surprised a lot of people.
    At the request of Senator Reed, in his capacity as a Chair 
of one of the subcommittees of this Committee, we are looking 
at risk management practices going forward and I will ask Ms. 
Williams to give you a little bit of an outline on what he has 
asked us to do, and we will be reporting on that shortly.
    But this is an area that I think is really in need of 
attention going forward. This is the role that we would see the 
systemic risk regulatory playing, to monitor the developments 
and to make that decision. And I think you are going to have to 
rely on the regulators to make the decision as to whether to 
intervene or not. There is the possibility perhaps of allowing 
pilots to go forward without it being system-wide. There are 
other cases where you may want to be watching it, monitoring it 
for a while very closely. But this risk management that we have 
in mind needs to be an active risk manager, not over-reactive, 
but not under-reactive, as well.
    Orice?
    Ms. Williams. Basically, what we are going to do on this 
engagement, we are looking at risk management oversight. We are 
specifically interested in what the Federal regulators do when 
they look at risk management at an institution, how they 
actually go about examining that particular aspect of a 
financial institution, and then we are looking at how the 
regulators identify risk that they are going to focus on in an 
examination, because they do risk-based examinations, to see 
how often risk management bubbled up in the past several years 
up to the current point. And then finally, we are looking at 
the resources that are dedicated to the examination function 
across the banking regulators, as well as the SEC.
    Senator Johanns. One other thing I wanted to ask you about 
as you start to look at this is the whole issue of offloading 
risk, and maybe there is no solution to that, but it seemed to 
me this system got created in such a way that the premium for 
me as the broker was to write the loan at all costs, whatever I 
could do to get that person to sign on the dotted line, then it 
is packaged and it is sold off and the risk goes to somebody 
else and somebody else or whatever.
    I would really like to hear your thoughts on how to deal 
with that, because--and maybe that gets back to the issue of 
valuation again. But to me, that seems to be an important 
element as we think about what we want to do with the 
regulatory system.
    Mr. Hillman. When you go back a decade or more, the process 
that depository institutions typically followed in funding 
mortgages is they would have their own underwriters review the 
competency of individuals to pay those loans and they would go 
through a detailed process before making a decision to provide 
a loan to an individual. Once that decision was made, they 
would hold that risk or hold that loan on their books 
themselves.
    Today, most oftentimes that is not the case. The case is a 
model of originate to distribute, where institutions are making 
decisions and receiving a fee for that service and passing that 
risk on to others. This originate to distribute model is one of 
the reasons why we have resulted in the crisis that we are in 
today and some say that additional attention is going to be 
needed in the future to help to ensure that at least some 
responsibilities are being held by each of the individual 
parties along the way to ensure the appropriateness of 
decisionmaking at each of those levels.
    Senator Johanns. Can I often one last piece to this? That 
piece would be the thought of rating the risk. Is that an 
appropriate governmental function? For example, if my bank 
wants to go out and originate junk in the hopes of marketing 
it, we should call it that. If, on the other hand, they are 
following a model of caution and due diligence and doing the 
very best they can to make sure that those loans are going to 
be repaid, that should be viewed differently.
    But the important thing is, how do we let the consumer know 
that? How do I, Mike Johanns, going in to make my deposit, how 
do I know that those practices have been employed, so if I buy 
their stock or invest my money in that stock or whatever, I am 
an informed consumer? These are complicated issues, but I think 
that is what we are trying to get to here, is to protect the 
consumer.
    Mr. Dodaro. I think basically the answer to that question, 
Senator, I think involves safeguards at various levels. You 
need to have the regulators in the examination be clear that 
the institutions are following due diligence, good practices; 
second, there is proper disclosure; and then third, there is 
education, and then a consumer protection safeguard in place.
    So it is a very important question. It runs--the threat of 
it runs through all these various areas that we are talking 
about. I don't think there is one solution to it, but it is 
something that needs to be looked at on a comprehensive basis 
because it is pivotal to the decisionmaking that takes place 
within all these various levels of institutions and products.
    Senator Johanns. We have run out of time, but my final 
thought, Mr. Chairman, is this. If we don't figure this piece 
out, the mechanism won't make a bit of difference. We can 
create this. We can put it under the Fed. We can do whatever, 
whatever, but if you don't solve that piece of it, then they 
are almost guaranteed to fail as a regulator and we will be 
back to reports like you just wrote.
    Mr. Dodaro. Yes, and basically, that is why we set out 
those characteristics, because if you address all the 
characteristics, we believe you will get at this issue. This 
isn't just the question of moving boxes around and solving a 
problem. It is not anywhere near that simple.
    Senator Johanns. I went over my time, so thank you.
    Chairman Dodd. No, you didn't, Senator. You just made a 
very, very valuable point to me, because if there is that 
common denominator, as Mr. Dodaro just described that thread, I 
believe it is consumer protection. I think we have operated for 
far too long, over the last number of years, where there has 
been a notion that consumer protection was antithetical to 
economic growth, that if you were talking consumer protection, 
you were creating hurdles, barriers to economic growth.
    And the painful lesson we have all learned in these last 
number of months, several years now, is that when consumer 
protection is foremost in your minds, what happens to that 
investor, what happens to that customer who walks in, if you 
are guarding and watching out for them, that you can avoid the 
very problems we got into.
    We didn't watch out, that is we, the regulators, the 
Government itself, was not watching out for what happened to 
that purchaser of that mortgage. We were assuming somehow that 
the system was taking care of them, and they weren't, and so 
they got cheated in the process. When you abandon the consumer 
in your analysis of all of this, you put economic growth at 
risk, and I think your question is right at the heart of it.
    We just move boxes around here and create different 
structures and make it look more simple, but without providing 
that kind of protection, coming back to the notion that 
protecting the consumer is absolutely essential for economic 
growth and the avoidance of the very situation we find 
ourselves in today, I think is an excellent point. Thank you 
for it.
    Senator Warner?
    Senator Warner. Thank you, Mr. Chairman.
    Mr. Dodaro, nice to see you again and, again, compliments 
on initiating this report and listing it as a top priority for 
the Congress to take on and the country to take on.
    I want to follow up on Senator Johanns' point. One of the 
areas that has been suggested--and I do not know if you all 
have weighed in--is if you are originator of one of these 
mortgages or one of these loans, you keep a stake in the game, 
that you cannot sell off 100 percent of that risk.
    Have you taken a position or do you have a comment on that 
``stake in the game'' notion?
    Mr. Dodaro. Now, we have not looked at that particular 
issue, Senator.
    Senator Warner. Mr. Chairman, that is one way, if you are 
not taking the whole--selling off 100 percent of the risk, as 
Mr. Hillman mentioned earlier. A decade ago the bank, the 
originator of the loan, would keep that loan on its books and 
have a long-term obligation. As they have been securitized and 
sliced and diced, that connection and bond between the lender 
and the lendee has disappeared. And one proposal is 
reconnection and making sure that if you originate, you keep 
some skin in the game.
    Chairman Dodd. Absolutely.
    Senator Warner. But let me also follow up on, I think, your 
appropriate point about protecting the consumer, and it is kind 
of, again, from a--I keep coming back to, you know, this kind 
of way we approach this. My concern is, Mr. Chairman, that we 
clearly need to do a better job of protecting the consumer, but 
I think we have operated on the premise that transparency and 
disclosure alone would be enough to protect the consumer. And 
it seems like we have had two contradictory policy goals. On 
one level, we want to protect the consumer. On the other level, 
as we push out these more challenging mortgages or credit 
cards, the population that we are dealing with are oftentimes 
the least financially literate.
    So what I question, even with more focus on financial 
literacy programs, is whether disclosure alone is going to get 
us there and, you know, will there need to be some type of 
restrictions--again, I come back to my bright lines--on certain 
products that if you are not, for example, a qualified 
investor--I spent 20 years in the venture capital business. You 
know, to invest in my venture capital funds, which were high 
risk, you had to be a qualified investor.
    Do we need to have, in addition to--if we are going to 
truly protect the consumer, in addition to disclosure and 
transportation, are we going to need actually some bright-line 
prohibitions?
    Mr. Dodaro. I definitely think that the systemic regulator 
that we are talking about would fulfill that function, or at 
least that could be one of the functions they fulfill, is to 
assess the risk level, and there have to be tolerances put in 
place and balances and decisions made on a case-by-case basis 
as to whether the risk--you know, assuming you have these clear 
goals of consumer protection as one of your goals, along with, 
you know, allowing innovation and capital formation. But, I 
mean, all those things have to be balanced. But I think you 
definitely need that in place.
    I agree with what you are saying, that, you know, 
disclosure, transparency alone are not going to be enough. I 
think you need to have it sort of from one end to the other. 
One is the regulators need to be protecting the consumers as 
well as allowing for innovation, all the way through 
transparency, disclosure, down to educating people more to make 
them more financially literate.
    Senator Warner. I had a family member who I warned time and 
again do not get into this adjustable rate mortgage. All the 
warnings in the world, all the transparency in the world, would 
not have precluded her from taking a bad long-term action. I 
was able to bail her out, but now we are looking to a national 
Uncle Sam bailing everybody out because at some point people 
with information may still not be making good financial 
judgments here.
    Mr. Dodaro. I agree completely.
    Senator Warner. So there has to be some protection 
component.
    Mr. Dodaro. Right.
    Senator Warner. I know our time is getting short, but one 
last question. We have spent a lot of time, again, about all 
these new financial tools and the over-financial engineering 
that is taking place. How do we make sure that the regulators 
stay abreast of these tools and have the skills and the 
technology and the competency to make sure that they actually 
understand these new products as they emerge?
    Mr. Dodaro. Well, I clearly think--and I will ask Ms. 
Williams to comment on this because she has been doing a lot of 
our work on these instruments. But, first, clearly the goal has 
to be set for them to do that. And I think if the Congress sets 
a statutory--as part of the regulatory goal, an expectation 
that occur, that is there, I think they need to be given then 
the authorities to be able to hire the necessary people and 
compensate them appropriately for doing that. And I do think 
they would have the capability to be able to do it.
    There is no doubt in my mind that you have some very 
talented people in the regulatory system right now that, given 
the proper goals and expectations, can, you know, develop in 
that area. It will not be easy because of the ingenuity of many 
of the market participants, but I think it is achievable.
    Orice, do you have anything?
    Ms. Williams. The only thing that I would add is that this 
is an area that the regulators are always going to be at a 
disadvantage in dealing with because the markets are always 
looking to come up with new and innovative products. But I 
think one of the things that would really help--and we tried to 
speak to this with our principal, focused on having, you know, 
a flexible, nimble process for regulators to be able to adjust, 
is to get beyond the type of product and the label that is 
attached to a particular product and really be able to focus on 
the risk that that product may pose to the system and making 
that the focus and the driver for whether or not products need 
to be brought under a regulatory umbrella.
    Senator Warner. So actually making a risk assessment of the 
product, and then if the assessment was the product was too 
risky, then perhaps saying some universes of consumers might 
not be eligible to----
    Ms. Williams. Or that it needs to be, you know, regulated 
or looked at from a regulatory perspective and not just focus 
specifically on it meets this statutory definition so, 
therefore, it falls out of a regulatory jurisdiction versus it 
poses this particular risk to the system, therefore, it needs 
to be subject to some level of regulation and oversight.
    Senator Warner. We had that situation last week in the 
Madoff hearing where we had both SEC and FINRA here, and, you 
know, asked very much suddenly, you know, on broker-dealers, if 
somebody says they were an investment adviser and FINRA is 
looking, they are going to suddenly stop and not turn over that 
information. These regulatory lines clearly in that case might 
have precluded exposing a real financial scam.
    Ms. Williams. Exactly. And one example, we have worked 
looking at credit default swaps, and that is another example of 
a product that meets a definition and, therefore, there is----
    Senator Warner. No examination beyond meeting the 
definition.
    Ms. Williams. Exactly.
    Senator Warner. Amen. Thank you very much.
    Ms. Williams. You are welcome.
    Senator Akaka.
    [Presiding.] Thank you very much, Senator Warner.
    Mr. Dodaro, it is good to see you again, and our panel. I 
am so glad that we have a new team that is addressing the 
problems that we are facing immediately. And I think you know 
the history of the so-called Financial Literacy and Education 
Commission. That is chaired by the Secretary of Treasury, and 
it has a mission that has really not been carried out. And I 
think that is an answer to some of the problems that have been 
mentioned here.
    Previously, I heard about protecting the consumers. Well 
before the current economic crisis that we are facing at this 
time, financial regulatory systems were failing--failing to 
adequately protect working families from predatory practices 
and exploitation. And this Commission was really put in place 
to try to prepare strategies that would deal with the problems 
that people in the country would have.
    I would tell you that one of the huge problems that this 
country has is that this country is financially illiterate. And 
so these financial literacy programs fill that void, and we 
need to really, I feel, try to bring that back to life and to 
help the causes here.
    Families have been pushed into mortgage products with 
associated risks and costs that they could not afford. And 
instead of utilizing affordable, low-cost financial services 
found at regulated banks and credit unions, too many working 
families have been exploited by the high cost of fringe 
financial service providers such as payday lenders and check 
cashers. I would tell you--and I am sure it is not only in 
Hawaii--that you find offices like these outside of our bases, 
and so our military personnel really suffer on this.
    So my question to you, Mr. Dodaro, is: How do we create a 
regulatory structure that better protects working families 
against predatory practices?
    Mr. Dodaro. I will ask Rick to elaborate on the Financial 
Literacy Commission, Senator Akaka, but first, it is a pleasure 
to see you again as well.
    We have studied the Financial Literacy Commission. We have 
also studied issues relating to information being provided to 
our military families to educate them. Ms. Williams was 
involved in that, and we can provide that information for the 
record as well.
    But I think, clearly, the issue first has to be a clear 
articulation of consumer protection being a clear goal of the 
regulatory system, to have it organized properly, resourced 
properly, and there needs to be continual congressional 
oversight. I think this is an area that the whole financial 
regulatory system needs to have some ongoing oversight 
activities. Even if the Congress makes the determination that 
the system is going to be modernized and a new system is put in 
place, the idea that that would operate effectively from day 
one without continual refinement and oversight I think is an 
unrealistic goal.
    And so I would say there needs to be a proper transition 
and it needs to be followed through on oversight. But let me 
have Rick talk about the Financial Literacy Commission, because 
I could not agree with you more about its importance.
    Senator Akaka. Thank you.
    Mr. Hillman. We recently completed a report assessing the 
Financial Literacy Commission at the Department of Treasury. 
Exactly as you have said, this Commission was established to 
help to promote financial literacy on a nationwide level. It 
brought together over 20 departments and agencies who had 
financial literacy programs with the hope of consolidating 
those efforts and distributing those out to the nations in 
need. What we have found, however, though, is that the 
Commission itself is well understaffed and unable to achieve 
the mission which it was set up to accomplish.
    For example, one of the activities that the Commission 
undertook was to ask each of these agencies to determine the 
extent to which they had any overlap or duplication in the 
individual financial literacy initiatives that they had 
undertaken. And due to a lack of resources, they asked each of 
the agencies to themselves make that assessment as opposed to 
having some sort of expert assessment done by an outside party.
    That internal assessment came up with very limited 
suggestions as to how the financial literacy programs could be 
improved, and we made a recommendation that they seek 
additional expertise to assess the effectiveness of those 
programs.
    Regarding the notion on the military bases, we have done 
significant work and we have work ongoing now that is looking 
at the extent to which sales of financial products to the 
military, particularly egregious insurance products, are 
continuing to cause havoc on bases. Sadly, we are finding that 
that continues to be the case.
    One of the major limitations associated with the oversight 
of payday lenders and other types of establishments that you 
mentioned in your State that is rampant across all States has 
to do with the fact that those types of associations that fall 
outside of the reach of a financial services regulator are 
under the regulatory authority of the Federal Trade Commission. 
The Federal Trade Commission is largely an enforcement agency, 
not an oversight agency. It is a small organization with 
significant responsibilities, and currently configured, it is 
simply unable to achieve the level of oversight that most would 
like to have.
    Senator Akaka. Yes, and I also understand that the 
Commission, as you said, has been understaffed. Also, they are 
having problems trying to come to some consensus among 
themselves, the 20 Federal agencies, and simply because they 
have different missions and perspectives. But I hope that we 
can look at these missions and perspectives as a means of 
bringing a solution to this particular problem. And part of the 
mission, of course, is education, and this is one thing that we 
really need to press across the country. And I feel that if 
more of the citizens of this country were better educated 
financially, some of the problems we are facing now may not 
have been as large as this.
    But I think we need to, Mr. Dodaro, work on this Commission 
to make it more effective and to use its efforts to deal with 
financial literacy in the country.
    Mr. Dodaro. I agree, Mr. Chairman, and we would be happy to 
follow up on our report and provide a follow-up activity report 
on how well they have implemented the recommendations to the 
Committee.
    Senator Akaka. Well, let me thank you for your January 2009 
report, and I have seen parts of it, and your report states 
that:

        New and more complex products raise challenges for regulators 
        in addressing financial literacy. Without sufficient financial 
        literacy, individuals will not be able to effectively evaluate 
        credit and investing opportunities or be able to cope with 
        difficult economic situations.

And we agree with that.
    My question to you is: How can we ensure that in a new 
regulatory structure financial literacy is effectively 
addressed?
    Mr. Dodaro. I think in the characteristics that we point 
out in our January report, Senator, we point out a couple 
things, characteristics that are pivotal to this issue. One is 
clear articulation in statute of a regulatory goal. So this 
needs to be clearly articulated. Someone has to be given the 
responsibility for doing it, proper resources, proper 
accountability back to the Congress, and I think that there 
needs to just be follow-up.
    This is not a hugely difficult task in the sense if we make 
a priority and then we apply the proper resources and we ensure 
people are following through on this initiative. Plus I think 
this is one that if there is work to be done with our education 
system, there needs to be an integrated fashion, you know, put 
in place to be able to do this.
    One of the things that I almost did rather than come to GAO 
many, many years ago is I had an idea to start a class to be 
taught in high schools on this very issue at that point in time 
because I think it is very important. It has got to start early 
with people and be built into the education system, and then it 
has to be reinforced on a more sophisticated level as people 
take on additional responsibilities and begin working and 
making larger purchases going forward.
    Senator Akaka. Well, I want to thank our witnesses today 
for appearing here, and I apologize for Chairman Dodd, who was 
called away. That is why he is not here. And I want to thank 
you again for your responses.
    The hearing record will remain open for additional 
statements and questions, and, again, I thank you for your 
responses and look forward to having you in hearings in the 
future.
    This hearing is adjourned.
    [Whereupon, at 5:36 p.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional material supplied for the record follow:]
                  STATEMENT OF SENATOR CHARLES SCHUMER
    First, I'd like to thank Chairman Dodd for holding the first of 
what I'm sure will be many hearings on financial regulatory reform. For 
decades, America generally, and New York in particular, have been the 
financial capitals of the world. Our markets have been the deepest, 
most liquid and safest. Our dominant position was built not only on our 
talent, ingenuity and expertise, but also on a foundation of strong but 
efficient regulation, and a reputation for fairness, that demonstrated 
to investors that they would be protected from fraud and financial 
recklessness here. The events of past 24 months have destroyed our 
reputation as the system has been gripped by a financial crisis that 
resulted from years of regulatory neglect at all levels.
    Eight years of the Bush Administration's one-sided, laissez-faire, 
deregulatory ideology have helped cripple our financial system, and an 
outdated and overmatched regulatory system in this country compounded 
their failure. Even former Federal Reserve Chairman Alan Greenspan, 
once an ardent defender of deregulation and the free market, recently 
acknowledged that there was a ``flaw'' in his belief that markets could 
and would regulate themselves. I hope that we've learned that as 
appealing as deregulation may seem in good times, the price we 
ultimately pay will be far higher than had we exercised the good 
judgment and restraint imposed by responsible regulation.
    Designing a regulatory system is a complicated and difficult task. 
Regulation must strike a delicate balance--providing a sense of safety 
and security for investors, without snuffing out the flame of 
entrepreneurial vigor and financial innovation that drives economic 
growth.
    It's easy, and even tempting, to go to the ideological extremes on 
either end of the spectrum. But threading this needle correctly is an 
essential component of restoring confidence and long-term stability to 
the financial system.
    For many years, the United States had struck that balance very 
well. However, new factors, including technology, globalization, and 
industry consolidation and evolution have left our regulatory 
infrastructure too far behind the reality of today's global financial 
system.
    Where does this leave us? Well, it leaves us needing significant 
reform. As we go forward, I believe there are a number of clear 
principles that we must adhere to. I've discussed these principles 
before, but I think they're worth repeating now as we begin the 
discussion of regulatory reform under a new Administration.

  1.)  We must focus on controlling systemic risk and ensuring 
        stability.

    In increasingly complex markets, even the most sophisticated 
financial institutions don't always understand the risks their 
decisions involve. Smaller institutions like some hedge funds and 
private equity firms, can also create systemic risk in today's world 
and cannot escape regulation, particularly when it comes to 
transparency. We need regulation that looks at risk systemically and 
above all, we need to ensure that whatever may happen to any individual 
financial actor, we can be confident that the financial system itself 
will remain strong and stable.

  2.)  We need to look closely at unifying and simplifying our 
        regulatory structure.

    In this era of global markets and global actors, we cannot maintain 
the older model of separate businesses with separate regulators. Right 
now there are too many regulators at the Federal level with overlapping 
authority. This creates a regulatory ``race to the bottom'' as less 
responsible firms are able to play the regulators off one another in 
their efforts to operate with as little oversight and as few 
restrictions as possible.

  3.)  It is clear that we must figure out how to regulate currently 
        unregulated parts of the financial markets and opaque and 
        complex financial instruments.

    There are too many vital players and products in the financial 
markets that operate beyond the scope of Federal regulators, yet have 
the ability to put the system at risk. We must create an effective 
regulatory framework for those actors and for more exotic financial 
instruments like complex derivatives and even the relatively plain 
vanilla credit-default swaps, which have grown into a multi-trillion 
dollar part of the financial system.

  4.)  We must recognize that a global financial world requires global 
        solutions.

    In this era of global finance, while we have international markets, 
we still have national regulations. The danger is that there is often a 
rush to the place where regulation is lightest and least effective. 
This may be our toughest challenge.

  5.)  Increased transparency must be a central goal.

    We must continue to emphasize transparency among all market 
participants. The ability of investors, lenders and especially 
regulators to evaluate the quality of holdings and borrowings is 
essential for restoring confidence.
    A complete overhaul of this nation's financial regulatory system 
will be difficult, complex and time consuming. I look forward to 
working with President Obama, and under the leadership of Chairman Dodd 
to advance this process so that as we begin to recover from the current 
financial crisis in the coming months, we have a system in place to 
prevent its repetition.
                                 ______
                                 
                 PREPARED STATEMENT OF PAUL A. VOLCKER
            Chairman, Steering Committee of the Group of 30
                            February 4, 2009
    Mr. Chairman and Members of the Senate Banking Committee:
    I appreciate your invitation to discuss the recent Report on 
Financial Reform issued by the ``Group of 30''. I remind you that the 
Group is international, bringing together members with broad financial 
experience from both the private and public sectors and drawn from both 
highly developed and emerging economies. While certainly relevant to 
the United States, most of the recommendations are generally applicable 
among globally active financial markets.
    I understand that the text of the Report has been distributed to 
you and your staff and will be included in the Committee record. 
Accordingly, my statement will be short.
    What is evident is that we meet at a time of acute distress in 
financial markets with strongly adverse effects on the economy more 
broadly. There is a clear need for early and effective governmental 
programs both to support economic activity and to ease the flow of 
credit. It is also evident that fundamental changes and reform of the 
financial system will be required to assure that strong, competitive 
and innovative private financial markets can in the future again 
support economic growth without risk of a systemic financial breakdown.
    It is that latter challenge to which the G-30 Report is addressed. 
I understand that President Obama and his administration will soon 
place before you a specific program for dealing with the banking 
crisis. Such emergency measures are not the subject of our Report. 
However, I do believe that the implementation of the more immediate 
measures will be facilitated by an agreed sense of the essential 
elements of a reformed financial system.
    In that respect, the basic thrust of the G-30 Report is to 
distinguish among the basic functions of any financial system. First, 
there is a need for strong and stable institutions serving the needs of 
individuals, businesses, governments, and others for a safe and sound 
repository of funds, as a reliable source of credit, and for a robust 
financial infrastructure able to withstand and diffuse shocks and 
volatility. I think of this as the service-oriented part of the 
financial system dealing with customer relationships. It is 
characterized mainly by commercial banks that have long been supported 
and protected by deposit insurance, access to Federal Reserve credit, 
and other elements of the Federal safety net.
    What has become apparent during this period of crisis is increasing 
concentration in banking and the importance of official support for 
systemically important institutions at risk of failure. What is 
apparent is that a sudden breakdown or discontinuity in the functioning 
of such institutions risks widespread repercussions on markets, on 
closely interconnected financial institutions, and on the broader 
economy.
    The design of any financial system raises large questions about the 
appropriate criteria for, and the ways and means of, providing official 
support for these systemically important institutions.
    In common ground with virtually all official and private analysts, 
the Report calls for ``particularly close regulation and supervision, 
meeting high and common international standards'' for institutions 
deemed systemically critical. It also explicitly calls for restrictions 
on ``proprietary activities that present particularly high risks and 
serious conflicts of interest'' deemed inconsistent with the primary 
responsibilities of those institutions. Of relevance in the light of 
recent efforts of some commercial enterprises to recast financial 
affiliates as bank holding companies, the Report strongly urges 
continuing past U.S. practice of prohibiting ownership or control of 
Government-insured, deposit-taking institutions by non-financial firms.
    Secondly, the Report implicitly assumes that, while regulated 
banking institutions will be dominant providers of financial services, 
a variety of capital market institutions will remain active. Organized 
markets and private pools of capital will be engaging in trading, 
transformation of credit instruments, and developing derivatives and 
hedging strategies, and other innovative activities, potentially adding 
to market efficiency and flexibility.
    These institutions do not directly serve the general public and 
individually are less likely to be of systemic significance. 
Nonetheless, experience strongly points to the need for greater 
transparency. Specifically beyond some minimum size, registration of 
hedge and equity funds, should be required, and if substantial use of 
borrowed funds takes place, an appropriate regulator should be able to 
require periodic reporting and appropriate disclosure. Furthermore, in 
those exceptional cases when size, leverage, or other characteristics 
pose potential systemic concerns, the regulator should be able to 
establish appropriate standards for capital, liquidity and risk 
management.
    The Report does not deal with important and sensitive questions of 
the appropriate administrative arrangements for the regulatory and 
supervisory functions. These are in any case likely to be influenced by 
particular national traditions and concerns. What is emphasized is that 
the quality and effectiveness of prudential regulation and supervision 
must be improved. Insulation from political and private special 
interests is a key, along with adequate and highly competent staffing. 
That implies adequate funding.
    The precise role and extent of the central bank with respect to 
regulation and supervision is not defined, and is likely to vary 
country by country. There is, however, a strong consensus that central 
banks should accept a continuing role in promoting and maintaining 
financial stability, not just in times of crisis, but in anticipating 
and dealing with points of vulnerability and risk.
    The Report deals with many more specific issues cutting across all 
institutions and financial markets. These include institutional and 
regulatory standards for governance and risk management, an appropriate 
accounting framework (including common international standards), reform 
of credit rating agencies, and appropriate disclosure and transparency 
standards for derivatives and securitized credits. Specifically, the 
Report calls for ending the hybrid private/public nature of the two 
very large Government-sponsored mortgage enterprises in the United 
States. Under the pressure of financial crisis, they have not been able 
to serve either their public purposes or private stockholders 
successfully. To the extent the Government wishes to provide support 
for the residential mortgage market, it should do so by means of 
clearly designated Government agencies.
    Finally, I want to emphasize that success in the reform effort, in 
the context of global markets and global institutions, will require 
consistency in approach among countries participating significantly in 
international markets. There are established fora for working toward 
such coordination. I trust the forthcoming G-20 meeting, bringing 
together leaders of so many relevant nations, can provide impetus for 
thoughtful and lasting reform.
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                  PREPARED STATEMENT OF GENE L. DODARO
   Acting Comptroller General, U.S. Government Accountability Office
                            February 4, 2009


























































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 RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON FROM PAUL A. 
                            VOLCKER

    Q.1. There is pressure to move quickly and reform our 
financial regulatory structure. What areas should we address in 
the near future and which areas should we set aside until we 
realize the full cost of the economic fallout we are currently 
experiencing?

    A.1. I recognize the desire to move quickly to reform the 
financial regulators structure, but more important is to get it 
right. Speed should not become the enemy of the good, and a 
piece-meal approach may inadvertently prejudice the 
thoroughgoing comprehensive measures we need. There may be a 
few measures--such as the proposed new crisis resolution 
procedure--that may be usefully enacted promptly, but we still 
have much to learn from unfolding experience and about the need 
to achieve international consistency.

    Q.2. The largest individual corporate bailout to date has 
not been a commercial bank, but an insurance company. Given the 
critical role of insurers in enabling credit transactions and 
insuring against every kind of potential loss, and the size and 
complexity of many insurance companies, do you believe that we 
can undertake serious market reform without establishing 
Federal regulation of the insurance industry?

    A.2. Consideration of Federal regulation of insurance 
companies and their holding companies is an example of the need 
for a comprehensive approach. A feasible starting point should 
be the availability of a Federal charter, at least for large 
institutions operating inter-state and internationally, with 
the implication of Federal supervision.

    Q.3. As Chairman of the G-30, can you go into greater 
detail about the report's recommended reestablishment of a 
framework for supervision over large international insurers? 
Particularly, cm you provide some further details or thoughts 
on how this recommendation could be developed here in the 
United States? Can you comment on the advantages of creating a 
Federal insurance regulator in the United States?

    A.3. As indicated, the absence of a Federal charter and 
supervision for insurance companies is a gap in our current 
regulatory framework. I am not prepared now to opine whether 
the Federal regulator should be separate from other supervisory 
agencies but some means of encouraging alignment is necessary. 
Again, I'd prefer to see the issue resolved in the context of a 
more comprehensive approach; in this case including 
consideration of appropriate and feasible international 
standards.

    Q.4. How should the Government and regulators look to 
mitigate the systemic risks posed by large interconnected 
financial companies? Do we risk distorting the market by 
identifying certain institutions as systemically important? How 
do foreign countries identify and regulate systemically 
critical institutions?

    A.4. The question of mitigating systemic risks is a key 
issue in financial reform, and can be approached in different 
ways. Specifically identifying particular institutions as 
systemically important, with the implication of special 
supervisory attention and support, has important adverse 
implications in terms of competitive balance and moral hazard. 
I am not aware of any foreign country that explicitly 
identifies and regulates particular systemically critical 
institutions, but in practice sizable banking institutions have 
been protected.
    An alternative approach toward systemic risk would be to 
provide a designated regulatory agency with authority to 
oversee banks and other institutions, with a mandate to 
identify financial practices (e.g., weak credit practices, 
speculative trading excesses, emerging ``bubbles'', capital 
weaknesses) that create systemic risk and need regulatory 
supervision. Particular institutions need not be identified for 
special attention.

    Q.5. In your testimony you say that you support continuing 
past U.S. practice of prohibiting ownership or control of 
Government-insured, deposit-taking institutions by non-
financial firms. What are your thoughts on the commercial 
industrial loan company (ILC) charter? Should this continue to 
exist?

    A.5. I do believe recent experience only reinforces long-
standing American aversion to mixtures of banking and commerce. 
The commercial industrial loan companies and other devices to 
blur the distinction should be guarded against, severely 
limited if not prohibited.
                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON FROM GENE L. 
                             DODARO

    Q.1. There is pressure to move quickly and reform our 
financial regulatory structure. What areas should we address in 
the near future and which areas should we set aside until we 
realize the full cost of the economic fallout we are currently 
experiencing?

    A.1. As we noted in our January 2009 report, financial 
regulators have been appropriately focused on limiting the 
damage from the current crisis to the United States economy and 
its financial system.\1\ Given the experiences of other 
countries, particularly Japan that suffered stagnation for a 
decade likely as a result of its ineffective attempts to 
address its financial crisis in the 1990s, Congress and 
regulators should likely continue to address in the near term 
efforts to further stem the crisis and restore our financial 
institutions to more normal operating conditions, including 
finding an appropriate and effective solution to the issue of 
troubled assets being held by so many institutions.
---------------------------------------------------------------------------
    \1\  GAO, Financial Regulation: A Framework for Crafting and 
Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory 
System, GAO-09-216 (Washington, D.C.: Jan. 8, 2009.)
---------------------------------------------------------------------------
    However, directing actions more to the current crisis 
should not preclude Congress from exploring with regulators 
plans for modernizing the United States financial regulatory 
system. As we pointed out, taking piecemeal actions and 
creating new regulations and regulatory bodies in the aftermath 
of past financial turmoil is one reason why our current 
structure is so fragmented and has the gaps and inconsistencies 
in oversight that have contributed to the current crisis. As a 
result, careful consideration of how best to develop a 
structure and financial regulatory bodies within it that more 
holistically embodies aspects like the nine elements of an 
effective regulatory system that we described in our report is 
important. Taking adequate time to consider and complete this 
critical task is more advisable than taking quick actions that 
could lead to gaps or inconsistencies later.

    Q.2. The largest individual corporate bailout to date has 
not been a commercial bank, but an insurance company. Given the 
critical role of insurers in enabling credit transactions and 
insuring against every kind of potential loss, and the size and 
complexity of many insurance companies, do you believe that we 
can undertake serious market reform without establishing 
Federal regulation of the insurance industry?

    A.2. Over the years, GAO has reported on the inconsistency 
and lack of uniformity of regulation that insurance companies 
receive across states. This lack of consistency can lead to 
uneven protections for consumers across states as well as 
inefficiencies for insurers that could lead to higher premiums. 
We currently have a study under way looking at reciprocity and 
uniformity of State insurance regulation in three key areas: 
product approval, producer licensing, and market conduct 
regulation. The study will touch on issues of consistent 
oversight across states. Having an optional Federal charter for 
insurance would be one way to potentially increase the 
consistency of oversight of insurance companies.
    Although the problems experienced by AIG and the subsequent 
action by the Government to address them demonstrates that the 
United States has significant gaps in its oversight of 
significant financial institutions, the extent to which this 
case demonstrates the need for Federal insurance oversight is 
unclear. Although some of AIG's financial difficulties arose 
from the securities lending activities engaged in by its life 
insurance companies, and some of the Federal assistance went 
toward unwinding those transactions, the insurance company 
operations were, and have remained, stable. Those companies 
have been negatively affected by the damage to the parent 
company's reputation, and may no longer benefit to the same 
extent from the parent company's financial strength, but they 
appear to be financially sound. While it's possible closer 
review by State insurance regulators may have more quickly 
identified the risk associated with the life insurance 
companies' securities lending operations, the primary problems 
appear to have originated in one of AIG's non-insurance 
subsidiaries. In addition, State insurance laws require State 
insurance regulators to approve any significant transactions 
between an insurance company and its parent company or other 
subsidiaries, and, according to State regulatory officials and 
AIG securities filings, some State regulators did not allow 
transactions that would have transferred capital from AIG's 
insurance companies to the parent company.

    Q.3. The GAO recommends consistent financial oversight--to 
ensure that similar institutions, products, risk and services 
are subject to consistent regulation oversight and 
transparency. In the case of insurance, the regulation and 
oversight is not consistent. Shouldn't insurance receive the 
same consistent financial oversight that is desperately needed 
for other financial institutions?

    A.3. In our January 2009 report on the need for regulatory 
reform, we noted that the United States needs a financial 
regulatory system that is appropriately comprehensive and 
provides consistent oversight of institutions engaging in 
similar activities and risks. In addition, we advocated that 
consumer protections be similarly consistent across 
institutions and products. As a result, to the extent that 
insurance companies conduct activities, such as over-the-
counter derivatives trading or market products as investment 
alternatives to securities or bank saving products, we 
advocated that they be overseen with similar risk management, 
capital, and consumer disclosure requirements.
    In general, the operations of most insurance companies 
themselves do not appear to have given rise to the complexities 
that made regulation difficult in the case of AIG. For entities 
that just engage in insurance activities, having Federal 
oversight could be one way that more uniformity of oversight is 
achieved. However, our report also noted that State regulators, 
including those for insurance, have played important roles in 
identifying and taking actions to address problems for 
consumers. As noted above, we have a study under way looking at 
reciprocity and uniformity of State insurance regulation that 
will touch on issues of consistent oversight across States.

    Q.4. The GAO's report suggests that Congress should 
consider establishing a Federal insurance regulator; can you 
comment on the advantages of creating a Federal insurance 
regulator in the United States?

    A.4. As we noted above, a Federal insurance charter could 
have the potential to alleviate some of the challenges in 
harmonizing insurance regulation across States. However, we 
also note that such an approach could have various 
disadvantages. Currently, property and casualty insurance 
activities are heavily influenced by State laws--including 
those relating to insurance, torts, and business operations--
and having Federal oversight of such varying requirements could 
be very challenging. In addition, State regulators assert that 
because of their greater familiarity with the particular 
demographics of their jurisdictions, they are in a better 
position to protect consumers. Another issue that would have to 
be addressed in implementing a Federal insurance charter would 
be the loss of income to states from taxes paid on insurance 
premiums by consumers. These taxes generally provide funds 
beyond what is required to fund the regulation of insurance.

    Q.5. How should the Government and regulators look to 
mitigate the systemic risks posed by large interconnected 
financial companies? Do we risk distorting the market by 
identifying certain institutions as systemically important? How 
do foreign countries identify and regulate systemically 
critical institutions?

    A.5. Various options exist for addressing the systemic risk 
posed by large interconnected financial institutions. As we 
advocated in our January 2009 report, such institutions should 
receive comprehensive and consistent regulation from both a 
prudential and consumer protection standpoints.\2\ Having such 
oversight should reduce the potential for such institutions to 
experience problems that threaten the stability and soundness 
of other institutions and the overall financial system itself. 
In addition, we advocated that our regulatory system needs a 
systemwide focus to address the potential threats to system 
stability that can arise from institutions, products, and 
markets. Such a focus could be achieved by designating an 
existing regulator or creating a new entity to be tasked with 
overseeing systemic risk in the United States. Such an entity 
could also be tasked with prudential oversight of the large 
interconnected financial institutions or their primary 
oversight could remain the responsibility of another regulator 
with the systemic risk regulator supplementing this oversight 
by collecting information, examining operations, and directing 
changes from the large institutions as needed.
---------------------------------------------------------------------------
    \2\ GAO-09-216.
---------------------------------------------------------------------------
    While one obvious way of ensuring that these large 
institutions are all subject to similar regulatory requirements 
and oversight would be to designate them as systemically 
important and place them under the regulation of a single 
regulatory body, such an approach also has disadvantages. Some 
market observers have expressed concerns that designating 
certain institutions as systemically important could distort 
competition in the financial market sectors in which these 
entities operate by providing the designated institutions with 
funding advantages and reducing market discipline of the firms 
that do business with them because of the belief that the 
Government will not allow such institutions to fail. In light 
of the experience of the housing Government-sponsored 
enterprises recently, such concerns should be taken seriously.
    However, the more extensive oversight that systemically 
important financial institutions would likely receive could 
offset some of the competitive advantage they receive from 
being designated as so. Given such institutions greater 
potential than other institutions to create systemic problems, 
they should appropriately be subject to higher prudential 
standards for capital, liquidity, and counter-party risk 
management, etc. So although their status as systemically 
important institutions could possibly create competitive 
distortions or moral hazard, increased prudential standards 
would seek to mitigate that (and any systemic risks they might 
pose).
    Other countries have not generally had to face the issue of 
whether their systemically important institutions should be 
supervised separately because of the differences in the 
regulatory and market structures outside the United States. In 
many countries, the primary financial institutions are 
universal banks that offer a range of services across sectors, 
including banking, securities, and insurance activities, and 
that are overseen by a single regulatory body, which reduces 
the potential for inconsistent oversight. In addition, the 
number of financial institutions in many countries is 
relatively small, which also reduces the potential for less 
consistent oversight across institutions that might provide a 
competitive advantage for those designated as systemically 
important.
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