[Senate Hearing 111-109]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 111-109

          MODERNIZING BANK SUPERVISION AND REGULATION--PART I

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

                                HEARING

                               before the

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

      EXAMINING WAYS TO MODERNIZE AND IMPROVE BANK REGULATION AND 
  SUPERVISION, TO PROTECT CONSUMERS AND INVESTORS, AND HELP GROW OUR 
                         ECONOMY IN THE FUTURE

                               ----------                              

                             MARCH 19, 2009

                               ----------                              

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







                                                        S. Hrg. 111-109


          MODERNIZING BANK SUPERVISION AND REGULATION--PART I

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

                                HEARING

                               before the

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

      EXAMINING WAYS TO MODERNIZE AND IMPROVE BANK REGULATION AND 
  SUPERVISION, TO PROTECT CONSUMERS AND INVESTORS, AND HELP GROW OUR 
                         ECONOMY IN THE FUTURE

                               __________

                             MARCH 19, 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


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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         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
                       Amy Friend, Chief Counsel
                      Aaron Klein, Chief Economist
               Jonathan Miller, Professional Staff Member
                       Deborah Katz, OCC Detailee
                   Charles Yi, Senior Policy Advisor
                       Lynsey Graham-Rea, Counsel
                Mark Oesterle, Republican Chief Counsel
                   Hester Peirce, Republican Counsel
                    Jim Johnson, Republican Counsel
                       Dawn Ratliff, Chief Clerk
                      Devin Hartley, Hearing Clerk
                      Shelvin Simmons, IT Director
                          Jim Crowell, Editor

                                  (ii)














                            C O N T E N T S

                              ----------                              

                        THURSDAY, MARCH 19, 2009

                                                                   Page

Opening statement of Chairman Dodd...............................     1

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     3
    Senator Bunning
        Prepared statement.......................................    49

                               WITNESSES

John C. Dugan, Comptroller of the Currency, Office of the 
  Comptroller of the Currency....................................     5
    Prepared statement...........................................    49
    Response to written questions of:
        Senator Shelby...........................................   184
        Senator Reed.............................................   196
        Senator Crapo............................................   200
        Senator Kohl.............................................   203
        Senator Hutchison........................................   206
Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation..     7
    Prepared statement...........................................    56
    Response to written questions of:
        Senator Shelby...........................................   207
        Senator Reed.............................................   215
        Senator Crapo............................................   220
        Senator Kohl.............................................   226
        Senator Hutchison........................................   233
Michael E. Fryzel, Chairman, National Credit Union Administration     8
    Prepared statement...........................................    65
    Response to written questions of:
        Senator Shelby...........................................   237
        Senator Reed.............................................   242
        Senator Crapo............................................   245
        Senator Kohl.............................................   249
        Senator Hutchison........................................   250
Daniel K. Tarullo, Member, Board of Governors of the Federal 
  Reserve
  System.........................................................    10
    Prepared statement...........................................    74
    Response to written questions of:
        Senator Shelby...........................................   251
        Senator Reed.............................................   264
        Senator Crapo............................................   270
        Senator Kohl.............................................   274
        Senator Hutchison........................................   279
Scott M. Polakoff, Acting Director, Office of Thrift Supervision.    12
    Prepared statement...........................................    85
    Response to written questions of:
        Senator Shelby...........................................   281
        Senator Reed.............................................   290
        Senator Crapo............................................   293
        Senator Kohl.............................................   297
        Senator Hutchison........................................   300

                                 (iii)

Joseph A. Smith, Jr., North Carolina Commissioner of Banks, and
  Chair-Elect of the Conference of State Bank Supervisors........    14
    Prepared statement...........................................    90
    Response to written questions of:
        Senator Shelby...........................................   300
        Senator Reed.............................................   304
        Senator Crapo............................................   307
        Senator Kohl.............................................   309
George Reynolds, Chairman, National Association of State Credit 
  Union
  Supervisors, and Senior Deputy Commissioner, Georgia Department 
  of Banking and Finance.........................................    15
    Prepared statement...........................................   103
    Response to written questions of:
        Senator Shelby...........................................   311
        Senator Reed.............................................   315
        Senator Crapo............................................   318
        Senator Kohl.............................................   320

 
          MODERNIZING BANK SUPERVISION AND REGULATION--PART I

                              ----------                              


                        THURSDAY, MARCH 19, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:37 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. The Committee will come to order.
    Senator Shelby is in his office. He will be along shortly 
but asked us to commence the hearing. So we will begin this 
morning. Let me welcome my colleagues, welcome our witnesses as 
well. We have another long table here this morning of 
witnesses, and we are trying to move through this series of 
hearings on the modernization of financial regulation. So I am 
very grateful to all of you for your testimony.
    The testimony is lengthy, I might add. Going through last 
evening the comments--there is Senator Shelby. Very, very 
helpful, though, and very informative testimony, so we thank 
you all for your contribution.
    I will open up with some comments. I will turn to Senator 
Shelby, and then we will get right to our witnesses. We have 
got votes this morning as well, I would notify my colleagues, 
coming up so we are going to have to stagger this a bit so we 
do not delay the hearing too long, and we will try to, each one 
of us, go out and vote and come back so we can continue the 
hearing uninterrupted, if that would work out. So I will ask my 
colleagues' indulgence in that regard as well.
    We are gathering here again this morning to discuss the 
modernization of bank supervision and regulation. This hearing 
marks yet another in a series of hearings to identify causes of 
the financial crisis and specific responses that will guide 
this Committee's formulation of a new architecture for the 21st 
century financial services regulation.
    Today, we are going to explore ways to modernize and 
improve bank regulation and supervision, to protect consumers 
and investors, and help grow our economy in the decades ahead. 
A year ago, this Committee heard from witnesses on two separate 
occasions that the banking system was sound and that the vast 
majority of banks would be well positioned to weather the 
storm.
    A year later, taxpayers are forced to pump billions of 
dollars into our major banking institutions to keep them 
afloat. Meanwhile, every day 20,000 people, we are told, are 
losing their jobs in our country, 10,000 families' homes are in 
jeopardy from foreclosure, and credit--the lifeblood of our 
economy--is frozen solid. People are furious right now, and 
they should be. But history will judge whether we make the 
right decisions. And as President Obama told the Congress last 
month, we cannot afford to govern out of anger or yield to the 
politics of the moment as we prepare to make choices that will 
shape the future of our country literally for decades and 
decades to come.
    We must learn from the mistakes and draw upon those lessons 
to shape the new framework for financial services regulation, 
an integrated, transparent, and comprehensive architecture that 
serves the American people well through the 21st century.
    Instead of the race to the bottom we saw in the run-up to 
the crisis, I want to see a race to the top, with clear lines 
of authority, strong checks and balances that build the 
confidence in our financial system that is so essential to our 
economic growth and stability.
    Certainly there is a case to be made for a so-called 
systemic risk regulator within that framework, and whether or 
not those vast powers will reside in the Fed remains an open 
question, although the news this morning would indicate that 
maybe a far more open question in light of the balance sheet 
responsibilities.
    And, Mr. Tarullo, we will be asking you about that question 
this morning to some degree as well. This news this morning 
adds yet additional labors and burdens on the Fed itself, and 
so the question of whether or not, in addition to that job, we 
can also take on a systemic risk supervisor capacity is an 
issue that I think a lot of us will want to explore.
    As Chairman Bernanke recently said, the role of the 
systemic risk regulator will entail a great deal of expertise, 
analytical sophistication, and the capacity to process large 
amounts of disparate information. I agree with Chairman 
Bernanke, which is why I wonder whether it would not make more 
sense to give authority to resolve failing and systemically 
important institutions to the agency with actual experience in 
the area--the FDIC.
    If the events of this week have taught us anything, it is 
that the unwinding of these institutions can sap both public 
dollars and public confidence essential to getting our economy 
back on track. This underscores the importance of establishing 
a mechanism to resolve these failing institutions.
    From its failure to protect consumers, to regulate mortgage 
lending, to effectively oversee bank holding companies, the 
instances in which the Fed has failed to execute its existing 
authority are numerous. In a crisis that has taught the 
American people many hard learned lessons, perhaps the most 
important is that no institution should ever be too big to 
fail. And going forward, we should consider how that lesson 
applies not only to our financial institutions, but also to the 
Government entities charged with regulating them.
    Replacing Citibank-size financial institutions with 
Citibank-size regulators would be a grave mistake. This crisis 
has illustrated all too well the dangers posed to the consumer 
and our economy when we consolidate too much power in too few 
hands with too little transparency and accountability.
    Further, as former Fed Chairman Volcker has suggested, 
there may well be an inherent conflict of interest between 
prudential supervision--that is, the day-to-day regulation of 
our banks--and monetary policy, the Fed's primary mission--and 
an essential one, I might add.
    One idea that has been suggested that could complement and 
support an entity that oversees systemic risk is a consolidated 
safety and soundness regulator. The regulatory arbitrage, 
duplication, and inefficiency that comes with having multiple 
Federal banking regulators was at least as much of a problem in 
creating this crisis as the Fed's inability to see the crisis 
coming and its failure to protect consumers and investors. And 
so systemic risk is important, but no more so than the risk to 
consumers and depositors, the engine behind our very banking 
system.
    Creating that race to the top starts with building from the 
bottom up. That is why I am equally interested in what we do to 
the prudential supervision level to empower regulators, the 
first line of defense for consumers and depositors, and 
increase the transparency that is absolutely essential to 
checks and balances and to a healthy financial system.
    Each of these issues leads us to a simple conclusion: The 
need for broad, comprehensive reform is clear. We cannot afford 
to address the future of our financial system piecemeal or ad 
hoc without considering the role that every actor at every 
level must play in creating a stable banking system that helps 
our economy grow for decades to come. That must be our 
collective goal.
    With that, let me turn to Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Chairman Dodd.
    We are in the midst of an unprecedented financial crisis. I 
believe the challenge before us involves three tasks: First, we 
must work to stabilize the system. Second, we must understand 
the origins of the current crisis. And, third, we must work to 
restructure our regulatory regime to meet the demands of a 21st 
century financial system.
    Today, the Committee will focus primarily on the third 
task, rebuilding the regulatory structure. I believe the 
success of our effort will depend a great deal on our ability 
to determine what led us to this point. Without that knowledge, 
we will not know whether we are regulating the right things in 
the right way.
    We need to determine whether the regulators had sufficient 
authority and whether they used the authority they had to the 
fullest extent. We need to consider here whether market 
developments outpace current regulatory capabilities. We also 
need to better understand the impact regulation has on the 
private sector's due diligence and risk management practices.
    After understanding the nature of the regulatory structure, 
I believe we need to come to an understanding as to the 
specific cause or causes of the regulatory failure. We then 
need to address those failures in such a manner where we create 
a durable, flexible, and robust regime that can grow with 
markets while still protecting consumers and market stability.
    This is a very tall order. It will take an intensive and 
extended effort on our behalf, but in the end, getting this 
thing done right is more important than getting it done 
quickly.
    Thank you, Mr. Chairman.
    Chairman Dodd. We have a lot of witnesses, but some of my 
colleagues may want to make some very brief opening comments on 
this. Senator Brown, you are next in line. Do you want to make 
a brief opening comment on this at all?
    Senator Brown. I will pass.
    Chairman Dodd. You will. Senator Bunning.
    Senator Bunning. Pass.
    Chairman Dodd. As well. Senator Tester.
    Senator Tester. I will pass.
    Chairman Dodd. As well. Senator Crapo.
    Senator Crapo. Pass.
    Chairman Dodd. Let me see. Senator Warner.
    Senator Warner. I will pass.
    Chairman Dodd. We have a trend going here. Senator Bennett? 
I was told by my staff that some members wanted to be heard, so 
I am just responding to the staff request.
    Senator Bennett. I just want to thank you for holding the 
hearing and recognize that it is going to be the first in a 
series, because there is probably nothing more important that 
we will do in this Committee this year than deal with this 
problem. The future is a very--there are many demands that we 
have to deal with, with respect to the future here.
    Chairman Dodd. Thank you.
    Senator Schumer.
    Senator Schumer. Pass.
    Chairman Dodd. All right. Senator Merkley.
    Senator Merkley. I will pass.
    Chairman Dodd. Senator Bennet.
    Senator Bennet. I appreciate the opportunity to make a 
lengthy opening statement.
    [Laughter.]
    Chairman Dodd. Statements will be included in the record. 
We will make sure that happens.
    We will begin with our witnesses here. We are very 
fortunate to have a good, strong group of folks who know these 
issues well and have been involved before with this Committee 
on numerous occasions. Let me briefly introduce them each.
    I will begin with John Dugan. He is currently the 
Comptroller of the Currency. We thank you for coming back 
before the Committee once again.
    Sheila Bair, Chairperson of the Federal Deposit Insurance 
Corporation, has been before the Committee on numerous 
occasions.
    We have next Michael Fryzel, Chairman of the National 
Credit Union Administration, and we appreciate your 
participation.
    Dan Tarullo is with the Federal Reserve. We thank you, Dan. 
Congratulations on your recent confirmation as well.
    Scott Polakoff currently serves as the Acting Director of 
the Office of Thrift Supervision.
    Joseph Smith is currently North Carolina Commissioner on 
Banks and is appearing on behalf of the State Bank Supervisors, 
and we thank you for being here.
    And George Reynolds is the Chairman of the National 
Association of State Credit Union Supervisors and Senior Deputy 
Commissioner of the Georgia Department of Banking and Finance. 
And we thank you as well for joining us.
    I am going to ask, given the magnitude, the size of our 
Committee here this morning--I noticed, for instance, John, 
your testimony is about 18 or 20 pages long last night as I 
went through it, and I am hopeful you are not going to try and 
do all 20 pages here this morning. Dan, yours is about 16 or 17 
pages as well. If you could abbreviate this down to about 5 or 
6 minutes or so--and it is important we hear what you have to 
say, so I do not want to constrain you too much. But I would 
like to be able to get through everyone so we can go through 
the question period.
    We will begin with you.

STATEMENT OF JOHN C. DUGAN, COMPTROLLER OF THE CURRENCY, OFFICE 
               OF THE COMPTROLLER OF THE CURRENCY

    Mr. Dugan. Thank you, Chairman Dodd, Ranking Member Shelby, 
and Members of the Committee.
    The financial crisis has raised legitimate questions about 
whether we need to restructure and reform our financial 
regulatory system, and I welcome the opportunity to testify on 
this important subject on behalf of the OCC.
    Let me summarize the five key recommendations from my 
written statement which address issues raised in the 
Committee's letter of invitation.
    First, we support the establishment of a systemic risk 
regulator, which probably should be the Federal Reserve Board. 
In many ways, the Board already serves this role with respect 
to systemically important banks, but no agency has had similar 
authority with respect to systemically important financial 
institutions that are not banks, which created real problems in 
the last several years as risk increased in many such 
institutions. It makes sense to provide one agency with 
authority and accountability for identifying and addressing 
such risks across the financial system.
    This authority should be crafted carefully, however, to 
address the very real concerns of the Board taking on too many 
functions to do all of them well, while at the same time 
concentrating too much authority in a single Government agency.
    Second, we support the establishment of a regime to 
stabilize resolve and wind down systemically significant firms 
that are not banks. The lack of such a regime this past year 
proved to be an enormous problem in dealing with distressed and 
failing institutions such as Bear Stearns, Lehman Brothers, and 
AIG. The new regime should provide tools that are similar to 
those the FDIC currently has for resolving banks, as well as 
provide a significant funding source, if needed, to facilitate 
orderly dispositions, such as a significant line of credit from 
the Treasury. In view of the systemic nature of such 
resolutions and the likely need for Government funding, the 
systemic risk regulator and the Treasury Department should be 
responsible for this new authority.
    Third, if the Committee decides to move forward with 
reducing the number of bank regulators--and that would, of 
course, shorten this hearing--we have two general 
recommendations. The first may not surprise you. We believe 
strongly that you should preserve the role of a dedicated 
prudential banking supervisor that has no job other than bank 
supervision. Dedicated supervision produces no confusion about 
the supervisor's goals or mission, no potential conflict with 
competing objectives; responsibility and accountability are 
well defined; and the result is a strong culture that fosters 
the development of the type of seasoned supervisors that we 
need. But my second recommendation here may sound a little 
strange coming from the OCC given our normal turf wars. 
Congress, I believe, should preserve a supervisory role for the 
Federal Reserve Board, given its substantial experience with 
respect to capital markets, payment systems, and the discount 
window.
    Fourth, Congress should establish a system of national 
standards that are uniformly implemented for mortgage 
regulation. While there were problems with mortgage 
underwriting standards at all mortgage providers, including 
national banks, they were least pronounced at regulated banks, 
whether State or nationally chartered. But they were extremely 
severe at the nonbank mortgage companies and mortgage brokers 
regulated exclusively by the States, accounting for a 
disproportionate share of foreclosures. Let me emphasize that 
this was not the result of national bank preemption, which in 
no way impeded States from regulating these providers. National 
mortgage standards with comparable implementation by Federal 
and State regulators would address this regulatory gap and 
ensure better mortgages for all consumers.
    Finally, the OCC believes the best way to implement 
consumer protection regulation of banks, the best way to 
protect consumers is to do so through prudential supervision. 
Supervisors' continual presence in banks through the 
examination process creates especially effective incentives for 
consumer protection compliance, as well as allowing examiners 
to detect compliance failures much earlier than would otherwise 
be the case. They also have strong enforcement powers and 
exceptional leverage over bank management to achieve corrective 
action. That is, when examiners detect consumer compliance 
weaknesses or failures, they have a broad range of corrective 
tools from informal comments to formal enforcement action, and 
banks have strong incentives to move back into compliance as 
expeditiously as possible.
    Finally, because examiners are continually exposed to the 
practical effects of implementing consumer protection rules for 
bank customers, the prudential supervisory agency is in the 
best position to formulate and refine consumer protection 
regulation for banks.
    Proposals to remove consumer protection regulation and 
supervision from prudential supervisors, instead consolidating 
such authority in a new Federal agency, would lose these very 
real benefits, we believe. If Congress believes that the 
consumer protection regime needs to be strengthened, the best 
answer is not to create a new agency that would have none of 
the benefits of the prudential supervisor. Instead, we believe 
the better approach is for Congress to reinforce the agency's 
consumer protection mission and direct them to toughen the 
applicable standards and close any gaps in regulatory coverage. 
The OCC and the other prudential bank supervisors will 
rigorously apply any new standards, and consumers will be 
better protected.
    Thank you very much. I would be happy to answer questions.
    Chairman Dodd. Thank you very much.
    Ms. Bair, thank you for joining us.

    STATEMENT OF SHEILA C. BAIR, CHAIRMAN, FEDERAL DEPOSIT 
                     INSURANCE CORPORATION

    Ms. Bair. Chairman Dodd, Ranking Member Shelby, and Members 
of the Committee, thank you for the opportunity to testify 
today.
    Our current regulatory system has clearly failed in many 
ways to manage risk properly and to provide market stability. 
While it is true that there are regulatory gaps which need to 
be plugged, U.S. regulators already have broad powers to 
supervise financial institutions. We also have the authority to 
limit many of the activities that undermined our financial 
system. The plain truth is that many of the systemically 
significant companies that have needed unprecedented Federal 
help were already subject to extensive Federal oversight. Thus, 
the failure to use existing authorities by regulators casts 
doubt on whether simply entrusting power in a new systemic risk 
regulator would be enough.
    I believe the way to reduce systemic risk is by addressing 
the size, complexity, and concentration of our financial 
institutions. In short, we need to end ``too big to fail.'' We 
need to create regulatory and economic disincentives for 
systemically important financial firms. For example, we need to 
impose higher capital requirements on them in recognition of 
their systemic importance to make sure they have adequate 
capital buffers in times of stress. We need greater market 
discipline by creating a clear, legal mechanism for resolving 
large institutions in an orderly manner that is similar to the 
one for FDIC-insured banks.
    The ad hoc response to the current crisis is due in large 
part to the lack of a legal framework for taking over an entire 
complex financial organization. As we saw with Lehman Brothers, 
bankruptcy is a very poor way to resolve large, complex 
financial organizations. We need a special process that is 
outside bankruptcy, just as we have for commercial banks and 
thrifts.
    To protect taxpayers, a new resolution regime should be 
funded by fees charged to systemically important firms and 
would apply to any institution that puts the system at risk. 
These fees could be imposed on a sliding scale, so the greater 
the risk the higher the fee. In a new regime, rules and 
responsibility must be clearly spelled out to prevent conflicts 
of interest. For example, Congress gave the FDIC back-up 
supervisory authority and the power to self-appoint as receiver 
when banks get into trouble. Congress did this to ensure that 
the entity resolving a bank has the power to effectively 
exercise its authority even if there is disagreement with the 
primary supervisor. As Congress has determined for the FDIC, 
any new resolution authority should also be independent of any 
new systemic risk regulator.
    The FDIC's current authority to act as receiver and to set 
up a bridge bank to maintain key functions and sell assets is a 
good starting point for designing a new resolution regime. 
There should be a clearly defined priority structure for 
settling claims depending on the type of firm. Any resolution 
should be required to minimize losses to the public. And the 
claims process should follow an established priority list. 
Also, no single Government entity should have the power to 
deviate from the new regime. It should include checks and 
balances that are similar to the systemic risk exception for 
the least cost test that now applies to FDIC-insured 
institutions.
    Finally, the resolution entity should have the kinds of 
powers the FDIC has to deal with such things as executive 
compensation. When we take over a bank, we have the power to 
hire and fire. We typically get rid of the top executives and 
the managers who caused the problem. We can terminate 
compensation agreements, including bonuses. We do whatever it 
takes to hold down costs. These types of authorities should 
apply to any institution that gets taken over by the 
Government.
    Finally, there can no longer be any doubt about the link 
between protecting consumers from abusive products and 
practices and the safety and soundness of America's financial 
system. It is absolutely essential that we set uniform 
standards for financial products. It should not matter who the 
seller is, be it a bank or nonbank. We also need to make sure 
that whichever Federal agency is overseeing consumer 
protection, it has the ability to fully leverage the expertise 
and resources accumulated by the Federal banking agencies. To 
be effective, consumer policy must be closely coordinated and 
reflect a deep understanding of financial institutions and the 
dynamic nature of the industry as a whole.
    The benefits of capitalism can only be recognized if 
markets reward the well managed and punish the lax. However, 
this fundamental principle is now observed only with regard to 
smaller financial institutions. Because of the lack of a legal 
mechanism to resolve the so-called systemically important, 
regardless of past inefficiency or recklessness, nonviable 
institutions survive with the support of taxpayer funds. 
History has shown that Government policies should promote, not 
hamper, the closing and/or restructuring of weak institutions 
into stronger, more efficient ones. The creation of a systemic 
risk regulator could be counterproductive if it reinforced the 
notion that financial behemoths designated as systemic are, in 
fact, too big to fail.
    Congress' first priority should be the development of a 
framework which creates disincentives to size and complexity 
and establishes a resolution mechanism which makes clear that 
managers, shareholders, and creditors will bear the 
consequences of their actions.
    Thank you.
    Chairman Dodd. Thank you very much.
    Mr. Fryzel.

STATEMENT OF MICHAEL E. FRYZEL, CHAIRMAN, NATIONAL CREDIT UNION 
                         ADMINISTRATION

    Mr. Fryzel. Thank you, Chairman Dodd, Ranking Member 
Shelby, and Members of the Committee. As Chairman of the 
National Credit Union Administration, I appreciate this 
opportunity to provide the agency's position on regulatory 
modernization.
    Federally insured credit unions comprise a small but 
important part of the financial institution community, and I 
hope NCUA's perspective on this matter will add to the 
understanding of the unique characteristics of the credit union 
industry and the 90 million members they serve.
    The market dislocations underscore the importance of your 
review of this subject. I see a need for revisions to the 
current regulatory structure in ways that would improve Federal 
oversight of not just financial institutions, but the entire 
financial services market. My belief is that there is a better 
way forward, a way that would enable Federal regulators to more 
quickly and effectively identify and deal with developing 
problems.
    Before I express my views on possible reforms, I want to 
briefly update you on the condition of the credit union 
industry.
    Overall, credit unions maintained reasonable performance in 
2008. Aggregate capital level finished the year at 10.92 
percent, and while earnings decreased due to the economic 
downturn, credit unions still posted a 0.30 percent return on 
assets in 2008. I am pleased to report that even in the face of 
market difficulties, credit unions were able to increase 
lending by just over 7 percent. Loan delinquencies were 1.3 
percent, and charge-offs were 0.8 percent, indicating that 
credit unions are lending prudently.
    Credit unions are fundamentally different in structure and 
operation than other types of financial institutions. They are 
not-for-profit cooperatives owned and governed by their 
members. Our strong belief is that these unique and distinct 
institutions require unique and distinct regulation, 
accompanied by supervision tailored to their special way of 
operating.
    Independent NCUA regulation has enabled credit unions to 
perform in a safe and sound manner while fulfilling the 
cooperative mandate set forth by Congress. One benefit of our 
distinct regulatory approach is the 18-percent usury ceiling 
for Federal credit unions that enhances their ability to act a 
low-cost alternative to predatory lenders. Another is the 
existence of a supervisory committee for Federal charters, 
unique among all financial institutions. These committees, 
comprised of credit union members, have enhanced consumer 
protection by giving members peer review of complaints and have 
supplemented the ability of NCUA to resolve possible violations 
of consumer protection laws.
    NCUA administers the National Credit Union Share Insurance 
Fund, the Federal insurance fund for both Federal and State-
chartered credit unions. The fund currently has an equity ratio 
of 1.28 percent. The unique structure of the fund where credit 
unions make a deposit equal to 1 percent of their insured 
shares, augmented by premiums as needed, to keep the fund above 
a statutory level of 1.20 percent has resulted in a very stable 
and well-functioning insurance fund. Even in the face of 
significant stress in the corporate credit union part of the 
industry, stress that necessitated extraordinary actions by the 
NCUA board to stabilize the corporates, the fund has proven 
durable.
    I want to underscore the benefits of having the fund 
administered by NCUA. Working in concert with our partners in 
the State regulatory system, NCUA uses close supervision to 
control risks. This concept was noted prudently by GAO studies 
over the years, as were the benefits of a streamlined oversight 
and insurance function under one roof. This consolidated 
approach has enabled NCUA to manage risk in an efficient manner 
and identify problems in a way that minimizes losses to the 
fund.
    NCUA considers the totality of our approach for mixed 
deposit and premium funding mechanism to unify supervisory and 
insurance activities, to be the one that has had significant 
public policy benefits, and one worth preserving. Whatever 
reorganization Congress contemplates, the National Credit Union 
Share Insurance Fund should remain integrated into the Federal 
credit union regulator and separate from any other Federal 
insurance funds.
    Regarding restructuring of the financial regulatory 
framework, I suggest creating a single oversight entity whose 
responsibilities would include monitoring financial institution 
regulators and issuing principles-based regulations and 
guidance. The entity would be responsible for establishing 
general safety and soundness standards, while the individual 
regulators would enforce them in the institutions they 
regulated. It would also monitor systemic risks across 
institution types.
    Again, for this structure to be effective for federally 
insured credit unions and the consumers they serve, the 
National Credit Union Share Insurance Fund should remain 
independent in order to maintain the dual NCUA regulatory and 
insurance roles that have been tested and proven to work for 
almost 40 years.
    I appreciate the opportunity to provide testimony today and 
would be pleased to answer any questions.
    Chairman Dodd. Thank you very, very much.
    Dan Tarullo, thank you very much for being here on behalf 
of the Fed.

 STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF GOVERNORS OF 
                   THE FEDERAL RESERVE SYSTEM

    Mr. Tarullo. Thank you, Mr. Chairman, Senator Shelby, and 
Members of the Committee. We are here this morning because of 
systemic risk. We have had a systemic crisis. We are still in 
the middle of it, and I would endorse wholeheartedly Senator 
Shelby's three-part approach to responding to that crisis.
    In the weeks that I have been at the Federal Reserve, the 
discussions that have taken place internally, both among staff 
and among the members, have focused on the issue of systemic 
risk and how to prevent it going forward. The important point I 
would make as a prelude to our recommendations is that the 
source of systemic risk in our financial system has to some 
considerable extent migrated from traditional banking 
activities to markets over the last 20 or 25 years. If you 
think about the problems that led to the Depression, that were 
apparent even in the 1970s among some banks, the concern was 
that there would be a run on a bank, that depositors would be 
worried about the safety and soundness of that bank and that 
there would be contagion spreading to other institutions as 
depositors were uncertain as to the status of those 
institutions.
    What has been seen more recently is a systemic problem 
starting in the interactions among institutions in markets. 
Now, banks are participants in markets, so this can still be 
something that affects banks. But we have also seen other kinds 
of institutions at the source of the systemic problems we are 
undergoing right now.
    I think you cannot focus on a single institution or even 
just look at institutions as a series of silos, as it were, and 
concentrate solely on trying to assure their safety and 
soundness. We need to look at the interaction among 
institutions. Sometimes that means their actual counterparty 
relationships with one another. Sometimes it means the fora in 
which they interact with one another, in payment systems and 
the like. Sometimes it even means the parallel strategies which 
they may be pursuing--when, for example, they are all relying 
on the same sources of liquidity if they have to change their 
investing strategies. So they may not even know that they are 
co-dependent with other actors in the financial markets.
    For all of these reasons, our view is that the focus needs 
to be on an agenda for financial stability, an agenda for 
systemic risk management. I emphasize that because, although 
there is rightly talk about a systemic risk regulator, it is 
important that we understand each component of an agenda which 
is going to be fulfilled by all the financial regulators over 
which you have jurisdiction.
    So what do we mean by this agenda? Well, I tried in my 
testimony to lay out five areas in which we should pay 
attention. First, we do need effective consolidated supervision 
of any systemically important institution. We need consolidated 
supervision and it needs to be effective. There are 
institutions that are systemically important, and certainly 
were systemically important over the last few years, which were 
not subject to consolidated prudential supervision by any 
regulator.
    But that supervision needs to be effective. I think 
everybody is aware, and ought to be aware, of the ways in which 
the regulation and supervision of our financial institutions in 
recent years has fallen short. And unless, as Senator Shelby 
suggests, we all concentrate on it and reflect on it without 
defensiveness, we are not going to learn the lessons that need 
to be learned.
    Second, there is need for a resolution mechanism. I am 
happy to talk about that in the back and forth with you, but 
Comptroller Dugan and Chairman Bair have laid that out very 
well.
    Third, there does need to be more oversight of key areas in 
which market participants interact in important ways. We have 
focused in particular on payments and settlement systems, 
because there the Fed's oversight authority derives largely 
from the coincidence that some of the key actors happen to be 
member banks. But if they weren't, if they had another 
corporate form, there is no statutory authority right now for 
us to exercise prudential supervision over those markets in 
which problems can arise.
    Fourth, consumer protection. Now, consumer protection is 
not and should not be limited to its relationship with 
potential systemic risk. But, as the current crisis 
demonstrated, there are times in which good consumer protection 
is not just good consumer protection, but it is an important 
component of an agenda for containment of systemic risk.
    Fifth and finally is the issue of a systemic risk 
regulator. This is something that does seem to fit into an 
overall agenda. There are gaps in covering systemically 
important institutions. There are also gaps in attempting to 
monitor what is going on across the system.
    I think in the past there have been times at which there 
was important information being developed by various regulators 
and supervisors which, if aggregated, would have suggested 
developing issues and problems. But without a charge to one or 
more entities to try to put all that together, one risks 
looking at things, as I said, in a more siloed fashion. The 
extent of those authorities for a systemic risk regulator is 
something that needs to be debated in this Committee and in the 
entire Congress. But I do think that it is an important 
complement to the other components of this agenda and the 
improvements in supervision and regulation under existing 
authorities, and thus something that ought to be considered.
    I am happy to answer any questions that you may have.
    Chairman Dodd. Thank you very much.
    There will be three or four consecutive votes that are 
going to occur, so regretfully, we are going to have to recess, 
and when we get over there, there are going to be, 10-minute 
votes, not 15-minute votes. I apologize to our witnesses, but 
all of you have been here before in the past when this has 
occurred. We will have three or four votes--it may even be two, 
it may be a voice on one, so we may get back much more quickly, 
and we will pick up with Mr. Polakoff.
    The Committee will stand in recess.
    [Recess.]
    Chairman Dodd. Could I invite all of you to come back in, 
and let me tell you how we will proceed. I apologize to our 
witnesses. There is going to be another vote, but I thought we 
could complete the testimony from our witnesses, and by that 
time, the third vote might begin. I have been advised the 
members will stay over there for the vote rather than run back 
and forth. As I said, we will complete your testimony, and then 
we will engage in the questioning for the remainder of the 
time.
    Mr. Polakoff, we welcome you. Thank you.

  STATEMENT OF SCOTT M. POLAKOFF, ACTING DIRECTOR, OFFICE OF 
                       THRIFT SUPERVISION

    Mr. Polakoff. Good morning, Chairman Dodd. Thank you for 
inviting me to testify on behalf of OTS on ``Modernizing Bank 
Supervision and Regulation.''
    As you know, our current system of financial supervision is 
a patchwork with pieces that date back to the Civil War. If we 
were to start from scratch, no one would advocate establishing 
a system like the one we have, cobbled together over the last 
century and a half. The complexity of our financial markets has 
in some cases reached mind-boggling proportions. To effectively 
address the risks in today's financial marketplace, we need a 
modern, sophisticated system of regulation and supervision that 
applies evenly across the financial services landscape.
    Our current economic crisis enforces the message that the 
time is right for an in-depth, careful review and meaningful, 
fundamental change. Any restructuring should take into account 
the lessons learned from this crisis. At the same time, the OTS 
recommendations that I am presenting here today do not 
represent a realignment of the current regulatory structure. 
Rather, they represent a fresh start using a clean slate. They 
represent the OTS vision for the way financial services 
regulation in this country should be. In short, we are 
proposing fundamental changes that would affect virtually all 
of the current financial regulators.
    It is important to note that these are high-level 
recommendations. Before adoption and implementation, many 
details would need to be worked out and many questions would 
need to be answered.
    The OTS proposal for modernization has two basic elements. 
First, a set of guiding principles, and second, recommendations 
for Federal bank regulation, holding company supervision, and 
systemic risk regulation. So what I would like to do is offer 
the five guiding principles.
    Number one, a dual banking system with Federal and State 
charters for banks.
    Number two, a dual insurance system with Federal and State 
charters for insurance companies.
    Number three, the institution's operating strategy and 
business model would determine its charter and identify its 
responsible regulatory agency. Institutions would not simply 
pick their regulator.
    Number four, organizational and ownership options would 
continue, including mutual ownership, public and private stock 
entities, and Subchapter S corporations.
    And number five, ensure that all entities offering 
financial products are subject to the consistent laws, 
regulations, and rigor of regulatory oversight.
    Regarding our recommendations on regulatory structure, the 
OTS strongly supports the creation of a systemic risk regulator 
with authority and resources to accomplish the following three 
functions.
    Number one, to examine the entire conglomerate.
    Number two, to provide temporary liquidity in a crisis.
    And number three, to process a receivership if failure is 
unavoidable.
    For Federal bank regulation, the OTS proposes two charters, 
one for banks predominately focused on consumer and community 
banking products, including lending, and the other for banks 
primarily focused on commercial products and services. The 
business models of the commercial bank and the consumer and 
community bank are fundamentally different enough to warrant 
two distinct Federal banking charters. These regulators would 
each be the primary Federal supervisor for State chartered 
banks with the relevant business models.
    A consumer and community bank regulator would close the 
gaps in regulatory oversight that led to a shadow banking 
system of uneven regulated mortgage companies, brokers, and 
consumer lenders that were significant causes of the current 
crisis. This regulator would also be responsible for developing 
and implementing all consumer protection requirements and 
regulations.
    Regarding holding companies, the functional regulator of 
the largest entity within a diversified financial company would 
be the holding company regulator.
    I realize I have provided a lot of information and I look 
forward to answering your questions, Mr. Chairman.
    Chairman Dodd. Thank you very, very much.
    Mr. Smith, welcome to the Committee.

STATEMENT OF JOSEPH A. SMITH, JR., NORTH CAROLINA COMMISSIONER 
                OF BANKS, AND CHAIR-ELECT OF THE
              CONFERENCE OF STATE BANK SUPERVISORS

    Mr. Smith. Thank you, Mr. Chairman. I am Joe Smith. I am 
North Carolina Commissioner of Banks and Chair-Elect of the 
Conference of State Bank Supervisors, on whose behalf I am 
testifying. I very much appreciate this opportunity.
    My colleagues and I have submitted to you written 
testimony. I will not read it to you today.
    Chairman Dodd. Thank you.
    Mr. Smith. I would like to emphasize a few points that are 
contained in it.
    The first of these points is that proximity, or closeness 
to the consumers, businesses, and communities that deal with 
our banks is important. We acknowledge that a modern financial 
regulatory structure must deal with systemic risks presented by 
complex global institutions. While this is necessary, sir, we 
would argue that it is not itself sufficient.
    A modern financial regulatory structure should also 
include, and as more than an afterthought, the community and 
regional institutions that are not systemically significant in 
terms of risk but that are crucial to effectively serving the 
diverse needs of our very diverse country. These institutions 
were organized to meet local needs and have grown as they have 
met such needs, both in our metropolitan markets and in rural 
and exurban markets, as well.
    We would further suggest that the proximity of State 
regulators and attorneys general to the marketplace is a 
valuable asset in our efforts to protect consumers from fraud, 
predatory conduct, and other abuses. State officials are the 
first responders in the area of consumer protection because 
they are the nearest to the action and see the problems first. 
It is our hope that a modernized regulatory system will make 
use of the valuable market information that the States can 
provide in setting standards of conduct and will enhance the 
role of States in enforcing such standards.
    To allow for this system to properly function, we strongly 
believe that Congress should overturn or roll back the OTS and 
OCC preemption of State consumer protection laws and State 
enforcement.
    A second and related point that we hope you will consider 
is that the diversity of our banking and regulatory systems is 
a strength of each. One size does not fit all, either with 
regard to the size, scope, and business methods of our banks or 
the regulatory regime applicable to them.
    We are particularly concerned that in addressing the 
problems of complex global institutions, a modernized financial 
system may inadvertently weaken community and regional banks by 
under-support for the larger institutions and by burdening 
smaller institutions with the costs of regulation that are 
appropriate for the large institutions, but not for the smaller 
regional ones.
    We hope you agree with us that community and regional banks 
provide needed competition in our metropolitan markets and 
crucial financial services in our smaller and more isolated 
markets. A corollary of this view is that the type of 
regulatory regime that is appropriate for complex global 
organizations is not appropriate for community and regional 
banks. In our view, the time has come for supervision and 
regulation that is tailored to the size, scope, and complexity 
of a regulated enterprise. One size should not and cannot be 
made to fit all.
    I would like to make it clear that my colleagues and I are 
not arguing for preservation of the status quo. Rather, we are 
suggesting that a modernized regulatory system should include a 
cooperative federalism that incorporates both national 
standards for all market participants and shared responsibility 
for the development and enforcement of such standards. We would 
submit that the shared responsibility for supervising State 
charter banks is one example, current example, of cooperative 
federalism and that the developing partnership between State 
and Federal regulators under the Secure and Fair Enforcement 
for mortgage licensing, or SAFE Act, is another.
    Chairman Dodd, my colleagues and I support this Committee's 
efforts to modernize our Nation's financial regulatory system. 
As always, sir, it is an honor to appear before you. I hope 
that our testimony is of assistance to the Committee and would 
be happy to answer any questions you may have. Thank you very, 
very much.
    Chairman Dodd. Thank you very much, Mr. Smith.
    We don't say this often enough in the Committee. The 
tendency today is to use the word ``bank,'' and I am worried 
about it becoming pejorative. There are 8,000 banks and I think 
there are 20--Governor Tarullo can correct me on this--that 
control about 70 to 80 percent of all the deposits in the 
country. The remaining 7,000-plus are regional or community 
banks. They do a terrific job and have been doing a great job. 
And the tendency to talk about lending institutions in broad 
terms is not fair to a lot of those institutions which have 
been very prudent in their behavior over the last number of 
years and it is important we recognize that from this side of 
the dais. And so your comments are appreciated.
    Mr. Reynolds.

STATEMENT OF GEORGE REYNOLDS, CHAIRMAN, NATIONAL ASSOCIATION OF 
STATE CREDIT UNION SUPERVISORS, AND SENIOR DEPUTY COMMISSIONER, 
           GEORGIA DEPARTMENT OF BANKING AND FINANCE

    Mr. Reynolds. Chairman Dodd, I appear today on behalf of 
NASCUS, the professional association of State Credit Union 
Regulators. My comments focus solely on the credit union 
regulatory structure and four distinct principles vital to the 
future growth and safety and soundness of State chartered 
credit unions.
    NASCUS believes regulatory reform must preserve charter 
choice and dual chartering, preserve the States' role in 
financial regulation, modernize the capital system for credit 
unions, and maintain strong consumer protections.
    First, preserving charter choice is crucial to any 
regulatory reform proposal. Charter choice is maintained by an 
active system of federalism that allows for clear 
communications and coordination between State and Federal 
regulators. Congress must continue to recognize and affirm the 
distinct roles played by State and Federal regulatory agencies. 
The Nation's regulatory structure must enable State credit 
union regulators to retain their regulatory authority over 
State-chartered credit unions. Further, it is important that 
new polices do not squelch the innovation and enhanced 
regulatory structure provided by the dual chartering system.
    The second principle I will highlight is preserving the 
State's role in financial regulation. The dual chartering 
system is predicated on the rights of States to authorize 
varying powers for their credit unions. NASCUS supports State 
authority to empower credit unions to engage in activities 
under State-specific rules. States should continue to have the 
authority to create and to maintain appropriate credit union 
powers in any new regulatory reform structure. Preemption of 
State laws and the push for more uniform regulatory systems 
will negatively impact our Nation's financial services industry 
and ultimately consumers.
    The third principle is the need to modernize the capital 
system of credit unions. We encourage Congress to include 
capital reform as part of the regulatory modernization process. 
State credit union regulators are committed to protecting 
credit union safety and soundness. Allowing credit unions to 
access supplemental capital would protect the credit union 
system and provide a tool for regulators if a credit union 
faces declining network or liquidity needs. Further, it will 
provide an additional layer of protection to the National 
Credit Union Share Insurance Fund, the NCUSIF, thereby 
maintaining credit unions' independence from the Federal 
Government and taxpayers.
    A simple fix to the definition of ``net worth'' in the 
Federal Credit Union Act would authorize regulators the 
discretion, when appropriate, to allow credit unions to use 
supplemental capital.
    The final principle I will discuss is the valuable role 
States play in consumer protection. Many consumer protection 
programs were designed by State legislators and State 
regulators to protect citizens in their States. The success of 
State programs have been recognized at the Federal level when 
like programs have been introduced. It is crucial that State 
legislatures have the primary role to enact consumer protection 
statutes for their residents and to promulgate and enforce 
State regulations.
    I would also mention that both State and Federal credit 
unions have access to the NCUSIF. federally insured credit 
unions capitalize this fund by depositing 1 percent of their 
shares into the fund. This concept is unique to credit unions 
and it minimizes exposure to the taxpayers. Any modernized 
regulatory system should recognize the NCUSIF. NASCUS and 
others are concerned about any proposal to consolidate 
regulators and eliminate State and Federal credit union 
charters.
    As Congress examines a regulatory reform system for credit 
unions, the following should be considered. Enhancing consumer 
choice provides a stronger financial regulatory system. 
Therefore, charter choice and dual chartering must be 
preserved. Preservation of the State's role in financial 
regulation is vital. Modernization of the capital system for 
credit unions is critical for safety and soundness. And strong 
consumer protection should be maintained, and these should be 
protected against Federal preemption.
    NASCUS appreciates the opportunity to testify and share our 
priorities. We urge the Committee to be watchful of Federal 
preemption and to remember the importance of dual chartering 
and charter choice in regulatory modernization. Thank you.
    Chairman Dodd. Thank you very much, Mr. Reynolds, and 
again, my appreciation to all of you here this morning. We are 
going to have an ongoing conversation with you as I know all of 
my colleagues are interested--deeply interested--in the subject 
matter of modernization of financial regulation. We are going 
to want to have as many conversations as we can with you as we 
move forward on how to develop these ideas. We all understand 
the critical importance of this and all of you can play a very 
critical role in helping us.
    Let me begin, if I can, with the issue of regulatory 
arbitrage, because all of you in your testimony addressed this 
issue as forum shopping. In 1994, when this Committee 
considered legislation to comprehensively reform of the 
financial regulatory system, then-Treasury Secretary Lloyd 
Bentsen appeared before the Committee, and let me quote him for 
you on that day, some 15 years ago. He said, ``What we are 
seeing is a situation that enables banks to shop for the most 
lenient Federal regulator.''
    In those very same hearings on that very same proposal, the 
Chairman of the Federal Reserve, at the time Alan Greenspan, 
said the following, and I am quoting him, ``Every bank should 
have a choice of Federal regulator.''
    So let me ask the panel here very quickly, beginning with 
you, Mr. Dugan, with whom do you agree? Should financial 
institutions be allowed to choose their regulators, leading to 
a potential race to the bottom, or should we attempt to end the 
regulatory arbitrage that is going on?
    Mr. Dugan. Well, I guess what I would say is this. 
Institutions should not be able to, when they have a problem 
with that one regulator, to leave that regulator to go to 
another regulator where they think they are not going to have 
the problem.
    I will say from the point of view of the OCC, we don't have 
any ability to stop someone from leaving, but we have ample 
authority to stop them from coming in and we exercise it. And 
so we will not allow someone to transfer in and become a 
national bank unless they have resolved their problems with 
their own institution and we make that clear, and we have had 
during my tenure as Comptroller several instances of companies 
wanting to come in and deciding not to when they realize that 
that would be the case. It is not a good situation to have 
people try to leave one problem to go to another.
    I am not sure you have to have only one charter to solve 
that problem. I think there are other ways to solve it where it 
does occur and I think there can be some benefits that some 
charters offer over others that are not what I just spoke 
about, and in those cases, I think that is a good thing. But it 
has to be clear. To go to the competition at the bottom, I 
think is a bad thing.
    Chairman Dodd. Yes. Chairman Bair.
    Ms. Bair. Yes. I think the problems with regulatory 
arbitrage have been more severe regarding banks than nonbanks, 
especially on capital constraints--leverage constraints--
certainly with regard to investment banks versus commercial 
banks, and bank mortgage lenders versus nonbank mortgage 
lenders with regard to lending standards. So I think there 
needs to be some baseline standards that apply to all types of 
financial institutions, especially with consumer protection and 
basic prudential requirements, such as capital standards.
    I think there are still some problems within the category 
of banks. We have four different primary regulators now and I 
think there have been some issues. There have been issues we 
have seen with banks converting charters because they fear 
perhaps the regulatory approach by one regulator. We have seen 
banks convert charters in order to get preemption, which is not 
always a good thing.
    So I think there is more work to be done here. Part of that 
may be Congress's call in terms of whether they want to 
establish basic consumer protections that cannot be preempted--
whether you want Federal protection to be a floor or a ceiling 
for consumer protection. I think among us as regulators, we 
could do more to formalize agreements among ourselves that we 
will respect each other's CAMELS ratings and enforcement 
actions even if a charter is converted to remove the bad 
incentives for charter conversion.
    So I think there are some steps to be taken, but I do agree 
with what Joe said, we need both State and Federal charters. 
There is a long history of the dual banking system in the 
United States and I think that should be preserved.
    Chairman Dodd. You mentioned the four bank regulators, and 
I think Mr. Dugan made the point earlier that this could be a 
briefer hearing----
    [Laughter.]
    Chairman Dodd. ----given the fact that we have the four 
regulators involved in all of this. Is this making any sense at 
all? And I am not jumping to one, but maybe the question ought 
to be what do we need out there to provide the safety and 
soundness and consumer protection. And I am not interested in 
just moving boxes around--take four and make it one--as 
attractive as that may seem to people, because that may defeat 
the very purpose of why we gather and talk about this issue.
    But the question is a basic one. Do we have too many 
regulators here and has that contributed, in your view, Sheila, 
to some of the issues we are confronting?
    Ms. Bair. I think that you probably could have fewer bank 
regulators. I do think you need at least a national and a State 
charter. I think you should preserve the dual structure. But I 
also think in terms of the immediate crisis, the bigger 
problems are with the bank versus nonbank arbitrage, not 
arbitrage within the banking system.
    Chairman Dodd. Yes, Mr. Fryzel.
    Mr. Fryzel. Thank you, Senator. I agree with my colleagues 
that there should be the dual chartering system between State 
and Federal banks as well as credit unions. Chairman Bair says 
that there probably are too many bank regulators. Well, 
fortunately, we only have one credit union regulator, so I 
think that is something we should maintain.
    But again, I think we need to look at where are the 
problems? Which regulator perhaps hasn't done the job that they 
should have done, and maybe that is where the correction should 
be. I think the majority of regulators have done the best they 
possibly can considering what the circumstances are. I think 
they have taken the right types of moves to correct the 
situation that is out there with the economy the way it is.
    But for restructuring, I think we need to see where is the 
problem. Is it with the banks? Is it with the insurance 
companies? Is it with other types of financial institutions, 
and address that. And then making that improvement, determine 
whether or not we need the systemic risk regulator above these 
other institutions.
    Chairman Dodd. Governor.
    Mr. Tarullo. Thank you, Mr. Chairman. I agree with my 
colleagues that we should not undermine the dual banking system 
in the United States, and so you are going to have at least two 
kinds of charters. It does seem to me, though, that the 
question is not so much one of can an institution choose, but 
what constraints are placed upon that choice.
    So, for example, under current law, with the improvements 
that were made to the Federal Deposit Insurance Act following 
the savings and loan crisis, there are now requirements on 
every federally insured institution that apply whether you are 
a State or a Federal bank. I think that Chairman Bair was 
alluding to some areas in which she might like to see more 
constraints within the capacity to choose, so that a bank 
cannot escape certain kinds of rules and regulations by moving 
from one charter to another.
    Chairman Dodd. Well, to make a distinction here, I do not 
know that anyone is really going to argue about the idea of 
having State-chartered and nationally chartered institutions, 
but are you suggesting having separate regulators, or could we 
talk about a common regulator and dual charters?
    Mr. Dugan. I think you have choices. Basically, of the four 
regulators of banks, you have two for Federal charters, two for 
State charters, and the question is: Does that make sense? You 
could have a single one for Federals; you could have a single 
one for States; you could have a single that cuts across all of 
them and still have two charters.
    There are complexities and issues with respect to each of 
those, and I should not leave out you have 12 Federal Reserve 
banks.
    Chairman Dodd. No. I know.
    Mr. Dugan. Which is another set of people at the table.
    Chairman Dodd. Right.
    Mr. Dugan. My own view, I think there are too many. I agree 
with Chairman Bair. I do not think that was a substantial cause 
of the problems that we have seen, but if you are looking at 
creating more efficiency and providing a system that is more 
flexible and works better, I think you do not need--we do not 
have four FDAs.
    Chairman Dodd. Would you agree with that, Sheila, that you 
can have a common regulator and dual charters?
    Ms. Bair. Well, I think it is tricky with the State charter 
we should not leave out the 50 State regulators. The Fed and 
the FDIC partner with the State regulators in our examination 
activities. So I think you could certainly consolidate all the 
Federal oversight with one Federal regulator. We would still, I 
assume, if you preserve a State charter, have shared 
responsibilities with the State regulator. And so there has 
been historical competition between national and State charters 
that----
    Chairman Dodd. Doesn't that lend itself to shopping again 
here? The point that Mr. Dugan raised here, that the FDA does 
not have a national regulator and a State regulator when it 
comes to food and drug safety. Why not financial products? Why 
shouldn't they be as safe?
    Ms. Bair. I think for the smaller banks, for the community 
banks, they like having the state option.
    Chairman Dodd. Yes.
    Ms. Bair. They like having the State option. They like 
having the regulator that is a little closer, more local to 
them, more accessible to them. So I think there are some 
benefits and I strongly support continuation of the community 
banking sector here, and I think maintaining the State charter 
is essential to that.
    Chairman Dodd. Let me jump----
    Mr. Polakoff. Mr. Chairman, if I could offer--in our 
written testimony--and I tried to synopsize it in my oral--we 
believe the dual banking system, State and Federal, makes 
sense. But we believe that the business model and the strategy 
of the organization should then dictate what regulatory agency 
oversees it.
    So from our perspective, there is a clear distinction 
between a commercial bank and a community and consumer bank. 
And it does not make a difference whether it is a Federal 
charter or State charter. Under our approach, we would submit 
to you that you have a Federal regulator and a Federal charter 
for commercial banks. And you have the same for community and 
consumer banks. And then if it is a State-chartered entity that 
fits one of those two business strategies, the relevant Federal 
regulator works with it.
    So it retains the dual banking system. It prevents the 
ability of the individual institution to select a regulator. 
Instead, this schematic would suggest that the business 
strategy determines the regulator.
    Chairman Dodd. That is a good point. Let me finish up, and 
I apologize to my colleagues. I will just get the comments and 
then go quickly to the----
    Mr. Smith. I would say that as a State charterer who has 
good experience with both of our Federal colleagues, we need to 
say that the current State system involves what we have called 
constructive or cooperative federalism now, and State-chartered 
banks are not exempt or are not free from federally enforced 
standards.
    Chairman Dodd. Right.
    Mr. Smith. And to be frank, we are grateful we have been 
included in the FFIC because in that case we work with our 
Federal colleagues to establish standards that we understand 
have to apply across the board. As I say in my testimony, we 
understand we have got to raise our game. In other words, we 
understand that going forward, working with our Federal 
colleagues, we would like to have a place in setting national 
standards and in enforcing them. But I think actually even in 
light of the current problems we have, the system has, the 
State system, in partnership with the Fed and the FDIC, is 
holding up so far. We have got our issues, but we are holding 
up pretty well. So I think there is a question in the future 
about our continuing to work more cooperatively with our 
Federal partners, and I think that can help.
    Chairman Dodd. Mr. Reynolds.
    Mr. Reynolds. Well, my observation, as a regulator that has 
been involved in financial institution regulation for over 30 
years, is that we do not have any tolerance for forum shopping; 
we do not have any tolerance for trying to arbitrage safety and 
soundness. And it has been my experience in dealing with other 
State regulators that that same approach applies.
    I think the State system does provide choice, but I do not 
believe there is any tolerance for that type of behavior in a 
State system.
    Chairman Dodd. Thanks very much.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I thank all of 
you for your testimony and your service.
    Ms. Bair, Chairman Bair, let me ask you this: Do you think 
that not having an entity that can do the overall resolution 
for complex entities is affecting the policies that we have in 
place right now as it relates to supporting them?
    Ms. Bair. It absolutely is. There is really no practical 
alternative to the course that has been set right now, because 
there is no flexibility for resolution.
    Senator Corker. So much of the actions that we are taking 
as a Congress and as an administration to support some of these 
entities have to do with the fact that we really do not have 
any way to unwind them in a logical way. Is that correct?
    Ms. Bair. I do agree with that.
    Senator Corker. I know the Chairman mentioned the potential 
of FDIC being the systemic regulator. What would be the things 
that the FDIC would need to do to move beyond bank resolution 
but into other complex entities like AIG, Lehman Brothers, and 
others?
    Ms. Bair. Right. Well, we think that if we had resolution 
authority, we actually should be separate from where we have 
the requirements for prudential supervision of systemic 
institutions. Those responsibilities are actually separated 
now, and I think it is a good check and balance to have the 
resolution authority with some back-up supervisory authority 
working in conjunction with the primary regulator who has 
responsibility for prudential supervision.
    In terms of resolution authority, I think that the current 
system--that we would like--if we were given it, is a good one. 
We can set up bridge banks, or conservatorships to provide for 
the orderly unwinding of institutions. There is a clear set of 
priorities, so investors and creditors know in advance what the 
imposition of loss will be. We do have the flexibility to 
deviate from that, but it is an extraordinary process that 
includes a super majority of the FDIC Board, the Federal 
Reserve Board, the concurrence of the Secretary of the Treasury 
and the President. So it is a very extraordinary procedure to 
deviate from the baseline requirement to minimize cost.
    So I think the model we have now is a good one and could be 
applied more broadly to complex financial organizations.
    Senator Corker. It sounds like in your opinion in a fairly 
easy way.
    Ms. Bair. Well, I think one easy step would be just to give 
us authority to resolve bank and thrift holding companies. I 
think that would be--I think there are going to be larger, more 
complex issues in terms of going beyond that category, what is 
systemic when you talk about insurance companies, hedge funds, 
other types of financial institutions. But, yes, I think that 
would be a relatively simple step that would give us all some 
additional flexibility, yes.
    Senator Corker. Thank you
    Mr. Dugan, you know, we talk about capital requirements and 
institutions, but regardless of the capital that any particular 
institution has, if they make really bad loans or make really 
bad decisions, it really does not matter how much they have, as 
we have seen, right? Are we focusing enough on minimum lending 
standards as we think about the overall regulation of financial 
institutions?
    Mr. Dugan. I think that is a very good question. I think 
capital is not enough by itself. I think you are right. And as 
I mentioned in my testimony, in the area of mortgages, I think 
if we had had or if we would have in the future some sort of 
more national standard in the area of--and if I think of two 
areas going back that I wish we had over again 10 years ago, it 
is in the area of stated income or no-documentation loans, and 
it is in the area of loan-to-value ratios or the requirement 
for a significant downpayment. Those are underwriting 
standards. They are our loan standards, and I think if we had 
more of a national minimum, as, for example, they have had in 
Canada and as we had in the GSE statutes for GSE conforming 
loans, I think we would have had far fewer problems. Now, fewer 
people would have gotten mortgages, and there would have been 
fewer people that would have been able to purchase homes, and 
there would be pressure on affordability. But it would have 
been a more prudent, sound, underwriting standard that would 
have protected us from a lot of problems.
    Senator Corker. I hope as we move forward with this you 
will continue to talk about that, because I think that is a 
very important component that may be left by the wayside. And I 
hope that all of us will look at a cause-neutral solution going 
forward. Right now we are focused on home mortgages and credit 
default swaps. But we do not know what the next cause might be.
    Mr. Tarullo, you mentioned something about credit default 
swaps, and I am not advocating this, but I am just asking the 
question. In light of the fact that it looks like as you go 
down the chain, I mean, we end up having far more credit 
default swap mechanisms in place than we have actual loans or 
collateral that is being insured, right? I mean, it is 
multiplied over and over and over. And it looks like that the 
person that is at the very end of the chain is kind of the 
greater fool, OK, because everybody keeps laying off.
    Is there any thought about the fact that credit default 
swaps may be OK, but the only people who should enter into 
those arrangements ought to be people that actually have an 
interest in the actual collateral itself and that you do not, 
in essence, put in place this off-racetrack-betting mechanism 
that has nothing whatsoever to do with the collateral that is 
being insured itself? Have there been any thoughts about that?
    Mr. Tarullo. Senator, I think that issue has been 
investigated and discussed by a number of people, in and out of 
the Government. Here, I think, are the issues.
    There is a group of market actors who have a reason why 
they want to hedge a particular exposure or instrument, and the 
most efficient way for them to do that is to have a credit 
default swap associated with a particular institution or 
product, even when they do not own the underlying product 
because there is a relationship.
    The difficulty, as a lot of people have pointed out, would 
come in trying to craft a rule which would allow that to occur 
while ending the kind of practice that I think you are worried 
about, which is much less tethered to a hedging strategy.
    I do think when it comes to credit default swaps, we can 
make a couple of observations, though. One, they do underscore, 
again, the importance of monitoring and overseeing the arenas 
in which big market actors come together. Making sure that 
there is a central counterparty, for example, helps to contain 
some of the risks associated with the use of credit default 
swaps.
    And, second, the problems with credit default swaps that we 
associate with this crisis did not come from institutions that 
were being regulated by Mr. Dugan, for example, or bank holding 
companies being regulated by the Fed. What does that tell you? 
It tells us that although looking at the interaction of 
entities is important, you still should do good, solid 
supervision of particular institutions. And if they have 
capital requirements and liquidity requirements and good risk 
management practices, then whatever use a particular trade an 
entity is putting a credit default swap to, we will not allow 
them to acquire too much exposure.
    Senator Corker. Mr. Chairman, my time is up. Thank you.
    Chairman Dodd. Senator Warner. And let me just say what I 
am going to do, this vote has started. I am going to go over 
and make the vote and come right back. So if you finish up, 
Senator Merkley, you may have time for questions as well, and I 
will try and get right back with other members as well.
    Senator Warner.
    Senator Warner. Well, Thank you, Mr. Chairman, and thank 
you for holding this hearing and for your leadership in the 
reform efforts that are going forward.
    I know the subject today is how do we reform on a 
prospective basis, but in the interim, as we have seen with the 
public and congressional outrage over AIG and with certain 
other actions by a number of our institutions, until we get 
this new regulatory structure in place, what I think we keep 
hearing is, well, we do not really have any tools to stop these 
actions.
    One area that I have had some folks talk to me about--and I 
would like to get your opinion--is that under the Federal 
Deposit Insurance Act--which obviously all of the Federal 
regulators have the ability to enforce, not only the FDIC but 
the OCC, OTS, and the Fed--my understanding is regulators do 
have at least the statutory ability to issue cease and desist 
orders to institutions or individuals if somebody has engaged 
in unsafe or unsound practices, if somebody has engaged in a 
breach of their fiduciary duty, or if somebody has received 
financial gain or other benefits that show willful disregard 
for the safety and soundness of the institution.
    And I understand that, you know, the case law is fairly 
narrow here, but my understanding of the remedies you have got 
is you can ban somebody from banking, you can get restitution, 
you can impose a series of other penalties. But, boy, oh, boy, 
with narrow case law, it sure does seem that some of the 
actions that have taken place--and, again, case in point being 
AIG, and I know the fact that it was offshore, off balance 
sheet, in the London derivatives entity, but it sure seems like 
this tool could be used or could be pushed because there sure 
has been a whole lot of activities that have led to either 
financial enrichment or unsound practices, at least in 
retrospect now. And I just question, you know, have you thought 
through this tool. Have you investigated it? Have you not used 
it because you felt that there would be--the case law would not 
allow it? And why not take a little bit of risk in pushing the 
edge, particularly with the amount of abuse and the amount of 
public outrage that we see today?
    Mr. Polakoff, do you want to start? And I would love to 
hear from all of the regulators.
    Mr. Polakoff. Senator, if I could offer some thoughts 
regarding AIG, as you know, September 15, 2008, with the 
Government's action, caused AIG to no longer be a savings and 
loan holding company. So 6 months have passed since that time.
    I can assure that if AIG was still a savings and loan 
holding company, we would have taken enforcement action under 
safety and soundness to say those bonuses were an unsafe and 
unsound practice and would not have allowed it. But it is not a 
savings and loan holding company.
    Senator Warner. I know the Government owns it, but even 
though the fact that there is a Treasury-owned trust, you say 
that--I know you testified here a week ago that, yes, you had 
oversight over AIG and maybe you have missed a bit. And now you 
are saying you have no regulatory ability to take any of these 
actions?
    Mr. Polakoff. Once the Government took ownership, by 
statute it is no longer a savings and loan holding company.
    Senator Warner. But the Government--again, I know you would 
know the law better than I, but I thought the Government has 
not taken full ownership, that there is still a trust in which 
the Treasury and others help put members. But you are saying--
even though the trust is an independent trust, it is not owned 
entirely and controlled entirely by the Government. As an 
independent trust, wouldn't you still have regulatory----
    Mr. Polakoff. No. Our legal analysis says that the control 
is with the Government. I mean, we would be thrilled if we 
could get to the legal status that it is still a savings and 
loan holding company. It would allow us to take action.
    Senator Warner. Let me hear from the regulators on the 
panel whether beyond just the AIG specific example, whether 
this tool--whether you have thought through using this tool as 
we have seen other actions, AIG being the most egregious, but 
there are other institutions that I think fall into that 
category. Ms. Bair?
    Ms. Bair. Well, I would say the FDI Act applies to 
depository institutions, and obviously AIG had a small thrift, 
a depository institution regulated by OTS, and OTS was their 
holding company regulator.
    Senator Warner. Right.
    Ms. Bair. But our authority as back-up supervisor and 
primary Federal regulator of nonmember State-chartered banks is 
only to the depository institution.
    When we take a bank over as receiver or conservator, we 
have separate authorities to repudiate all employment 
contracts. Typically, the boards are gone, obviously. The 
senior management is generally let go. And those who were 
responsible for the bank's problems are typically let go as 
well.
    We very aggressively pick and choose who we want to keep 
and who we think needs to leave when an institution fails and 
we become receiver or conservator. So we do use it in that 
context.
    Again, that is just for a bank, the depository institution 
part, and AIG certainly was a much larger entity.
    Senator Warner. But since the Fed and the OCC also, I 
believe, enforce this act, have you thought through using this 
tool for actions that you may find to be unsafe or where 
individuals might have received financial benefit with willful 
disregard to the safety and soundness of the underlying 
institution?
    Mr. Tarullo. I think, Senator, your question raises two 
questions: one about where we are now, but an important one 
about going forward as well.
    As to where we are now in respect to the compensation 
issues, by and large, as you know, those have been for TARP 
recipient institutions; those have been things that are either 
congressionally mandated or put in place by the Treasury 
Department. And so far as I am aware, with respect to 
institutions over which the Fed has regulatory authority, there 
has not been thought of going beyond the congressional and 
Treasury policies on compensation.
    I think, though, that the larger question you raise is one, 
again, of regulatory gaps. As Chairman Bair said, in order to 
be able to exercise any authority, you have got to have the 
basic supervisory structure in place. And so, thinking about 
where problems which anticipate today are going to arise 
underscores the importance of making sure that each of these 
systemically important institutions is, in fact, subject to the 
kinds of rules that you are talking about.
    Senator Warner. Mr. Dugan, I know our time has about 
expired, but I just----
    Mr. Dugan. Yes, well, we have a range of tools, of course, 
both informal and formal, for a number of different things. But 
in the compensation area, to find willful disregard that causes 
a safety and soundness problem is, in fact, a quite high 
standard to meet. There is separate authority under Part 30 of 
the Federal Deposit Insurance Act that the so-called safety and 
soundness standards that were adopted in FDICIA, also a 
somewhat lower standard but still tied to the safety and 
soundness of the institution, that possibly you could make a 
connection to. And we do look at these, but as I said, to make 
that connection to the safety and soundness is not an easy 
thing to do.
    Senator Warner. My only sense--and I would love to pursue 
this a bit more--is that we all understand we have got to fix 
this problem on a prospective basis. But there is still an 
interim time between now and when Congress would act and these 
new rules and regulations would be in place. I would just urge 
you to perhaps revisit with your legal staffs this tool 
because, as we have seen, it is not healthy for the public's 
confidence in the overall financial system when we see the kind 
of excesses and everybody saying we do not have any tools to go 
after this, when it appears there may be at least partial tools 
still here.
    Ms. Bair. And I just wanted to re-emphasize what I had 
indicated earlier about our lack of resolution authority that 
applies to the entire organization.
    Senator Warner. Absolutely. Very valid----
    Ms. Bair. The FDIC has very broad authority to repudiate 
these contracts at the discretion of the receiver/conservator. 
I think AIG is a good example. If the bank regulators had 
resolution authority of the entire organization, probably this 
problem would not----
    Senator Warner. Very, very valid point. But, again, we 
still have some interim period that may be a long period of 
months, and if the public has lost all confidence in the 
fairness and soundness of the actions of some actors in the 
financial community, it is going to make our challenge and task 
in terms of striking that appropriate balance between the free 
market system and appropriate regulatory oversight even more 
difficult going forward. So thank you very much.
    Senator Reed [presiding]. Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair.
    Very quick responses, because I understand it is 4 minutes 
until the closing of the vote. Chairman Bair, you noted the 
need to address the issue of ``too big to fail,'' and I believe 
talked in your testimony about increasing financial obligations 
as the size of organizations creates greater risk and perhaps 
regulating the public funds available to very large financial 
institutions.
    Do we need to also explore the issue of how mergers and 
acquisitions affect the growth of individual institutions? Is 
there any point in the process of a firm growing through 
mergers or acquisitions that this issue needs to be addressed? 
And I would open that up to any of you, and please speak 
quickly.
    Ms. Bair. Right, and I will speak quickly and turn it over 
to Dan because the Fed reviews merger and acquisition activity. 
But, yes, I think that is part of it. I think compensation tied 
to successful mergers and acquisitions, executive compensation 
tied to growth for the sake of growth is another area that I 
think has fed into this current problem we have.
    Senator Merkley. Did I catch you right that executive 
compensation as it is tied into growth?
    Ms. Bair. As it is tied into merger activity and growth, 
yes, I think that help feeds the beast. I do.
    Senator Merkley. Thank you.
    Mr. Tarullo. Certainly, Senator, with respect to mergers 
under the Bank Holding Company Act, there ought to be and is 
scrutiny under the anti-trust laws to determine whether there 
are going to be anti-competitive consequences to the merger. 
But you should understand that the competition analysis as it 
is put forth in the statute does not in itself directly feed 
into the issues of size and systemic risk. And so there does 
need to be an independent focus on systemic risk beyond the 
traditional anti-trust question of whether a merger would 
reduce competition in a particular market.
    Senator Merkley. Does anyone else want to add to that?
    Mr. Polakoff. Senator, I would just say real quick that for 
thrifts or savings and loan holding companies where there is a 
merger, there is absolutely an assessment of what the 
consolidated risk profile looks like and the competency of 
management. And I think all the regulators go through that 
analysis with a merger.
    Senator Merkley. So you feel like this--in your case, you 
are saying it has really been addressed in the past, we have 
done a great job, and no need to change any particular approach 
to that issue?
    Mr. Polakoff. When it comes to mergers, I think the 
regulators have the right powers to assess the consolidated 
risk profile of the company in deciding whether to approve it 
or not, yes, sir.
    Senator Merkley. They have those powers. Have they 
exercised those powers?
    Mr. Polakoff. Yes, sir.
    Senator Merkley. Anyone else?
    [No response.]
    Senator Merkley. OK. I want to turn to the issue of 
consumer protection and how this feeds into the risk, kind of 
the retail issues. Certainly it is my view that the current 
crisis is an example of how failure to provide for adequate 
consumer protection compromises the safe and sound operation of 
financial institutions. What is your view of the role of 
consumer protection in supervision and regulation? And how 
effective do you think your particular agencies have been in 
addressing the consumer protection side? Whoever would like to 
jump into that.
    Mr. Polakoff. I will jump in. I think, first of all, there 
is a keen connection between consumer protection and safety and 
soundness. That is one of the reasons that I believe all the 
regulatory agencies, as part of any safety and soundness 
examination, look at all of the consumer complaints. They keep 
a file. They look at them. They work through them, because 
there is a keen connection when consumers are complaining, they 
have some potential safety and soundness-related issues.
    I think all of us--certainly OTS has a robust system for 
addressing consumer complaints. We have made a number of 
referrals, actually a large number of referrals to Justice for 
fair lending issues. And I think it is a trend that many of the 
agencies are seeing.
    Mr. Tarullo. Senator, I would say that consumer protection 
is related both to safety and soundness and, as I suggested in 
my prepared remarks, to systemic risk.
    With respect to how consumer protection is done recently, I 
have to say in the interest of full disclosure, as you know I 
have only been at the Fed for 6 weeks, and before that was an 
academic who was critical of the failure of our bank regulatory 
agencies to give as much attention to consumer protection as 
they ought to.
    I do think in the last couple of years there has been 
renewed attention to it and that things have moved in a better 
direction. But I think it is something that everybody is going 
to need to continue to pay attention to.
    Mr. Smith. Senator, if I could respond to that briefly?
    Senator Merkley. Please, Mr. Smith.
    Mr. Smith. On behalf of the States, I will say that with 
regard to the mortgage issue, for example, the State response 
to the mortgage issue may have been imperfect, and it may not 
have been complete. In North Carolina, we started addressing 
predatory lending in 1999. I would say that I think that the 
actions of State AGs and State regulators should have been and 
ought to be in the future, market information in assessing 
systemic risk ought to be taken into account. And I think this 
has not been done in the past.
    Again, I do not claim that we are perfect. I do claim that 
we are closer to the market as a rule than our colleagues in 
the Federal Government. And I think we have something to add if 
we are allowed to add it. So I hope as we go forward, sir, the 
State role in consumer protection will be acknowledged and it 
will be given a chance to do more.
    Senator Merkley. OK. Well, let me just close with this 
comment since my time is up. The comment that this issue has 
had robust attention--I believe, Mr. Polakoff, you made that--
WAMU was a thrift. Countrywide was a thrift. On the ground, it 
does not look like anything close to robust regulation of 
consumer issues.
    I will say I really want to applaud the Fed for the actions 
they took over subprime lending, their action regarding escrow 
for taxes and insurance, their addressing of abusive prepayment 
penalties, the ending of liar loans in subprime. But I also 
want to say that from the perspective of many folks on the 
ground, one of the key elements was booted down the road, and 
that was the yield spread premiums.
    Just to capture this, when Americans go to a real estate 
agent, they have all kinds of protection about conflict of 
interest. But when they go to a broker, it is a lamb to the 
slaughter. That broker is being paid, unbeknownst to the 
customer is being paid proportionally to how bad a loan that 
consumer gets. And that conflict of interest, that failure to 
address it, the fact that essentially kickbacks are involved, 
results in a large number of our citizens, on the most 
important financial transaction of their life, ending up with a 
subprime loan rather than a prime loan. That is an outrage.
    And I really want to encourage you, sir, in your new 
capacity to carry this conversation. The Fed has powers that it 
has not fully utilized. I do applaud the steps it has taken. 
And I just want to leave with this comment: that the foundation 
of so many families financially is their homes, and that we 
need to provide superb protections designed to strengthen our 
families, not deregulation or loose regulations designed for 
short-term profits.
    Thank you.
    Senator Reed. Senator Johanns.
    Senator Johanns. Thank you very much.
    I am not even exactly certain who I direct this to, so I am 
hoping that you all have just enough courage to jump in and 
offer some thoughts about what I want to talk about today. As I 
was sitting here and listening to the great questioning from my 
colleague, the response to one of the questions was that we do 
make a risk assessment when there is a merger. We make an 
assessment as to the risk that is being taken on by this 
merger. And I sit here, I have to tell you, and I think to 
myself, well, if it is working that well, how did we end up 
where we are at today?
    So that leads me to these questions. The first one is, who 
has the authority, or does the authority exist for somebody to 
say that the sheer size of what we end up with poses a risk to 
our overall national, if not international economy, because you 
have got so many eggs in one basket that if your judgment is 
wrong about the risk assessment, you are not only wrong a 
little bit, you are wrong in a very magnificent sort of way. So 
who has that authority? Does that authority exist, and if it 
doesn't, should it exist?
    Mr. Tarullo. Senator, subject to correction or 
qualification by my colleagues, I can say that at present, 
there is no existing authority to take that kind of top-down 
look at the entire system and to make a judgment as to whether 
there is systemic risk arising--again, not out of individual 
actions, but out of what is happening collectively.
    Now, there is one point I should have made in my 
introductory remarks, and I will take your question as an 
opportunity to make it. We all need to be--I hope you are, and 
we certainly will be--we all need to be realistic about what we 
can achieve collectively, that is, everybody sitting here on 
the panel and all of you, in addressing this systemic risk 
issue. Because I don't think anybody should be under the 
illusion that simply by saying, oh, yes, systemic risk is 
important and everybody ought to pay more attention to it, that 
we are going to solve a lot of the really difficult analytic 
problems.
    Now, we all remember what happened 4 or 5 years ago when 
some people, with great prescience, raised issues about whether 
risks were being created by what was going on in the subprime 
market. And at the same time, many other people came back and 
said, don't kill this market. So what in retrospect appears to 
everybody to be a clear case of over-leveraging and bad 
underwriting and a bubble and all the rest, in at least some 
cases in real time produces a big debate over whether you are 
killing the market or you are regulating in the interest of the 
system.
    So that is not, I know, directly responsive to your 
question, but I do hope that everybody understands that this is 
going to be a challenge for us all going forward, to make sure 
that constraints are being placed where they ought to be, but 
to recognize that nobody wants to kill the process of credit 
allocation in the United States.
    Senator Johanns. Could we agree, and I appreciate you 
offering that. I appreciate the candor of your testimony. Could 
we agree, members of the panel, that if we really wanted today 
to make an assessment, again, getting back to this, it just 
gets so big and there are so few left that we are putting the 
whole economy at risk if one of them fails, that there really 
isn't anybody who can step in and say, time out. We can't do 
that merger or whatever based upon that premise. Or is that a 
false assumption on my part? Yes, sir?
    Mr. Dugan. I would just make two points. One is, we do have 
on the banking side a Congressional limit on the amount, the 
share of deposits that you can have in the United States----
    Senator Johanns. Right.
    Mr. Dugan. and that is an effective limit of a kind on 
growth. It doesn't prevent very large institutions, but it 
prevents--we still have, by worldwide standards, a quite deep 
consolidated U.S., or lack of concentrated U.S. industry. And, 
of course, you have the anti-trust limits. But there is nothing 
in the law that I am aware of that says just because you get 
large, other than what I just spoke about, that there is a 
limit on it.
    And I would also say that there are large American 
companies that need large banks, and so you have to be careful 
if you put some other kind of limit on it that you wouldn't 
have large European or Asian institutions come and make large 
loans. So we have to----
    Senator Johanns. Take the business away.
    Mr. Dugan. ----keep a balance here. There is a balance.
    Senator Johanns. Yes. The second thought I want to throw 
out, and I am very close to being out of time here, and these 
are very complicated issues, but I would like a quick thought 
if the Chairman will indulge me.
    Chairman Dodd [presiding]. Certainly.
    Senator Johanns. Let us say that you do have an 
institution. You have made your risk assessment. A merger has 
occurred. And all of a sudden you are looking at it and saying, 
boy, there were some things here that, if I had to do it over 
again, I would do it differently. Maybe they have gone a step, 
two, or three or four further than you anticipated they were 
going to, and now you can see the risk is growing and growing 
and growing to a dangerous level. Do we have in our system the 
cord we can pull that is the safety valve that says, again, in 
effect, time out. We are at a level where the risk is not 
acceptable for our economy.
    Mr. Tarullo. Senator, I think with respect to a regulated 
institution, which I believe is the premise of your question, 
the answer is yes. If the institution is regulated, then 
somebody sitting at this table is going to have the authority 
to say, you are assuming too many risks and you need to reduce 
your exposures in a particular area, you need to increase your 
capital, you need to do better liquidity management, whatever 
the proper guidance might be.
    The one footnote I place there again is that in order to 
get to that point, we need to make sure that people are aware 
of the risks, and sometimes just looking at it from the 
standpoint of the institution is completely adequate. It is 
always necessary. But there are these circumstances, and I 
think we have seen some of them in the last couple of years, 
where you do need to have a bit more of a system-wide 
perspective in order to know that something is a risk.
    Senator Johanns. I will just wrap up with this thought, 
because I am out of time, and I will try to do so quickly. I 
think it is a real frustration for us here to be faced with 
these issues of, well, Mike, this is just way too big to allow 
it to fail, and, Mike, it is going to take taxpayers' money to 
unravel the risk that they have gotten themselves into and a 
lot of money. These are big institutions. It is going to take 
big money.
    And so you can see from my questions what I am trying to do 
is if we are going to think about this in a global way--I 
certainly don't want to stall growth in this Nation. I mean, 
gosh, we are the greatest Nation on earth. But on the other 
hand, I would like to think whatever we are doing, we are going 
to give some policymakers the ability and some regulators the 
ability to, in effect, say, time out.
    Mr. Tarullo. Mr. Chairman, could I answer briefly?
    Chairman Dodd. Certainly.
    Mr. Tarullo. Senator, I not only understand but sympathize 
with your perspective, and with respect to your closing 
remarks, here is what I would suggest back to you: A number of 
the instruments--I would say, if I can over-generalize, a lot 
of what is in the prepared, the long prepared testimony of 
people at this table today is a rehearsing of some of the 
instruments which are available to you. And I am sure you and 
your staff and your colleagues, after you go through them all, 
you are going to want to tweak some. You may not be in favor of 
others at all. But I think this is the opportunity that we all 
have, which is to take this moment, not only to do an internal 
self-examination, but also to say, OK, how are we going to 
revamp this system to put in place structures that avoid 
exactly the kind of situation you are talking about?
    So just to use two, because I don't want to take up too 
much time, the resolution mechanism about which you have heard 
so much from Mr. Dugan, Ms. Bair, and me is really very 
important here precisely because of its association with a 
``too big to fail'' institution. Making sure that systemically 
important institutions are regulated in a way that takes that 
systemic importance into account in the first instance, with 
the capital and liquidity requirements they have, will be steps 
along that road.
    Chairman Dodd. Thank you very much, and I totally agree 
with that. I think that is very, very important.
    Senator Reed.
    Senator Reed. Well, thank you, Mr. Chairman.
    I want to thank the witnesses. I have great respect for 
your efforts and your colleagues' efforts to enforce the laws 
and to provide the kind of stability and regulation necessary 
for a thriving financial system. I think I have seen Mr. 
Polakoff at least three times this week, so I know you put in a 
lot of hours in here as well as back in the office, so thank 
you for that.
    Yesterday, we had a hearing based on a GAO report about the 
risk assessment capacities and capabilities of financial 
institutions, but one of the things that struck me is that 
perhaps either inadvertently or advertently, we have given you 
conflicting tasks. One is to maintain confidence in the 
financial system of the United States, but at the same time 
giving you the responsibility to expose those faults in the 
financial system to the public, to the markets, and also to 
Congress.
    And I think in reflecting back over the last several years 
or months, what has seemed to trump a lot of decisions by all 
these agencies has been the need or the perceived need to 
maintain confidence in the system when, in fact, many 
regulators had grave doubts about the ability of the system to 
perform, the risks that were being assembled, the strategies 
that were being pursued. And I think if we don't at least 
confront that conflict or conundrum directly, we could reassign 
responsibilities without making a significant change in 
anything we do.
    And so in that respect, I wonder if you have any kind of 
thoughts about this tradeoff between your role as cheerleaders 
for the banking system and your role as referees for the 
banking system. Mr. Dugan?
    Mr. Dugan. Well, I am not sure I would describe it as the 
cheerleader----
    Senator Reed. I think in some cases, we heard the cheers 
echoing through the halls.
    Mr. Dugan. I guess what I would say, Senator, is there is a 
tension with financial institutions that depend so heavily on 
confidence, particularly because of the run risk that was 
described earlier. And I am not just talking about depositors 
getting in line. I am talking about funding. That has always 
informed and is very deeply embedded in our whole system of 
financial regulation. There is much about what we do and how we 
do it that is by design confidential supervisory information 
and we do have to be careful in everything we do and how we 
talk about it, about not creating or making a situation worse.
    And at the same time, the tension you quite rightly talk 
about is knowing that there are problems that need to be 
addressed and finding ways to address them in public forums 
without running afoul of that earlier problem, and it gets 
harder when we have bigger problems in a financial crisis like 
the one we have and we all have to work hard to get through 
that and to try to work with that tension, and I think we can 
do that by the kinds of hearings that you have had. I think we 
have to avoid commenting about specific open institutions, but 
there are many things we can talk about and get at and I think 
that is what we need to do.
    Senator Reed. Ms. Bair, and I will try to get around 
briefly because of the time limit. Ms. Bair?
    Ms. Bair. Well, I hope we are cheerleaders for depositors. 
I think we are all about stability and public confidence, so I 
think it is important to keep perspective, though, for all bank 
regulators, that what we do should always be tied to the 
broader public interest. It is not our job to protect banks. It 
is our job to protect the economy and the system, and to the 
extent our regulatory functions relate to that, that is how 
they should be focused.
    I do think that the market is confused now because 
different situations have been handled in different ways, and I 
hate to sound like a Johnny-one-note, but I think a lot of it 
does come back to this inability to have a legal structure for 
resolving institutions once they get into trouble. I think 
whatever that structure might eventually look like, just 
clarity for the market--for investors and creditors--about how 
they will be treated and the consistency of the treatment, 
would go a long way to promoting financial stability and 
confidence.
    Senator Reed. Mr. Fryzel.
    Mr. Fryzel. Thank you, Senator. Paramount to NCUA is the 
safety and soundness of the funds of all our 90 million members 
in credit unions across this country, and in an effort to 
maintain their confidence is not an easy task, and we have made 
every effort to do so by public awareness campaigns. Certainly 
the action by Congress in raising the $250,000 limit has been 
fantastic in regards to the safety and their ability to think 
that their funds, or to know that their funds are safe. We 
tried to draw the fine line in letting them know that, yes, 
there are problems in our financial structure, but we are 
dealing with them and we are going to use the tools that we 
have to make sure that things get better. And when this economy 
turns around, financial institutions are again going to be in 
the position where they are going to be able to serve these 
consumers in the way they have in the past.
    So yes, Senator, it is a fine line, but I think it is one 
that we have to keep talking about. We cannot let anyone think 
that there are not problems out there. We have to tell them we 
are in a great country. This economy does come back and 
everything is going to be better in the future.
    Senator Reed. Mr. Tarullo.
    Mr. Tarullo. Senator, I may have misunderstood. I 
understood you to be asking not about regulatory actions in the 
midst of the crisis, but in the period preceding it, when 
supervision is supposed to be ongoing. And I think there is a 
lot to the question that you asked, not so much because, I 
would say, of the conflict of interests as such between 
different roles, but because everybody tends to fall into a 
notion of what operating principles are for whatever period we 
may be in. And so people come to accept things. Bankers do, 
supervisors do, maybe even Members of Congress do--something 
that is ongoing, is precisely because it has been ongoing, 
thought to be an acceptable situation.
    So I think from both our perspective and your perspective 
the challenge here is to figure out what kinds of mechanisms we 
put in place within agencies, between the Hill and agencies in 
legislation which force consideration of the kinds of emerging 
issues that we can't predict now because we don't know what the 
next crisis might look like, but which are going to be noticed 
by somebody along the way.
    And while I really don't want to overstate the potential 
utility of a systemic risk regulator for the reasons I said 
earlier, I would say that in an environment in which an overall 
assessment of the system is an explicit part of the mandate of 
one or more entities in the U.S. Government, you at least 
increase the chances that that kind of disparate information 
gets pulled together and somebody has to focus on it. Now, what 
you do with it, that is another set of questions, but I think 
that gets you at least a little bit down the road.
    Senator Reed. Mr. Polakoff, and my time is expiring, so 
your brevity is appreciated.
    Mr. Polakoff. I will be as short as possible, Senator. 
Thank you. We are not in the current situation we are in today 
because of actions over the last six to 12 months by the 
regulators, or in a lot of cases the bankers. It is from 3, 4, 
5 years ago.
    I think the notion of counter-cyclical regulation needs to 
be discussed at some point. When the economy is strong is when 
we should be our strongest in being aggressive, and when the 
economy is struggling, I think is when we need to be sure that 
we are not being too strong.
    Any of us at this table can prevent a bank from failing. We 
can prevent banks from failing. But what will happen is people 
who deserve credit will not get credit because they will be on 
the bubble. The thing I love about bank supervision is it is 
part art and it is part science, and I think what we are doing 
today is going to address the situation today. We have got to 
be careful we are doing the right thing for tomorrow and next 
year, as well.
    Senator Reed. Mr. Smith, and then Mr. Reynolds.
    Mr. Smith. Thank you, Senator. I agree with my friend, the 
Comptroller, that the two concepts of supervisory authority, on 
the one hand, and consumer protection, on the other, are 
intertwined. They should not be drawn apart.
    I will say that in the State system, sir, we have the 
advantage of having a partner with friends in the Federal 
Government. We have cooperative federalism. That is a good 
thing, because our Federal friends help us and sometimes tell 
us things we don't want to know, particularly about consumer 
compliance, that makes our system of regulation stronger.
    I would suggest, sir, that some of the actions the States 
have taken in consumer protection in the past, if they had been 
listened to, would have helped in terms of determining the 
systemic--understanding what the systemic risk of some 
activities in the marketplace were, and so I believe that as a 
part, as we say in our testimony, as part of an ongoing system 
of supervision, I would argue, and I will agree with, I 
believe, with Governor Tarullo, that you need--the fact that 
you have multiple regulators focusing on an issue can, in the 
proper circumstance, if there is cooperation, result in better 
regulation. The idea of a single regulator, I think, is 
inherently flawed.
    Senator Reed. Mr. Reynolds.
    Mr. Reynolds. My comment would be that it is appropriate 
that we take a measured response. I agree with Mr. Polakoff's 
observation that regulators have the ability to tighten down on 
regulation to the point where we make credit availability an 
issue. On the other side, it is important that our role as 
safety and soundness regulators be the primary role that we 
play and that we are not in the business of being cheerleaders 
for the industry. I am certain that my bankers and my credit 
union managers in the State of Georgia don't regard me as a 
cheerleader.
    Senator Reed. My time has expired. Thank you.
    Chairman Dodd. Well, thank you, Senator, very much.
    I should have taken note, and I apologize for not doing so, 
Senator Reed had a very good subcommittee hearing yesterday, 
and this is the seventh hearing we have had just this year on 
the subject matter of modernization of Federal regulations. We 
had dozens last year going back and examining the crisis as 
well as beginning to explore ideas on how to go forward. And so 
I am very grateful to Jack and the other subcommittee chairs 
who are meeting, as well. We have four hearings this week alone 
just on the subject matter, so it is very, very helpful and I 
thank Senator Reed for that.
    Senator Reed. Thank you, Mr. Chairman.
    Chairman Dodd. I am going to turn to Senator Menendez, but 
I want to come back to this notion about a supervisory capacity 
and consumer protection, because too often, the safety and 
soundness dominates the consumer protection debate and we have 
got to figure out a new direction--that can't go on, in my 
view. There has got to be a better way of dealing with this.
    But let me turn to Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman, and Mr. 
Chairman, I have a statement for the record, so I hope that can 
be included.
    Chairman Dodd. It will be included.
    Senator Menendez. Mr. Chairman, I look forward to asking 
some questions specifically, but I want to turn first to 
Chairman Bair. I cannot pass up the opportunity, first to 
compliment you on a whole host of things you are doing on 
foreclosure mitigation and what not. I think you were ahead of 
the curve when others were not and really applaud you for that.
    But I do have a concern. I have heard from scores of 
community banks who are saying, you know, we understand the 
need to rebuild the Federal Deposit Insurance Fund, but I 
understand when they say to me, look, we are not the ones who 
drove this situation. We have to compete against entities that 
are receiving TARP funds. We are not. And in some cases, we are 
looking at anywhere between 50 and 100 percent of profit.
    Isn't there--I know that--I understand you are statutorily 
prohibited from discriminating large versus small, but in this 
once--and so I understand this is supposedly a one-time 
assessment. Wouldn't it be appropriate for us to give you the 
authority to vary this in a way that doesn't have a tremendous 
effect on the one entity, it seems to me, that is actually out 
there lending in the marketplace as best as they can?
    Ms. Bair. Well, a couple of things. We have signaled 
strongly that if Congress will move with raising our borrowing 
authority, we feel that that will give us a little more 
breathing room.
    Senator Menendez. With what? I am sorry, I didn't hear.
    Ms. Bair. If Congress raises our borrowing authority--
Chairman Dodd and Senator Crapo have introduced a bill to do 
just that--if that can be done relatively soon, then we think 
we would have some flexibility to reduce the special 
assessment. Right now, we have built in a good cushion above 
what our loss projections would suggest would take us to zero 
because we think the borrowing authority does need to be 
raised. It has been at $30 billion since 1991. So we do think 
that needs to happen. But if it does get raised, we feel we 
could reduce our cushion a bit.
    Also, the FDIC Board just approved a phase-out of our TLGP, 
what we call our TLGP Debt Guarantee Program. We are raising 
the cost of that program through surcharges which we will put 
into the Deposit Insurance Fund. This could also reduce the 
need for the special assessment and so we will be monitoring 
that very closely.
    We have also asked for comment about whether we should 
change the assessment base for the special assessment. Right 
now, we use domestic deposits. If you used all bank assets, 
that would shift the burden to some of the larger institutions, 
because they rely less on deposits than the smaller 
institutions. So we are gathering comment on that right now. We 
will probably make a final decision in late May.
    Increasing the borrowing authority plus we expect to get 
some significant revenue through this surcharge we have just 
imposed on our TLGP--most of the larger banks are the 
beneficiaries of that Debt Guarantee program--we think that 
will help a lot.
    Senator Menendez. Well, I look forward, Mr. Chairman, to 
working with you to try to make this happen, because these 
community banks are the ones that are actually out there still 
lending in communities at a time in which we generally don't 
see much credit available. But this is a huge blow to them and 
however we can--I will submit my own comments for the 
regulatory process, but however we can lighten the load, I 
think will be incredibly important.
    Mr. Dugan, I want to pursue a couple of things with you. 
You recently said in a letter to the Congressional Oversight 
Panel, essentially defending your agency. Included in that 
letter is a chart of the ten worst, the lenders with the higher 
subprime and Alternate A foreclosure rates. Now, I see that 
three of them on this list have been originating entities under 
your supervision--Wells Fargo, Countrywide, and First Franklin. 
Can you tell us what your supervision of these entities told 
you during 2005 to 2007 about their practices?
    Mr. Dugan. Senator, as I said before, we certainly did have 
some institutions that were engaged in subprime lending, and 
what I said also is that it is a relatively smaller share of 
overall subprime lending in the home market and what you see. 
It was roughly ten to 15 percent of all subprime loans in 2005 
and 2006, even though we have a much larger share of the 
mortgage market.
    I think you will find that of the providers of those loans, 
the foreclosure rates were lower and were somewhat better 
underwritten, even though there were problem loans, and I don't 
deny that at all, and I would say that, historically, the 
commercial banks, both State and national, were much more 
heavily intensively regulating and supervising loans, including 
subprime loans. We had had a very bad experience 10 years ago 
or so with subprime credit cards, and as a result, we were not 
viewed as a particularly hospitable place to conduct subprime 
lending business.
    So even with organizations that were complex bank holding 
companies, they tended to do their subprime lending in holding 
company affiliates rather than in the bank or in the subsidiary 
of the bank where we regulated them. We did have some, but it 
turned out it was a much smaller percentage of the overall 
system than the subprime loans that were actually done.
    Senator Menendez. Well, subprimes is one thing. The 
Alternate As is another. Let me ask you this. How many 
examiners, on-site examiners, did you recently have at Bank of 
America, at Citi, at Wachovia, at Wells?
    Mr. Dugan. It is different for each one of those, but we 
have--on-site examiners can vary in our largest banks from 50 
to 70 examiners. It is a very substantial number, depending on 
which organization you are talking about.
    Senator Menendez. And what did they say to you about these 
major ``too big to fail'' lenders getting heavily into no-
document and low-document loans?
    Mr. Dugan. Well, we were never the leader in no-document 
and low-document loans. We did do some of it. The whole Alt A 
market, by definition, was a lower-documentation market and it 
was a loan product that mostly was sold into secondary markets.
    When I got and became Comptroller in 2005, we began to see 
the creeping situation where there were a number of layers of 
risk that were being added to all sorts of loans that we--our 
examiners were seeing, and that caused us to issue guidance on 
nontraditional mortgages, like payment option mortgages, which 
we were quite aggressively talking about the negative 
amortization in it as being not a good thing for the system, 
and that again we were quite vocal about pushing out of the 
national banks that were doing it.
    Senator Menendez. Well, let me ask you, you have twice been 
criticized by your own Inspector General for keeping, quote, 
``a light touch,'' light for too long when banks under your 
watch were getting in trouble. And I know you have consistently 
told us that you like to do things informally and in private 
with your banks. Do you think that changing that strategy makes 
sense in light of what we have gone through now?
    Mr. Dugan. I think I would say two things. The Inspector 
General does material loss reviews on all the agencies with 
respect to any bank that has more than a $25 million loss, and 
it is a good process, a healthy process, and we accept that 
constructive criticism. And they have talked about places where 
we could have moved more quickly with respect to a couple of 
institutions, and we agreed with that.
    What I would say is we have, as supervisors, a range of 
tools that we can use that are both informal tools that 
Congress has given us and formal enforcement tools. And on that 
spectrum, we do different things depending on the circumstances 
to try to get actions and behavior corrected. And merely 
because something is not formal and public does not mean that 
we are not paying attention or getting things addressed or 
fixed.
    Many times--many times--because we are on-site, have the 
presence, identify a problem, we can get things corrected 
quickly and efficiently without the need to go to a formal 
enforcement action. But we will not hesitate, if we have to, to 
take that action to fix those things.
    So I think there are things that we constantly look about 
to correct and to improve our supervision using that range of 
tools.
    Senator Menendez. Mr. Chairman, if I may have just one more 
moment?
    Chairman Dodd. Just following up on the Senator's question, 
how many of those banks did you find that violated your 
guidelines? And if so, what were the punishments you meted out 
for them? Looking back, do you think you missed any of the 
violations?
    Mr. Dugan. It would range from things we have something 
that--if we see something early, any kind of bank examination 
that you go through, there are certain kinds of violations of 
law. Some are less serious and some are more serious. And at 
one end of the spectrum, we do something called ``Matters 
requiring attention,'' which tells the directors we expect you 
to fix this and we want it fixed by the next time we come in.
    Chairman Dodd. Jump to the more serious ones.
    Mr. Dugan. Well, on that point, we saw 123 of them in that 
4-year period, and we got 109 of them corrected within that 
period.
    Chairman Dodd. Were there punishments meted out?
    Mr. Dugan. Oh, yes. Not for those things, but we have other 
situations in which we took actions for mortgage fraud, for 
other kinds of mortgage-related actions where we had problems, 
and we have provided some statistics that I could certainly get 
that we have compiled for the enforcement hearing where we are 
testifying tomorrow.
    Chairman Dodd. I am sorry, Senator.
    Senator Menendez. No. Thank you, Senator Dodd. I appreciate 
it. Just one more line of questioning.
    You know, we had a witness before the Committee, Professor 
McCoy of the University of Connecticut School of Law, and she 
made some statements that were, you know, pretty alarming to 
me. She said, ``The OCC has asserted that national banks made 
only 10 percent of subprime loans in 2006. But this assertion 
fails to mention that national banks moved aggressively into 
Alternate-A low-documentation and no-documentation loans during 
the housing boom.''
    ``Unlike OTS, the OCC did promulgate one rule in 2004 
prohibiting mortgages to borrowers who could not afford to pay. 
However, the rule was vague in design and execution, allowing 
lax lending to proliferate at national banks and their mortgage 
lending subsidiaries through 2007.''
    ``Despite the 2004 rules, through 2007, large national 
banks continued to make large quantities of poorly underwritten 
subprime loans and low- and no-documentation loans.''
    ``The five largest U.S. banks in 2005 were all national 
banks and too big to fail. They too made heavy inroads into 
low- and no-documentation loans.''
    And so it just seems to me that some of the biggest bank 
failures have been under your agency's watch, and they, too, 
involved thrifts heavily into nil documents, low documents, 
Alternate A, and nontraditionals, and it is hard to make the 
case that we had an adequate job of oversight given those 
results.
    We have heard a lot here about one of our problems is 
regulatory arbitrage. Don't you think that they chose your 
agency because they thought they would get a better break?
    Mr. Dugan. I do not and, Senator, I would be happy to 
respond to those specific allegations, and there are a number 
of them that were raised. I looked at that testimony, and there 
are a number of statistics which we flatly disagree with and 
that were compiled in a way that actually do not give a true 
picture of what was happening and what was not happening.
    National banks increasingly have been involved in the 
supervision of mortgage loans. There is no doubt about that. 
But I would say that we have done a good job in that area--not 
perfect, but we think we have excellent, on-the-ground 
supervisors in that area, and it did not lead to all the kinds 
of problems in national banks, from national banks, that is----
    Senator Menendez. Well, I will submit the question for the 
record because the Chairman has been very generous with my 
time, but one of the things I would ask you is: What are you 
doing in comparison to State regulators who, in fact--
regulators of State depositories who, in fact, have much better 
performance rates, considerable better than yours?
    Mr. Dugan. Actually, that is not true. I have seen that 
chart, and I will provide----
    Senator Menendez. OK. So I would love to either sit down 
with you to get all that information----
    Mr. Dugan. I would welcome that.
    Senator Menendez. ----so we can dispel is not the case.
    Thank you, Mr. Chairman.
    Chairman Dodd. Let me follow up on that, because it is a 
very important line of questioning. There were hundreds of 
thousands, we know now, of bad loans. Hundreds of thousands of 
them. You talk about 123 violations. I do not just focus the 
question on the OCC but also the FDIC, the OTS, the Fed. What 
was your experience? Obviously, Dan, you were not there at the 
time, but I would like to get some information, if I could, 
from the Fed as to what was going on. When you consider the 
hundreds of thousands of bad loans that are the root cause of 
why we are here today, the reason we are sitting here today is 
because of what happened under that framework and that time, 
going back 4 or 5 years ago, longer maybe. And so we have 
hundreds of thousands of bad loans that were issued, and it is 
awfully difficult to explain to people that out of that 
quantity, 123 violations are identified.
    Mr. Dugan. Well, let me say two things. One, I was 
referring to one particular kind of violation. There are others 
that we will be happy to submit for the record. But I think the 
more fundamental point is this: There were many of these loans 
that did not violate the law. They were just underwritten in a 
way with easier standards than they had been historically. And 
that was not necessarily a legal violation, but a prudential--
--
    Chairman Dodd. But shouldn't that have raised a red flag? 
You are the experts in this area, and you were watching people 
get loans with no documentation, these liar loans and so forth. 
Was anyone watching?
    Mr. Dugan. People were watching. I think what drove that 
initially--my own personal view on this--is that most of those 
loans were sold into the secondary market. They were not loans 
held on the books of the institutions that originated them. And 
so for someone to sell it and get rid of the risk, it did not 
look like it was something that was presenting the same kind of 
risk to the institution.
    And if you go back and look at the time when house prices 
were rising and there were not high default rates on it, people 
were making the argument that these things are a good thing and 
provide more loans to more people.
    It made our examiners uncomfortable. We eventually, I think 
too late, came around to the view that it was a practice that 
should not occur, and that is exactly why I was talking 
earlier, if we could do one thing--two things that we should 
have done as an underwriting standard earlier is, one, the low-
documentation loans and the other is the decline in 
downpayments.
    Chairman Dodd. I want to ask the other panelists here with 
regard to Senator Menendez's line of questioning. The guidance 
is not on the securitization of those loans or what happens 
with rating agencies. The guidance is on the origination of the 
loans, which is clearly the responsibility of the OCC. And so 
the fact that these things were sold later on is a point I 
take, but your responsibility is in origination, and 
origination involved this kind of behavior. I appreciate you 
providing us with numbers in one area, but I assume there are 
more numbers you can give us in other areas. I do not think you 
can get away by suggesting--I say this respectfully to you--
that because they have not been held at the institution--as 
most of us here have a little gray hair on our head and have 
had our mortgage for years that you could not notice changes in 
the way mortgages were originated. On the other hand, when 
mortgages are kept with originators and you could look at them 
for 30 years if you wanted.
    Mr. Dugan. Right.
    Chairman Dodd. Obviously that is all changed. But your 
responsibility falls into origination, which is a very 
different question than what happens in terms of whether or not 
the mortgage is held at the institution or sold.
    Mr. Dugan. I totally agree with that point. The point I was 
really trying to make was we had a market where the 
securitization market got very powerful.
    Chairman Dodd. Right.
    Mr. Dugan. It was buying loans from people in the 
marketplace, standards reduced, particularly from nonbank 
brokers and mortgage originators that were providing those. 
Banks were competing with them, and people were not at that 
time suffering very significant losses on those loans because 
house prices were going up. And I think----
    Chairman Dodd. You cannot just look at losses. Is the 
practice acceptable?
    Mr. Dugan. I understand that, and I believe that we were 
too late getting to the notion, all of us, about getting at 
stated income practices and low-documentation loans. We did get 
to it, but it was after the horse had left the barn in a number 
of cases, and we should have gotten there earlier.
    The point I was just trying to make to you, though, is that 
as these things were leaving the institution, they were less of 
a risk to that institution from a safety and soundness point of 
view.
    Chairman Dodd. We are going back around. Chairman Bair, let 
me ask you to comment on this as well.
    Ms. Bair. Well, I think John is right. These practices 
became far too pervasive. For the most part, the smaller State-
chartered banks we regulate did not do this type of lending 
they do more traditional lending, and then obviously they do 
commercial real estate lending, which had a separate set of 
issues.
    We had one specialty lender who we ordered out of the 
business in February of 2007. There have been a few others. We 
have had some other actions, and I would have to go back to the 
examination staff to get the details for you. But I was also 
concerned that even after the guidance on the nontraditional 
mortgages, which quite specifically said you are not going to 
do low-doc and no-doc anymore, that we still had very weak 
underwriting in 2007.
    So I think that is a problem that all of us should look 
back on and try to figure out, because clearly by 2007 we knew 
this was epidemic in proportion, and the underwriting standards 
did not improve as well as you would have thought they should 
have, and the performance of those loans had been very poor as 
well. I do think we need to do a lot more----
    Chairman Dodd. Well, quickly the Fed and the OTS. I know it 
is a little difficult to ask you this question, Dan, because 
you were not there at the time, but any response to this point?
    Mr. Tarullo. I do not, Senator, except as an external 
observer. But anything that you would like from the Fed, if you 
just----
    Chairman Dodd. Well, it might be helpful to find out 
whether or not there were violations, and punishments meted out 
at all. Again, many of us have heard over the last couple of 
years the complaint is that Congress in 1994 passed the HOEPA 
legislation which mandated that the Federal Reserve promulgate 
regulations to deal with fraudulent and deceptive residential 
mortgage practices. Not a single regulation was ever 
promulgated until the last year or so, and obviously that is 
seen as a major gap in terms of the responsibility of moving 
forward.
    OTS quickly, do you have any----
    Mr. Polakoff. Mr. Chairman, you are right. The private 
label securitization market, we could have done a better job in 
looking at the underwriting as those loans passed off the 
institution's books and into a securitization process. Yes, 
sir.
    Chairman Dodd. Senator Menendez, do you want to make any 
further comment on this point or not?
    Senator Menendez. I think, Mr. Chairman, you are on the 
road--you know, to me--and I know Mr. Tarullo was not there, 
but the Federal Reserve, you know, is at the forefront of what 
needed to be done because they had the ability to set the 
standard. And the lack of doing so, you know, is a major part 
of the challenge that we are facing today. But I appreciate it 
and I look forward to the follow-up.
    Chairman Dodd. Senator Bunning.
    Senator Bunning. Thank you. I hurried back, and I heard 
that Senator Menendez asked my question, but that is all right. 
This is for Sheila.
    I am not used to angry bankers. I have had a great 
relationship with the Kentucky Association and their leaders, 
but I did a roundtable discussion in Paducah, Kentucky. 
Paducah, Kentucky, is a town of about 29,000 people. Two 
community bankers. One came to me and said, ``We have just been 
assessed by the Federal Deposit Insurance Corporation, and 
guess what? We will not be profitable in 2009 because of that 
assessment.'' No bad loans, no nothing. No bad securities. They 
keep their mortgages in-house. Everything just like community 
bankers in most places do.
    There was a gentleman from BB&T. Now, that is not a 
community bank. That is a much larger bank. The assessment for 
the community bank was $800,000, wiped out their total 
profitability. BB&T was $1.2 million. Now, that did not wipe 
out their profitability because they have many banks all over 
the country. But how can you explain to the American people 
that for doing your job and doing it well, you are being 
assessed your total profitability in 1 year to pay for those 
who did not do their job very well? Maybe you can explain that 
to me because I do not understand it.
    Ms. Bair. Well, deposit insurance has always been funded by 
industry assessments. The FDIC actually has never--we do have 
the full faith and credit of the U.S. Government backing us. We 
do have lines of credit----
    Senator Bunning. There are a lot of other ways that you 
could have done it.
    Ms. Bair. Well, sir, all banks that get deposit insurance 
pay for it. It is an expense that they need to factor in. And 
we have been signaling for some time that we will need to raise 
premiums. We are in a much more distressed economic 
environment. Our loss projections are going up, and I think 
most community banks agree that we should continue our 
industry-funded self-sufficiency and not turn to taxpayers.
    We did not want to do the 20-basis-point special 
assessment, but our loss projections are going up 
significantly, and we felt it was necessary to maintain an 
adequate cushion above zero.
    Senator Bunning. For this one community bank, it was a 
1,000-percent increase in their assessment.
    Ms. Bair. Well, I would be happy to go over those numbers 
with you.
    Senator Bunning. I will be glad to go over them, because 
she did. She went over them with me.
    Ms. Bair. OK. We would like to see that, because they are 
miscalculating what the assessment is.
    I would say the base assessment is 12 to 16 basis points. 
The interim special assessment is 20 basis points. It is out 
for comment. It has not been finalized yet. We are hoping that 
through increasing our borrowing authority we can----
    Senator Bunning. Don't you have a line of credit with the 
Treasury? It seems like everybody else does, so I would assume 
that you do.
    Ms. Bair. We do. It is pretty low. It has not been raised 
since 1991, and we are working with Chairman Dodd and Senator 
Crapo to get it raised. But I would say the FDIC has never 
borrowed from Treasury to cover our losses. We have only 
borrowed once in our entire history. That was for short-term 
borrowing.
    Senator Bunning. We can print you some money. I mean, what 
the heck. It is printed by----
    [Laughter.]
    Senator Bunning. Yesterday, our Chairman of the Fed 
announced $1.2 trillion--not billion but trillion dollars of 
printed money going out.
    Ms. Bair. Right.
    Senator Bunning. It is just scary.
    Ms. Bair. That is a policy call. I think a lot of community 
banks--Ken Guenther had an excellent blog yesterday he has 
obviously been long associated with community bankers--
suggesting that it would not be in community bankers' interest, 
because right now they are not tarnished with the bailout 
brush. But if the FDIC starts going to taxpayers for our 
funding instead of relying on our industry assessments, I think 
that perception could change.
    We are working very hard to reduce the special assessment. 
I have already said that if the borrowing authority is 
increased, we feel we can reduce it meaningfully. This week we 
approved a surcharge to a debt guarantee program we have that 
is heavily used by large institutions. We will put that 
surcharge into our deposit insurance fund and also use that to 
offset the 20-basis-point assessment.
    So we are working hard to get it down. We want to get it 
down. But I do think the principle of industry funding is 
important to the history of the FDIC, and I think it is 
important to the reputation and confidence of community banks 
that they are not getting taxpayer assistance. They continue to 
stand behind their fund.
    Senator Bunning. Well, that all sounds really well and 
good. I would like to take you to that roundtable and let you--
--
    Ms. Bair. Senator, I have personally----
    Senator Bunning. ----explain that to those two bankers.
    Ms. Bair. I have talked to a lot of community bankers about 
this. I absolutely have. I would also like to share numbers 
with you, though, that show deposit insurance, even with the 
special assessments, is still very cheap compared to 
alternative sources of funding. Even with the special 
assessments, it is much cheaper than any other sources of 
funding that they would have to tap into.
    Senator Bunning. You have taken up all my time. I cannot 
ask another question--may I?
    Chairman Dodd. Sure.
    Senator Bunning. OK. The gentleman from the Federal Reserve 
is here. Thank you for being here. Do you or anybody else at 
the Fed have concerns about the Fed being the systemic risk 
regulator or payment system regulator? And where would you say 
would be the right place to place that task?
    Mr. Tarullo. Senator, with respect to payment systems, I 
think there is a fair consensus at the Fed that some formal 
legal authority to regulate payment systems is important to 
have. As you probably know, de facto right now the Fed is able 
to exercise supervisory authority over payment systems. That is 
because of the peculiarity of the fact that the entities 
concerned are member banks of the Federal Reserve System. They 
have got supervisory authority. If their corporate form were to 
change, there would be some question about it, and payments, as 
you know, are historically and importantly related to the 
operation of the financial system.
    Now, with respect to the systemic risk regulator, I think 
there is much less final agreement on either one of the 
questions that I think are implicit in what you asked. One, 
what should a systemic risk regulator do precisely? And, two, 
who should do it?
    The one thing I would say--and I think this bears 
repeating, so I will look for occasions to say it again--is 
however the Congress comes down on this issue, I think that we 
need all to be clear, you need to be clear in the legislation, 
whoever you delegate tasks to needs to be clear, not just what 
exactly the authorities are, which is important, but also the 
expectations are, because we need to be clear as to what we 
think can be accomplished. You do not want to give 
responsibility without authority----
    Senator Bunning. Well, sometimes we give the responsibility 
and the authority----
    Mr. Tarullo. That is correct.
    Senator Bunning. And it is not used, just the 1994 law when 
we handed the Fed the responsibility and it was 14 years before 
they promulgated one rule or regulation.
    Mr. Tarullo. I agree. Believe me, Senator. That is 
something that I observed myself before I was in my present 
job. So I have got no----
    Senator Bunning. No, I am not faulting you, but I am just 
stating the fact that even when we are sometimes very clear in 
our demand that certain people regulate certain things, they 
have to take the ball and carry it then.
    Mr. Tarullo. Absolutely. Absolutely correct. And so on the 
systemic risk regulator issue, there is a strong sense that if 
there is to be a systemic risk regulator, the Federal Reserve 
needs to be involved because of our function as lender of last 
resort, because of the mission of protecting financial 
stability. How that function is structured seems to me 
something that is open-ended because the powers in question 
need to be decided by the Congress. Let me give you one example 
of that.
    It is very important that there be consolidated supervision 
of every systemically important institution. So with bank 
holding companies, that is not a problem, because we have 
already got that authority. But there are other institutions 
out there currently unregulated over which no existing agency 
has prudential, safety and soundness, supervisory authority.
    Senator Bunning. You realize that your two Chairmen came to 
us and told us that certain entities----
    Mr. Tarullo. Right, absolutely.
    Senator Bunning. ----should not be regulated.
    Mr. Tarullo. I am sorry. Which entity----
    Senator Bunning. Well, credit default swaps and other 
things that are related to that. Your past Chairman and your 
current Chairman.
    Mr. Tarullo. OK, so I can--let me get to credit default 
swaps in a moment, but let me try to address the institution 
issue, because it is the case that we believe consolidated 
supervision is important for each institution. A consolidated--
--
    Senator Bunning. We maybe should make a regulator for each 
institution.
    Mr. Tarullo. If there is a good prudential regulator for 
each systemically important institution, then you would not 
need a systemic regulator to fulfill that----
    Senator Bunning. That is correct.
    Mr. Tarullo. I think that is----
    Senator Bunning. And we also would not have people too big 
to fail.
    Mr. Tarullo. Well, you would hope that the regulation, 
including a resolution mechanism and the like, would be such as 
to contain that----
    Senator Bunning. That is what I mean.
    Mr. Tarullo. Yes, exactly, Senator.
    Senator Bunning. Thank you.
    Mr. Tarullo. OK, sure.
    Chairman Dodd. Thanks, Senator Bunning, for the question, I 
am not going to ask you to respond to this because I have taken 
a lot of your time already today, not to mention there was a 
little confusion with the votes we have had. But we want to 
define what we mean when we talk about a systemic risk 
regulator. Do you mean regulating institutions that are 
inherently systemically risky or important? Or are you talking 
about regulating systemically risky practices that institutions 
can engage in? Or are you talking about regulating or setting 
up a resolution structure so that when you have institutions 
like AIG and Lehman Brothers, you have got an alternative other 
than just pumping capital into them, as we did in the case of 
AIG?
    I get uneasy about the fact that the Fed is the lender of 
last resort. Simultaneously the Fed now also falls into the 
capacity of being particularly in the last function, the 
resolution operation. It seems to me you get, like in the 
thrift crisis years ago, the regulator becomes also the one 
that also deals with these resolutions. I think that is an 
inherently dangerous path to go down. That is my instinct.
    Mr. Tarullo. Let me just take 30 seconds, Senator. That 
little litany you had I think is right. I would just add one 
thing to it. You have got supervision of systemically important 
institutions not currently subject to supervision.
    Chairman Dodd. That could be one role.
    Mr. Tarullo. That is one role. The second role, which you 
also identified, practices that are pervasive in an industry, 
no matter what the size of the entity, which rise to the level 
of posing true systemic risk--probably unusual, but certainly 
possible.
    Chairman Dodd. Right.
    Mr. Tarullo. And I think we have seen it in the last couple 
of years.
    Third is the resolution mechanism you spoke about. It seems 
to me that should not be included within the definition of 
system risk regulator. You could, under some configurations, 
have the same entity doing those two functions. I think what 
you would need is to ensure that the systemic regulator had a 
role in the decisions on resolving systemically important 
institutions, as Chairman Bair pointed out, such as under the 
systemic risk exception in the FDI Act that already exists.
    The fourth function that I would add is the monitoring one. 
I understand that is a prerequisite for some of the other ones 
we talked about, but it also serves an independent purpose, and 
I think, if I am not mistaken, this is some of what Senator 
Reed has been getting at in the past--the need to focus on 
issues and get them out, get them discussed and get them 
reported.
    Chairman Dodd. Right.
    Mr. Tarullo. So I think that is your choice, that you have 
got four functions there. My sense is that the resolution issue 
is not necessarily----
    Chairman Dodd. You could be right. And your fourth point, 
the private sector model where you have the official or the 
officer in the business doing the risk assessment. As I 
understand it, in a lot of these entities, they do not have the 
capacity to shut something down on their own except in very 
extreme cases. But they will advise the individuals who are 
engaging in that thing that their behavior is posing risks to 
their company. So it does not have the ability to say no, but 
it has the power or at least the information to warn.
    I am a little uneasy about that because it just seems to me 
whether or not you are going to get the decisions that actually 
would shut things down when they arise. There are too many dots 
to connect to reach that point of shutting something down 
before it poses even greater risk.
    Mr. Tarullo. Well, but you do, I think, Mr. Chairman, 
want--again, this is why it is important for Congress 
ultimately to decide what scope of authorities it wants 
somewhere, and then figure out where the best place to put them 
is. But that does require us all to make this judgment as to 
how broadly we want authority reaching and under what 
circumstances. As you can tell from my testimony, our view is 
that you do not want to displace the regular prudential 
supervision of all the agencies.
    Chairman Dodd. No.
    Mr. Tarullo. This should be something which is an oversight 
mechanism on top of it in the general course of things. But as 
I think you have pointed out, you will sometimes have 
practices--and subprime mortgage lending that was either 
predatory or not well backed by good underwriting is a 
principal example--that became pervasive and should have been 
regulated earlier.
    Chairman Dodd. I have said over and over again I am sort of 
agnostic on all of this. I want to do what works. But if you 
ask me where I was inclining, it is on that point. I think you 
have got to watch practices. Just because something is called 
important does not mean it is. And there may be practices that 
may not seem important but are terribly important. And it seems 
to me we ought to be focusing on that, not at the exclusion of 
the other.
    Let me ask the other panelists quickly to comment if they 
have--any comments on this from anyone else on this discussion? 
Sheila, do you have----
    Mr. Fryzel. I just have one comment. If the Congress takes 
the action and puts in place a systemic regulator, that is 
certainly not going to stop or prevent some of the problems 
that we have now out in the financial services industry.
    As Chairman Bair talked about, the fact that she has asked 
for an increase in the lending from the Treasury, as we have at 
NCUA, which is paramount to us taking care of the problems 
between now and the time the systemic risk regulator is able to 
take over and watch over all of our industries. So that there 
are tools that we are going to be coming back to the Congress 
for between now and then that the regulators are going to need 
to solve the problems that are existing out there now. We still 
need things to get those solved.
    Chairman Dodd. Sheila, do you want to comment?
    Ms. Bair. Yes, I would--I agree with what you said about 
practices. I would only add that, to some extent, they are 
connected in that if the Federal Government or the agencies do 
not have the ability both to write rules--which we did have--
and enforce those rules for all institutions, you still get the 
kind of dynamic we had with mortgages where it started with the 
nonbanks creating competitive pressure on the banks to respond 
in kind.
    And another thing that--you do not have the SEC and the 
CFTC here, but I think any discussion of regulatory 
restructuring needs to note the need for market regulation of 
the derivatives markets, especially the CDS markets.
    Chairman Dodd. We do not have a table big enough.
    Ms. Bair. That is not institution-specific, absolutely, but 
it is another area.
    Chairman Dodd. But I must say, I was sitting here looking 
at this and we are missing the CFTC and the SEC at this table. 
But in a sense, and I say this very respectfully, this is the 
problem. With all due respect, this is the problem. In a sense, 
we talk about too big to fail in the sense of private 
institutions. But in a sense, we have a bureaucracy or a 
regulatory structure and so forth, that is too big to succeed 
because it is so duplicative.
    And I can understand there is a value in that, in terms of 
protecting some things, but we are having the SEC next week 
testify before the Committee.
    But if I wanted to capture in a photograph what is the 
essence of the problem, I can't. And this is the problem. And 
this is what we've got to sort out in a way that provides some 
clarity to the process as we go forward.
    By the way, there is going to be a hearing at 2 o'clock--I 
know that is what all of you want to hear--on deposit insurance 
that Senator Johnson is hosting in 538 of the Dirksen Building.
    [Laughter.]
    Chairman Dodd. That will be good news for our panelists, we 
know I have got to wrap up here as we are getting near 2 
o'clock.
    We are going to proceed on this, I would say to Chairman 
Bair as well, and we are trying to resolve some other issues, 
if we can, in going forward. I know you are aware of that. 
Obviously, we are very interested in getting the legislation 
adopted, and we will move quickly.
    Any other further comment on this last point? And then I 
want to end, if not? Yes, John.
    Mr. Dugan. Senator, I would just agree with your point. It 
is not obvious that, in many cases, the gathering of the 
information is not really the most important thing you need to 
do. For example, if you had hedge funds, it is not clear you 
would want to go in and regulate them like you regulate a bank. 
You might want to find out what they were doing, how they were 
doing it, have some authority to take some action if you had 
to.
    But the gathering of information, understanding what they 
do, was completely absent during the current crisis with 
respect to nonbanks, and it is a really important thing that 
you are talking about, to learn what people are doing. So that 
is a fundamental building block.
    Chairman Dodd. Thank you.
    I can see you chafing. Go ahead, Governor.
    Mr. Tarullo. Just one point on that. This is what I meant 
earlier about being clear about where they go, where 
authority----
    Chairman Dodd. We need the mic on.
    Mr. Tarullo. I am sorry. Because if you say you are a 
systemic risk regulator, you are responsible for everything, no 
matter where it may happen. But there is not a regular system 
in place for overseeing a particular market or overseeing 
particular institutions. That is when I think you risk having 
things falling between the cracks and expectations not being 
met.
    And so I come back to the point I opened with, that is why 
there needs to be an agenda for systemic stability which takes 
into account each of the roles that the various agencies will 
play.
    Chairman Dodd. Well, I thank you. There are additional 
questions I will submit for the record, and I know my 
colleagues will, as well. We are going to be very engaged with 
all of you over the coming weeks on this matter. As I said, we 
have got more hearings to hold on this, the SEC next week. We 
have had seven already. And I thank each and every one of you 
for your participation. It has been very, very helpful here 
this morning.
    The Committee will stand adjourned.
    [Whereupon, at 1:40 p.m., the hearing was adjourned.]
    [Prepared statements and response to written questions 
supplied for the record follow:]
               PREPARED STATEMENT OF SENATOR JIM BUNNING
    Thank you, Mr. Chairman. This is a very important hearing, and I 
hope our witnesses will give us some useful answers. AIG has been in 
the news a lot this week, but it is not the only problem in our 
financial system. Other firms, including some regulated by our 
witnesses, have failed or been bailed out.
    We all want to make any changes we can that will prevent this from 
happening again. But before we jump to any conclusions about what needs 
to be done to prevent similar problems in the future, we need to 
consider whether any new regulations will really add to stability or 
just create a false sense of security.
    For example, I am not convinced that if the Fed had clear power to 
oversee all of AIG they would have noticed the problems or done 
anything about it. They clearly did not do a good enough job in 
regulating their holding companies, as we discussed at the Securities 
Subcommittee hearing yesterday. Their poor performance should throw 
cold water on the idea of giving them even more responsibility.
    Finally, I want to say a few words about the idea of a risk 
regulator. While the idea sounds good, there are several questions that 
must be answered to make such a plan work. First, we have to figure out 
what risk is and how to measure it. This crisis itself is evidence that 
measuring risk is not as easy as it sounds. Second, we need to consider 
what to do about that risk. In other words, what powers would that 
regulator have, and how do you deal with international companies? 
Third, how do we keep the regulator from always being a step behind the 
markets? Do we really believe the regulator will be able to recruit the 
talent needed to see and understand risk in an ever-changing financial 
system on government salaries? Finally, will the regulator continue the 
expectation of government rescue whenever things go bad?
    We should at least consider if we can accomplish the goal of a more 
stable system by making sure the parties to financial deals bear the 
consequences of their actions and thus act more responsibly in the 
first place.
    Thank you, Mr. Chairman.
                                 ______
                                 

                  PREPARED STATEMENT OF JOHN C. DUGAN
                      Comptroller of the Currency,
               Office of the Comptroller of the Currency
                             March 19, 2009
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
I appreciate this opportunity to discuss reforming the regulation of 
our financial system.
    Recent turmoil in the financial markets, the unprecedented distress 
and failure of large financial firms, the mortgage and foreclosure 
crises, and growing numbers of problem banks--large and small--have 
prompted calls to reexamine and revamp thenation's financial regulatory 
system. The crisis raises legitimate questions about whether our 
existing complex system has both redundancies and gaps that 
significantly compromise its effectiveness. At the same time, any 
restructuring effort that goes forward should be carefully designed to 
avoid changes that undermine the parts of our current regulatory system 
that work best.
    To examine this very important set of issues, the Committee will 
consider many aspects of financial regulation that extend beyond bank 
regulation, including the regulation of government-sponsored 
enterprises, insurance companies, and the intersection of securities 
and commodities markets. Accordingly, my testimony today focuses on key 
areas where I believe the perspective of the OCC--with the benefit of 
hindsight from the turmoil of the last two years--can most usefully 
contribute to the Committee's deliberations. Specifically, I will 
discuss the need to--

    improve the oversight of systemic risk, especially with 
        respect to systemically important financial institutions that 
        are not banks;

    establish a better process for stabilizing, resolving or 
        winding down such firms;

    reduce the number of bank regulators, while preserving a 
        dedicated prudential supervisor;

    enhance mortgage regulation; and

    improve consumer protection regulation while maintaining 
        its fundamental connection to prudential supervision.
Improving Systemic Risk Oversight
    The unprecedented events of the past year have brought into sharp 
focus the issue of systemic risk, especially in connection with the 
failures or near failures of large financial institutions. Such 
institutions are so large and so intertwined with financial markets and 
other major financial institutions that the failure of one could cause 
a cascade of serious problems throughout the financial system--the very 
essence of systemic risk.
    Years ago, systemically significant firms were generally large 
banks, and our regime of extensive, consolidated supervision of banks 
and bank holding companies--combined with the market expertise provided 
by the Federal Reserve through its role as central bank--provided a 
means to address the systemic risk presented by these institutions. 
More recently, however, large nonbank financial institutions like AIG, 
Fannie Mae and Freddie Mac, Bear Stearns, and Lehman began to present 
similar risks to the system as large banks. Yet these nonbank firms 
were subject to varying degrees and different kinds of government 
oversight. In addition, no one regulator had access to risk information 
from these nonbank firms in the same way that the Federal Reserve has 
with respect to bank holding companies. The result, I believe, was that 
the risk these firms presented to the financial system as a whole could 
not be managed or controlled until their problems reached crisis 
proportions.
    One suggested way to address this problem going forward would be to 
assign one agency the oversight of systemic risk throughout the 
financial system. This approach would fix accountability, centralize 
data collection, and facilitate a unified approach to identifying and 
addressing large risks across the system. Such a regulator could also 
be assigned responsibility for identifying as systemically significant 
those institutions whose financial soundness and role in financial 
intermediation is important to the stability of U.S. and global 
markets.
    But the single systemic regulator approach would also face 
challenges due to the diverse nature of the firms that could be labeled 
systemically significant. Key issues would include the type of 
authority that should be provided to the regulator; the types of 
financial firms that should be subject to its jurisdiction; and the 
nature of the new regulator's interaction with existing prudential 
supervisors. It would be important, for example, for the systemic 
regulatory function to build on existing prudential supervisory 
schemes, adding a systemic point of view, rather than replacing or 
duplicating regulation and supervisory oversight that already exists. 
How this would be done would need to be evaluated in light of other 
restructuring goals, including providing clear expectations for 
financial institutions and clear responsibilities and accountability 
for regulators; avoiding new regulatory inefficiencies; and considering 
the consequences of an undue concentration of responsibilities in a 
single regulator.
    It has been suggested that the Federal Reserve Board should serve 
as the single agency responsible for systemic risk oversight. This 
makes sense given the comparable role that the Board already plays with 
respect to our largest banking companies; its extensive involvement 
with capital markets and payments systems; and its frequent interaction 
with central banks and supervisors from other countries.
    If Congress decides to take this approach, however, it would be 
necessary to define carefully the scope of the Board's authority over 
institutions other than the bank holding companies and state-chartered 
member banks that it already supervises. Moreover, the Board has many 
other critical responsibilities, including monetary policy, discount 
window lending, payments system regulation, and consumer protection 
rulewriting. Adding the broad role of systemic risk overseer raises the 
very real concerns of the Board taking on too many functions to do all 
of them well, while at the same time concentrating too much authority 
in a single government agency. The significance of these concerns would 
depend very much on both the scope of the new responsibilities as 
systemic risk regulator, and any other significant changes that might 
be made to its existing role as the consolidated bank holding company 
supervisor.
    Let me add that the contours of new systemic authority may need to 
vary depending on the nature of the systemically significant entity. 
For example, prudential regulation of banks involves extensive 
requirements with respect to risk reporting, capital, activities 
limits, risk management, and enforcement. The systemic supervisor might 
not need to impose all such requirements on all types of systemically 
important firms. The ability to obtain risk information would be 
critical for all such firms, but it might not be necessary, for 
example, to impose the full array of prudential standards, such as 
capital requirements or activities limits on all types of systemically 
important firms, e.g., hedge funds (assuming they were subject to the 
new regulator's jurisdiction). Conversely, firms like banks that are 
already subject to extensive prudential supervision would not need the 
same level of oversight as firms that are not--and if the systemic 
overseer were the Federal Reserve Board, very little new authority 
would be required with respect to banking companies, given the Board's 
current authority over bank holding companies.
    It also may be appropriate to allocate different levels of 
authority to the systemic risk overseer at different points in time 
depending on whether financial markets are functioning normally, or are 
instead experiencing unusual stress or disruption. For example, in a 
stable economic environment, the systemic risk regulator might focus 
most on obtaining and analyzing information about risks. Such 
additional information and analysis would be valuable not only for the 
systemic risk regulator, but also for prudential supervisors in terms 
of their understanding of firms' exposure to risks occurring in other 
parts of the financial services system to which they have no direct 
access. And it could facilitate the implementation of supervisory 
strategies to address and contain such risk before it increased to 
unmanageable levels.
    On the other hand, in times of stress or disruption it may be 
appropriate to authorize the systemic regulator to take actions 
ordinarily reserved for prudential supervisors, such as imposing 
specific conditions or requirements on operations of a firm. Such 
authority would need to be crafted to ensure flexibility, but the 
triggering circumstances and process for activating the authority 
should be clear. Mechanisms for accountability also should be 
established so that policymakers, regulated entities, and taxpayers can 
understand and evaluate appropriate use of the authority.
    Let me make one final point about the systemic risk regulator. Our 
financial system's ``plumbing''--the major systems we have for clearing 
payments and settling transactions--are not now subject to any clear, 
overarching regulatory system because of the variety in their 
organizational form. Some systems are clearinghouses or banking 
associations subject to the Bank Service Company Act. Some are 
securities clearing agencies or agency organizations pursuant to the 
securities or commodities laws. Others are chartered under the 
corporate laws of states. \1\
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     \1\ For a description of the significance of payment and 
settlement systems and the various forms under which they are organized 
in the United States, see U.S. Department of the Treasury, Blueprint 
for a Modernized Financial Regulatory Structure 100-103 (March 2008) 
(2008 Treasury Blueprint).
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    Certain of these payment and settlement systems are systemically 
significant for the liquidity and stability of our financial markets, 
and I believe these systems should be subjected to overarching federal 
supervision to reduce systemic risk. One approach to doing so was 
suggested in the 2008 Treasury Blueprint, which recommended 
establishing a new federal charter for systemically significant payment 
and settlement systems and authorizing the Federal Reserve Board to 
supervise them. I believe this approach is appropriate given the 
Board's extensive experience with payment system regulation.
Resolving Systemically Significant Firms
    Events of the past year also have highlighted the lack of a 
suitable process for resolving systemically significant financial firms 
that are not banks. U.S. law has long provided a unique and well 
developed framework for resolving distressed and failing banks that is 
distinct from the federal bankruptcy regime. Since 1991, this unique 
framework, administered by the Federal Deposit Insurance Corporation, 
has also provided a mechanism to address the problems that can arise 
with the potential failure of a systemically significant bank--
including, if necessary to protect financial stability, the ability to 
use the bank deposit insurance fund to prevent uninsured depositors, 
creditors, and other stakeholders of the bank from sustaining loss.
    Unfortunately, no comparable framework exists for resolving most 
systemically significant financial firms that are not banks, including 
systemically significant holding companies of banks. Such firms must 
therefore use the normal bankruptcy process unless they can obtain some 
form of extraordinary government assistance to avoid the systemic risk 
that might ensue from failure or the lack of a timely and orderly 
resolution. While the bankruptcy process may be appropriate for 
resolution of certain types of firms, it may take too long to provide 
certainty in the resolution of a systemically significant firm, and it 
provides no source of funding for those situations where substantial 
resources are needed to accomplish an orderly solution. As a result, in 
the last year as a number of large nonbank financial institutions faced 
potential failure, government agencies have had to improvise with 
various other governmental tools to address systemic risk issues at 
nonbanks, sometimes with solutions that were less than ideal.
    This gap needs to be addressed with an explicit statutory regime 
for facilitating the resolution of systemically important nonbank 
companies as well as banks. This new statutory regime should provide 
tools that are similar to those the FDIC currently has for resolving 
banks, including the ability to require certain actions to stabilize a 
firm; access to a significant funding source if needed to facilitate 
orderly dispositions, such as a significant line of credit from the 
Treasury; the ability to wind down a firm if necessary, and the 
flexibility to guarantee liabilities and provide open institution 
assistance if necessary to avoid serious risk to the financial system. 
In addition, there should be clear criteria for determining which 
institutions would be subject to this resolution regime, and how to 
handle the foreign operations of such institutions.
    One possible approach to a statutory change would be to simply 
extend the FDIC's current authority to nonbanks. That approach would 
not appear to be appropriate given the bank-centric nature of the 
FDIC's mission and resources. The deposit insurance fund is paid for by 
assessments on insured banks, with a special assessment mechanism 
available for certain losses caused by systemically important banks. It 
would not be fair to assess only banks for problems at nonbanks. In 
addition, institutional conflicts may arise when the insurer must 
fulfill the dual mission of protecting the insurance fund and advancing 
the broader U.S. Government interests at stake when systemically 
significant institutions require resolution. Indeed, important changes 
have recently been proposed to improve the FDIC's systemic risk 
assessment process to provide greater equity when the FDIC's protective 
actions extend beyond the insured depository institution to affiliated 
entities that are not banks.
    A better approach may be to provide the new authority to the new 
systemic risk regulator, in combination with the Treasury Department, 
given the likely need for a substantial source of government funds. The 
new systemic risk regulator would by definition have systemic risk 
responsibility, and the Treasury has direct accountability to 
taxpayers. If the systemic risk regulator were the Federal Reserve, 
then the access to discount window funding would also provide a 
critical resource to help address significant liquidity problems. It is 
worth noting that, in most other countries, it has been the Treasury 
Department or its equivalent that has provided extraordinary assistance 
to systemically important financial firms during this crisis, whether 
in the form of capital injections, government guarantees, or more 
significant government ownership.
Reducing the Number of Bank Regulators
    It is clear that the United States has too many bank regulators. We 
have four federal regulators, 12 Federal Reserve Banks, and 50 state 
regulators, nearly all of which have some type of overlapping 
supervising responsibilities. This system is largely the product of 
historical evolution, with different agencies created for different 
legitimate purposes reflecting a much more segmented banking system 
from the past. No one would design such a system from scratch, and it 
is fair to say that, at times, it has not been the most efficient way 
to establish banking policy or supervise banks.
    Nevertheless, the banking agencies have worked hard over the years 
to make the system function appropriately despite its complexities. On 
many occasions, the diversity in perspectives and specialization of 
roles has provided real value. And from the perspective of the OCC, I 
do not believe that our sharing of responsibilities with other agencies 
has been a primary driver of recent problems in the banking system.
    That said, I recognize the considerable interest in reducing the 
number of bank regulators. The impulse to simplify is understandable, 
and it may well be appropriate to streamline our current system. But we 
ought not approach the task by prejudging the appropriate number of 
boxes on the organization chart. The better approach is to determine 
what would be achieved if the number of regulators were reduced. What 
went wrong in the current crisis that changes in regulatory structure 
(rather than regulatory standards) will fix? Will accountability be 
enhanced? Will the change result in greater efficiency and consistency 
of regulation? Will gaps be closed so that opportunities for regulatory 
arbitrage in the current system are eliminated? Will overall market 
regulation be improved?
    In this context, while there is arguably an agreement on the need 
to reduce the number of bank regulators, there is no such consensus on 
what the right number is or what their roles should be. Some have 
argued that we should have just one regulator responsible for bank 
supervision, and that it ought to be a new agency such as the Financial 
Services Agency in the UK, or that all such responsibilities should be 
consolidated in our central bank, the Federal Reserve Board. Let me 
explain why I don't think either of these ideas is the right one for 
our banking system.
    The fundamental problem with consolidating all supervision in a 
new, single independent agency is that it would take bank supervisory 
functions away from the Federal Reserve Board. In terms of the normal 
turf wars among agencies, it may sound strange for the OCC to take this 
position. But as the central bank and closest agency we have to a 
systemic risk regulator, I believe the Board needs the window it has 
into banking organizations that it derives from its role as bank 
holding company supervisor. More important, given its substantial role 
and direct experience with respect to capital markets, payments 
systems, the discount window, and international supervision, the Board 
provides unique resources and perspective to bank holding company 
supervision.
    Conversely, I believe it also would be a mistake to move all direct 
banking supervision to the Board, or even all such supervision for the 
most systemically important banks. The Board has many other critical 
responsibilities, including monetary policy, discount window lending, 
payments system regulation, and consumer protection rulewriting. 
Consolidating all banking supervision there as well would raise a 
serious concern about the Board taking on too many functions to do all 
of them well. There would also be a very real concern about 
concentrating too much authority in a single government agency. And 
both these concerns would be amplified substantially if the Board were 
also designated the new systemic risk regulator and took on supervisory 
responsibilities for systemically significant payment and clearing 
systems.
    Most important, moving all supervision to the Board would lose the 
very real benefit of having an agency whose sole mission is bank 
supervision. That is, of course, the sole mission of the OCC, and I 
realize that, coming from the Comptroller, support for preserving a 
dedicated prudential banking supervisor may be portrayed by some as 
merely protecting turf. That would be unfortunate, because I strongly 
believe that the benefits of dedicated supervision are real. Where it 
occurs, there is no confusion about the supervisor's goals and 
objectives, and no potential conflict with competing objectives. 
Responsibility is well defined, and so is accountability. Supervision 
takes a back seat to no other part of the organization, and the result 
is a strong culture that fosters the development of the type of 
seasoned supervisors that are needed to confront the many challenges 
arising from today's banking business.
    In the case of the OCC, I would add that our role as the front-
line, on-the-ground prudential supervisor is complementary to the 
current role of the Federal Reserve Board as the consolidated holding 
company regulator. This model has allowed the Board to use and rely on 
our work to perform its role as supervisor for complex banking 
organizations that are often involved in many businesses other than 
banking. Such a model would also work well with respect to any new 
authority provided to a systemic risk regulator, whether or not the 
Board is assigned that role.
    In short, there are a number of options for reducing the number of 
bank regulators, and many detailed issues involved with each. It is not 
my intent to address these issues in detail in this testimony, but 
instead to make two fundamental and related points about changes to the 
banking agency regulatory structure. While it is important to preserve 
the Federal Reserve Board's role as a holding company supervisor, it is 
equally if not more important to preserve the role of a dedicated, 
front-line prudential supervisor for our nation's banks.
Enhanced Mortgage Regulation
    The current financial crisis began and continues with problems 
arising from poorly underwritten residential mortgages, especially 
subprime mortgages. While these lending practices have been brought 
under control, and federal regulators have taken actions to prevent the 
worst abuses, more needs to be done. As part of any regulatory reform 
to address the crisis, Congress should establish a mortgage regulatory 
regime that ensures that the mortgage crisis is never repeated.
    A fundamental reason for poorly underwritten mortgages was the lack 
of consistent regulation for mortgage providers. Depository institution 
mortgage providers--whether state or federally chartered--were the most 
extensively regulated, by state and federal banking supervisors. 
Mortgage providers affiliated with depository institutions were less 
regulated, primarily by federal holding company supervisors, but also 
by state mortgage regulators. Mortgage providers not affiliated with 
depository institutions--including mortgage brokers and lenders--were 
the least regulated by far, with no direct supervision at the federal 
level, and limited ongoing supervision at the state level.
    The results have been predictable. As the 2007 Report of the 
Majority Staff of the Joint Economic Committee recognized, ``[s]ince 
brokers and mortgage companies are only weakly regulated, another 
outcome [of the increase in subprime lending] was a marked increase in 
abusive and predatory lending.'' \2\ Nondepository institution mortgage 
providers originated the overwhelming preponderance of subprime and 
``Alt-A'' mortgages during the crucial 2005-2007 period, and the loans 
they originated account for a disproportionate percentage of defaults 
and foreclosures nationwide, with glaring examples in the metropolitan 
areas hardest hit by the foreclosure crisis. For example, a recent 
analysis of mortgage loan data prepared by OCC staff, from a well-known 
source of mortgage loan data, identified the 10 mortgage originators 
with the highest number of subprime and Alt-A mortgage foreclosures--in 
the 10 metropolitan statistical areas (MSAs) experiencing the highest 
foreclosure rates in the period 2005-2007. While each type of mortgage 
originator has experienced elevated levels of delinquencies and 
defaults in recent years, of the 21 firms comprising the ``worst 10'' 
in those ``worst 10'' MSAs, the majority--accounting for nearly 60 
percent of nonprime mortgage loans and foreclosures--were exclusively 
supervised by the states. \3\
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     \2\ Majority Staff of the Joint Economic Committee, 110th Cong., 
Report and Recommendations on the Subprime Lending Crisis: The Economic 
Impact on Wealth, Property Values and Tax Revenues, and How We Got Here 
17 (October 2007).
     \3\ Letter from Comptroller of the Currency John Dugan to 
Elizabeth Warren, Chair, Congressional Oversight Panel, February 12, 
2009, at http://www.occ.treas.gov/ftp/occ_copresponse_021209.pdf.
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    In view of this experience, Congress should take at least two 
actions in connection with regulatory reform. First, it should 
establish national mortgage standards that would apply consistently 
regardless of originator, similar to the mortgage legislation that 
passed the House of Representatives last year. In taking this 
extraordinary step, Congress should provide flexibility to regulators 
to implement the statutory standards through regulations that protect 
consumers and balance the need for conservative underwriting with the 
equally important need for access to affordable credit.
    Second, Congress should also ensure that the new standards are 
applied and enforced in a comparable manner, again, regardless of 
originator. This objective can be accomplished relatively easily for 
mortgages provided by depository institutions or their affiliates: 
federal banking regulators have ample authority to ensure compliance 
through ongoing examination and supervision reinforced by broad 
enforcement powers. The objective is not so easily achieved with 
nonbank mortgage providers regulated exclusively by the states, 
however. The state regime for regulating mortgage brokers and lenders 
typically focuses on licensing, rather than ongoing examination and 
supervision, and enforcement by state agencies typically targets 
problems after they have become severe, not before. That difference 
between the federal and state regimes can result in materially 
different levels of compliance, even with a common federal standard. As 
a result, it will be important to develop a mechanism to facilitate a 
level of compliance at the state level that is comparable to compliance 
of depository institutions subject to federal standards. The goal 
should be robust national standards that are applied consistently to 
all mortgage providers.
Enhanced Consumer Protection Regulation
    Effective protection for consumers of financial products and 
services is a vital part of financial services regulation. In the OCC's 
experience, and as the mortgage crisis illustrates, safe and sound 
lending practices are integral to consumer protection. Indeed, contrary 
to several recent proposals, we believe that the best way to implement 
consumer protection regulation of banks--the best way to protect 
consumers--is to do so through prudential supervision. Let me explain 
why.
    First, prudential supervisors' continual presence in banks through 
the examination process puts them in the very best position to ensure 
compliance with consumer protection requirements established by statute 
and regulation. Examiners are trained to detect weaknesses in banks' 
policies, systems, and procedures for implementing consumer protection 
mandates, and they gather information both on-site and off-site to 
assess bank compliance. Their regular communication with the bank 
occurs through examinations at least once every 18 months for smaller 
institutions, supplemented by quarterly calls with management, and for 
the very largest banks consumer compliance examiners are on site every 
day. We believe this continual supervisory presence creates especially 
effective incentives for consumer protection compliance, as well as 
allowing examiners to detect compliance failures much earlier than 
would otherwise be the case.
    Second, prudential supervisors have strong enforcement powers and 
exceptional leverage over bank management to achieve corrective action. 
Banks are among the most extensively supervised firms in any type of 
industry, and bankers understand very well the range of negative 
consequences that can ensue from defying their regulator. As a result, 
when examiners detect consumer compliance weaknesses or failures, they 
have a broad range of tools to achieve corrective action, from informal 
comments to formal enforcement action--and banks have strong incentives 
to move back into compliance as expeditiously as possible.
    Indeed, behind the scenes and without public fanfare, bank 
supervision results in significant reforms to bank practices and 
remedies for their customers--and it can do so much more quickly than 
litigation, formal enforcement actions, or other publicized events. For 
example, as part of the supervisory process, bank examiners identify 
weaknesses in areas pertaining both to compliance and safety and 
soundness by citing MRAs--``matters requiring attention''--in the 
written report of examination. An MRA describes a problem, indicates 
its cause, and requires the bank to implement a remedy before the 
matter can be closed. In the period between 2004 and 2007, OCC 
examiners cited 123 mortgage-related MRAs. By the end of 2008, 
satisfactory corrective action had been taken with respect to 109 of 
those MRAs, without requiring formal enforcement actions. Corrective 
actions were achieved for issues involving mortgage underwriting, 
appraisal quality, monitoring of mortgage brokers, and other consumer-
related issues. We believe this type of extensive supervision and early 
warning oversight is a key reason why the worst form of subprime 
lending practices did not become widespread in the national banking 
system.
    Third, because examiners are continually exposed to the practical 
effects of implementing consumer protection rules for bank customers, 
the prudential supervisory agency is in the best position to formulate 
and refine consumer protection regulations for banks. Indeed, while 
most such rule-writing authority is currently housed in the Federal 
Reserve Board, we believe that the rule-writing process would benefit 
by requiring more formal consultation with other banking supervisors 
that have substantial supervisory responsibilities in this area.
    Recently, alternative models for financial product consumer 
protection regulation have been suggested. One is to remove all 
consumer protection regulation and supervision from prudential 
supervisors, instead consolidating such authority in a new federal 
agency. This model would be premised on an SEC-style regime of 
registration and licensing for all types of consumer credit providers, 
with standards set and compliance achieved through enforcement actions 
by a new agency. The approach would rely on self-reporting by credit 
providers, backstopped by enforcement or judicial actions, rather than 
ongoing supervision and examination.
    The attractiveness of this alternative model is that it would 
centralize authority and accountability in a single agency, which could 
write rules that would apply uniformly to financial services providers, 
whether or not they are depository institutions. Because the agency 
would focus exclusively on consumer protection, proponents also argue 
that such a model eliminates the concern sometimes expressed that 
prudential supervisors neglect consumer protection in favor of safety 
and soundness supervision.
    But the downside of this approach is considerable. It would not 
have the benefits of on-site examination and supervision and the very 
real leverage that bank supervisors have over the banks they regulate. 
That means, we believe, that compliance is likely to be less effective. 
Nor would this approach draw on the practical expertise that examiners 
develop from continually assessing the real-world impact of particular 
consumer protection rules--an asset that is especially important for 
developing and adjusting such rules over time. More troubling, the 
ingredients of this approach--registration, licensing and reliance on 
enforcement actions to achieve compliance with standards--is the very 
model that has proved inadequate to protect consumers doing business 
with state regulated mortgage lenders and brokers.
    Finally, I do not agree that the banking agencies have failed to 
give adequate attention to the consumer protection laws that they have 
been charged with implementing. For example, predatory lending failed 
to gain a foothold in the banking industry precisely because of the 
close supervision commercial banks, both state and national, received. 
But if Congress believes that the consumer protection regime needs to 
be strengthened, the best answer is not to create a new agency that 
would have none of the benefits of a prudential supervisor. Instead, 
the better approach is a crisp Congressional mandate to already 
responsible agencies to toughen the applicable standards and close any 
gaps in regulatory coverage. The OCC and the other prudential bank 
supervisors will rigorously apply them. And because of the tools we 
have that I've already mentioned, banks will comply more readily and 
consumers will be better protected than would be the case with mandates 
applied by a new federal agency.
Conclusion
    My testimony today reflects the OCC's views on several key aspects 
of regulatory reform. We would be happy provide more details or 
additional views on other issues at the Committee's request.

                  PREPARED STATEMENT OF SHEILA C. BAIR
                               Chairman,
                 Federal Deposit Insurance Corporation
                             March 19, 2009
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
I appreciate the opportunity to testify on behalf of the Federal 
Deposit Insurance Corporation (FDIC) on the need to modernize and 
reform our financial regulatory system.
    The events that have unfolded over the past two years have been 
extraordinary. A series of economic shocks have produced the most 
challenging financial crisis since the Great Depression. The widespread 
economic damage has called into question the fundamental assumptions 
regarding financial institutions and their supervision that have 
directed our regulatory efforts for decades. The unprecedented size and 
complexity of many of today's financial institutions raise serious 
issues regarding whether they can be properly managed and effectively 
supervised through existing mechanisms and techniques. In addition, the 
significant growth of unsupervised financial activities outside the 
traditional banking system has hampered effective regulation.
    Our current system has clearly failed in many instances to manage 
risk properly and to provide stability. U.S. regulators have broad 
powers to supervise financial institutions and markets and to limit 
many of the activities that undermined our financial system, but there 
are significant gaps, most notably regarding very large insurance 
companies and private equity funds. However, we must also acknowledge 
that many of the systemically significant entities that have needed 
federal assistance were already subject to extensive federal 
supervision. For various reasons, these powers were not used 
effectively and, as a consequence, supervision was not sufficiently 
proactive. Insufficient attention was paid to the adequacy of complex 
institutions' risk management capabilities.
    Too much reliance was placed on mathematical models to drive risk 
management decisions. Notwithstanding the lessons from Enron, off-
balance sheet-vehicles were permitted beyond the reach of prudential 
regulation, including holding company capital requirements. Perhaps 
most importantly, failure to ensure that financial products were 
appropriate and sustainable for consumers has caused significant 
problems not only for those consumers but for the safety and soundness 
of financial institutions. Moreover, some parts of the current 
financial system, for example, over the counter derivatives, are by 
statute, mostly excluded from federal regulation.
    In the face of the current crisis, regulatory gaps argue for some 
kind of comprehensive regulation or oversight of all systemically 
important financial firms. But, the failure to utilize existing 
authorities by regulators casts doubt on whether simply entrusting 
power in a single systemic risk regulator will sufficiently address the 
underlying causes of our past supervisory failures. We need to 
recognize that simply creating a new systemic risk regulator is a not a 
panacea. The most important challenge is to find ways to impose greater 
market discipline on systemically important institutions. The solution 
must involve, first and foremost, a legal mechanism for the orderly 
resolution of these institutions similar to that which exists for FDIC 
insured banks. In short, we need an end to too big to fail.
    It is time to examine the more fundamental issue of whether there 
are economic benefits to institutions whose failure can result in 
systemic issues for the economy. Because of their concentration of 
economic power and interconnections through the financial system, the 
management and supervision of institutions of this size and complexity 
has proven to be problematic. Taxpayers have a right to question how 
extensive their exposure should be to such entities.
    The problems of supervising large, complex financial institutions 
are compounded by the absence of procedures and structures to 
effectively resolve them in an orderly fashion when they end up in 
severe financial trouble. Unlike the clearly defined and proven 
statutory powers that exist for resolving insured depository 
institutions, the current bankruptcy framework available to resolve 
large complex nonbank financial entities and financial holding 
companies was not designed to protect the stability of the financial 
system. This is important because, in the current crisis, bank holding 
companies and large nonbank entities have come to depend on the banks 
within the organizations as a source of strength. Where previously the 
holding company served as a source of strength to the insured 
institution, these entities now often rely on a subsidiary depository 
institution for funding and liquidity, but carry on many systemically 
important activities outside of the bank that are managed at a holding 
company level or nonbank affiliate level.
    While the depository institution could be resolved under existing 
authorities, the resolution would cause the holding company to fail and 
its activities would be unwound through the normal corporate bankruptcy 
process. Without a system that provides for the orderly resolution of 
activities outside of the depository institution, the failure of a 
systemically important holding company or nonbank financial entity will 
create additional instability as claims outside the depository 
institution become completely illiquid under the current system.
    In the case of a bank holding company, the FDIC has the authority 
to take control of only the failing banking subsidiary, protecting the 
insured depositors. However, many of the essential services in other 
portions of the holding company are left outside of the FDIC's control, 
making it difficult to operate the bank and impossible to continue 
funding the organization's activities that are outside the bank. In 
such a situation, where the holding company structure includes many 
bank and nonbank subsidiaries, taking control of just the bank is not a 
practical solution.
    If a bank holding company or nonbank financial holding company is 
forced into or chooses to enter bankruptcy for any reason, the 
following is likely to occur. In a Chapter 11 bankruptcy, there is an 
automatic stay on most creditor claims, with the exception of specified 
financial contracts (futures and options contracts and certain types of 
derivatives) that are subject to termination and netting provisions, 
creating illiquidity for the affected creditors. The consequences of a 
large financial firm filing for bankruptcy protection are aptly 
demonstrated by the Lehman Brothers experience. As a result, neither 
taking control of the banking subsidiary or a bankruptcy filing of the 
parent organization is currently a viable means of resolving a large, 
systemically important financial institution, such as a bank holding 
company. This has forced the government to improvise actions to address 
individual situations, making it difficult to address systemic problems 
in a coordinated manner and raising serious issues of fairness.
    My testimony will examine some steps that can be taken to reduce 
systemic vulnerabilities by strengthening supervision and regulation 
and improving financial market transparency. I will focus on some 
specific changes that should be undertaken to limit the potential for 
excessive risk in the system, including identifying systemically 
important institutions, creating incentives to reduce the size of 
systemically important firms and ensuring that all portions of the 
financial system are under some baseline standards to constrain 
excessive risk taking and protect consumers. I will explain why an 
independent special failure resolution authority is needed for 
financial firms that pose systemic risk and describe the essential 
features of such an authority. I also will suggest improvements to 
consumer protection that would improve regulators' ability to stem 
fraud and abusive practices. Next, I will discuss other areas that 
require legislative changes to reduce systemic risk--the over-the-
counter (OTC) derivatives market and the money market mutual fund 
industry. And, finally, I will address the need for regulatory reforms 
related to the originate-to-distribute model, executive compensation in 
banks, fair-value accounting, credit rating agencies and counter-
cyclical capital policies.
Addressing Systemic Risk
    Many have suggested that the creation of a systemic risk regulator 
is necessary to address key flaws in the current supervisory regime. 
According to the proposals, this new regulator would be tasked with 
monitoring large or rapidly increasing exposures--such as to sub-prime 
mortgages--across firms and markets, rather than only at the level of 
individual firms or sectors; and analyzing possible spillovers among 
financial firms or between firms and markets, such as the mutual 
exposures of highly interconnected firms. Additionally, the proposals 
call for such a regulator to have the authority to obtain information 
and examine banks and key financial market participants, including 
nonbank financial institutions that may not be currently subject to 
regulation. Finally, the systemic risk regulator would be responsible 
for setting standards for capital, liquidity, and risk management 
practices for the financial sector.
    Changes in our regulatory and supervisory approach are clearly 
warranted, but Congress should proceed carefully and deliberately in 
creating a new systemic risk regulator. Many of the economic challenges 
we are facing continue and new aspects of interconnected problems 
continue to be revealed. It will require great care to address evolving 
issues in the midst of the economic storm and to avoid unintended 
consequences. In addition, changes that build on existing supervisory 
structures and authorities--that fill regulatory voids and improve 
cooperation--can be implemented more quickly and more effectively.
    While I fully support the goal of having an informed, forward 
looking, proactive and analytically capable regulatory community, 
looking back, if we are honest in our assessment, it is clear that U.S. 
regulators already had many broad powers to supervise financial 
institutions and markets and to limit many of the activities that 
undermined our financial system. For various reasons, these powers were 
not used effectively and as a consequence supervision was not 
sufficiently proactive.
    There are many examples of situations in which existing powers 
could have been used to prevent the financial system imbalances that 
led to the current financial crisis. For instance, supervisory 
authorities have had the authority under the Home Ownership and Equity 
Protection Act to regulate the mortgage industry since 1994. 
Comprehensive new regulations intended to limit the worst practices in 
the mortgage industry were not issued until well into the onset of the 
current crisis. Failure to address lax lending standards among nonbank 
mortgage companies created market pressure on banks to also relax their 
standards. Bank regulators were late in addressing this phenomenon.
    In other important examples, federal regulatory agencies have had 
consolidated supervisory authority over institutions that pose a 
systemic risk to the financial system; yet they did not to exercise 
their authorities in a manner that would have enabled them to 
anticipate the risk concentrations in the bank holding companies, 
investment bank holding companies and thrift holding companies they 
supervise. Special purpose financial intermediaries--such as structured 
investment vehicles (SIVs)--played an important role in funding and 
aggregating the credit risks that are at the core of the current 
crisis. These intermediaries were formed outside the banking 
organizations so banks could recognize asset sales and take the assets 
off the balance sheet, or remotely originate assets to keep off the 
balance sheet and thereby avoid minimum regulatory capital and leverage 
ratio constraints. Because they were not on the bank's balance sheet 
and to the extent that they were managed outside of the bank by the 
parent holding company, SIVs escaped scrutiny from the bank regulatory 
agencies.
    With hindsight, all of the regulatory agencies will focus and find 
ways to better exercise their regulatory powers. Even though the 
entities and authorities that have been proposed for a systemic 
regulator largely existed, the regulatory community did not appreciate 
the magnitude and scope of the potential risks that were building in 
the system. Having a systemic risk regulator that would look more 
broadly at issues on a macro-prudential basis would be of incremental 
benefit, but the success of any effort at reform will ultimately rely 
on the willingness of regulators to use their authorities more 
effectively and aggressively.
    The lack of regulatory foresight was not specific to the United 
States. As a recent report on financial supervision in the European 
Union noted, financial supervisors frequently did not have, and in some 
cases did not insist on obtaining--or received too late--all of the 
relevant information on the global magnitude of the excess leveraging 
that was accumulating in the financial system. \1\ Further, they did 
not fully understand or evaluate the size of the risks, or share their 
information properly with their counterparts in other countries. The 
report concluded that insufficient supervisory and regulatory resources 
combined with an inadequate mix of skills as well as different systems 
of national supervision made the situation worse. In interpreting this 
report, it is important to recall that virtually every European central 
bank is required to assess and report economic and financial system 
conditions and anticipate emerging financial-sector risks.
---------------------------------------------------------------------------
     \1\ European Union, Report of the High-level Group on Financial 
Supervision in the EU, J. de Larosiere, Chairman, Brussels, 25 February 
2009.
---------------------------------------------------------------------------
    With these examples in mind, we should recognize that while 
establishing a systemic risk regulator is important, it is far from 
clear that it will prevent a future systemic crisis.
Limiting Risk by Limiting Size and Complexity
    Before considering the various proposals to create a systemic risk 
regulator, Congress should examine a more fundamental question of 
whether there should be limitations on the size and complexity of 
institutions whose failure would be systemically significant. Over the 
past two decades, a number of arguments have been advanced about why 
financial organizations should be allowed to become larger and more 
complex. These reasons include being able to take advantage of 
economies of scale and scope, diversifying risk across a broad range of 
markets and products, and gaining access to global capital markets. It 
was alleged that the increased size and complexity of these 
organizations could be effectively managed using new innovations in 
quantitative risk management techniques. Not only did institutions 
claim that they could manage these new risks, they also argued that 
often the combination of diversification and advanced risk management 
practices would allow them to operate with markedly lower capital 
buffers than were necessary in smaller, less-sophisticated 
institutions. Indeed many of these concepts were inherent in the Basel 
II Advanced Approaches, resulting in reduced capital requirements. In 
hindsight, it is now clear that the international regulatory community 
relied too heavily on diversification and risk management when setting 
minimum regulatory capital requirements for large complex financial 
institutions.
    Notwithstanding expectations and industry projections for gains in 
financial efficiencies, economies of scale seem to be reached at levels 
far below the size of today's largest financial institutions. Also, 
efforts designed to realize economies of scope have not lived up to 
their promise. In some instances, the complex institutional 
combinations permitted by the Gramm-Leach-Bliley (GLB) legislation were 
unwound because they failed to realize anticipated economies of scope. 
The latest studies of economies produced by increased scale and scope 
find that most banks could improve their cost efficiency more by 
concentrating their efforts on reducing operational inefficiencies.
    There also are limits to the ability to diversify risk using 
securitization, structured finance and derivatives. No one disputes 
that there are benefits to diversification for smaller and less-complex 
institutions, but as institutions become larger and more complex, the 
ability to diversify risk is diminished. When a financial system 
includes a small number of very large complex organizations, the system 
cannot be well-diversified. As institutions grow in size and 
importance, they not only take on a risk profile that mirrors the risk 
of the market and general economic conditions, but they also 
concentrate risk as they become the only important counterparties to 
many transactions that facilitate financial intermediation in the 
economy. The fallacy of the diversification argument becomes apparent 
in the midst of financial crisis when these large complex financial 
organizations--because they are so interconnected--reveal themselves as 
a source of risk in the system.
Managing the Transition to a Safer System
    If large complex organizations concentrate risk and do not provide 
market efficiencies, it may be better to address systemic risk by 
creating incentives to encourage a financial industry structure that is 
characterized by smaller and therefore less systemically important 
financial firms, for instance, by imposing increasing financial 
obligations that mirror the heightened risk posed by large entities.
Identifying Systemically Important Firms
    To be able to implement and target the desired changes, it becomes 
important to identify characteristics of a systemically important firm. 
A recent report by the Group of Thirty highlights the difficulties that 
are associated with a fixed common definition of what comprises a 
systemically important firm. What constitutes systemic importance is 
likely to vary across national boundaries and change over time. 
Generally, it would include any firm that constitutes a significant 
share of their market or the broader financial system. Ultimately, 
identification of what is systemic will have to be decided within the 
structure created for systemic risk regulation, but at a minimum, 
should rely on triggers based on size and counterparty concentrations.
Increasing Financial Obligations To Reflect Increasing Risk
    To date, many large financial firms have been given access to vast 
amounts of public funds. Obviously, changes are needed to prevent this 
situation from reoccurring and to ensure that firms are not rewarded 
for becoming, in essence, too big to fail. Rather, they should be 
required to offset the potential costs to society.
    In contrast to the capital standards implied in the Basel II 
Accord, systemically important firms should face additional capital 
charges based on both size and complexity. In addition, they should be 
subject to higher Prompt Corrective Action (PCA) limits under U.S. 
laws. Regulators should judge the capital adequacy of these firms, 
taking into account off-balance-sheet assets and conduits as if these 
risks were on balance sheet.
Next Steps
    Currently, not all parts of the financial system are subject to 
federal regulation. Insurance company regulation is conducted at the 
state level. There is, therefore, no federal regulatory authority 
specifically designed to provide comprehensive prudential supervision 
for large insurance companies. Hedge funds and private equity firms are 
typically designed to operate outside the regulatory structures that 
would otherwise constrain their leverage and activities. This is of 
concern not only for the safety and soundness of these unregulated 
firms, but for regulated firms as well. Some of banking organizations' 
riskier strategies, such as the creation of SIVs, may have been driven 
by a desire to replicate the financial leverage available to less 
regulated entities. Some of these firms by virtue of their gross 
balance sheet size or by their dominance in particular markets can pose 
systemic risks on their own accord. Many others are major participants 
in markets and business activities that may contribute to a systemic 
collapse. This loophole in the regulatory net cannot continue. It is 
important that all systemically important financial firms, including 
hedge funds, insurance companies, investment banks, or bank or thrift 
holding companies, be subject to prudential supervision, including 
across the board constraints on the use of financial leverage.
New Resolution Procedures
    There is clearly a need for a special resolution regime, outside 
the bankruptcy process, for financial firms that pose a systemic risk, 
just as there is for commercial banks and thrifts. As noted above, 
beyond the necessity of capital regulation and prudential supervision, 
having a mechanism for the orderly resolution of institutions that pose 
a systemic risk to the financial system is critical. Creating a 
resolution regime that could apply to any financial institution that 
becomes a source of systemic risk should be an urgent priority.
    The differences in outcomes from the handling of Bear Stearns and 
Lehman Brothers demonstrate that authorities have no real alternative 
but to avoid the bankruptcy process. When the public interest is at 
stake, as in the case of systemically important entities, the 
resolution process should support an orderly unwinding of the 
institution in a way that protects the broader economic and taxpayer 
interests, not just private financial interests.
    In creating a new resolution regime, we must clearly define roles 
and responsibilities and guard against creating new conflicts of 
interest. In the case of banks, Congress gave the FDIC backup 
supervisory authority and the power to self-appoint as receiver, 
recognizing there might be conflicts between a primary regulators' 
prudential responsibilities and its willingness to recognize when an 
institution it supervises needs to be closed. Thus, the new resolution 
authority should be independent of the new systemic risk regulator.
    This new authority should also be designed to limit subsidies to 
private investors (moral hazard). If financial assistance outside of 
the resolution process is granted to systemically important firms, the 
process should be open, transparent and subject to a system of checks 
and balances that are similar to the systemic-risk exception to the 
least-cost test that applies to insured financial institutions. No 
single government entity should be able to unilaterally trigger a 
resolution strategy outside the defined parameters of the established 
resolution process.
    Clear guidelines for this process are needed and must be adhered to 
in order to gain investor confidence and protect public and private 
interests. First, there should be a clearly defined priority structure 
for settling claims, depending on the type of firm. Any resolution 
should be subject to a cost test to minimize any public loss and impose 
losses according to the established claims priority. Second, it must 
allow continuation of any systemically significant operations. The 
rules that govern the process, and set priorities for the imposition of 
losses on shareholders and creditors should be clearly articulated and 
closely adhered to so that the markets can understand the resolution 
process with predicable outcomes.
    The FDIC's authority to act as receiver and to set up a bridge bank 
to maintain key functions and sell assets offers a good model. A 
temporary bridge bank allows the government to prevent a disorderly 
collapse by preserving systemically significant functions. It enables 
losses to be imposed on market players who should appropriately bear 
the risk. It also creates the possibility of multiple bidders for the 
bank and its assets, which can reduce losses to the receivership.
    The FDIC has the authority to terminate contracts upon an insured 
depository institution's failure, including contracts with senior 
management whose services are no longer required. Through its 
repudiation powers, as well as enforcement powers, termination of such 
management contracts can often be accomplished at little cost to the 
FDIC. Moreover, when the FDIC establishes a bridge institution, it is 
able to contract with individuals to serve in senior management 
positions at the bridge institution subject to the oversight of the 
FDIC. The new resolution authority should be granted similar statutory 
authority in the resolution of financial institutions.
    Congress should recognize that creating a new separate authority to 
administer systemic resolutions may not be economic or efficient. It is 
unlikely that the separate resolution authority would be used 
frequently enough to justify maintaining an expert and motivated 
workforce as there could be decades between systemic events. While many 
details of a special resolution authority for systemically important 
financial firms would have to be worked out, a new systemic resolution 
regime should be funded by fees or assessments charged to systemically 
important firms. In addition, consistent with the FDIC's powers with 
regard to insured institutions, the resolution authority should have 
backup supervisory authority over those firms which it may have to 
resolve.
Consumer Protection
    There can no longer be any doubt about the link between protecting 
consumers from abusive products and practices and the safety and 
soundness of the financial system. Products and practices that strip 
individual and family wealth undermine the foundation of the economy. 
As the current crisis demonstrates, increasingly complex financial 
products combined with frequently opaque marketing and disclosure 
practices result in problems not just for consumers, but for 
institutions and investors as well.
    To protect consumers from potentially harmful financial products, a 
case has been made for a new independent financial product safety 
commission. Certainly, more must be done to protect consumers. We could 
support the establishment of a new entity to establish consistent 
consumer protection standards for banks and nonbanks. However, we 
believe that such a body should include the perspective of bank 
regulators as well as nonbank enforcement officials such as the FTC. 
However, as Congress considers the options, we recommend that any new 
plan ensure that consumer protection activities are aligned and 
integrated with other bank supervisory information, resources, and 
expertise, and that enforcement of consumer protection rules for banks 
be left to bank regulators.
    The current bank regulation and supervision structure allows the 
banking agencies to take a comprehensive view of financial institutions 
from both a consumer protection and safety-and-soundness perspective. 
Banking agencies' assessments of risks to consumers are closely linked 
with and informed by a broader understanding of other risks in 
financial institutions. Conversely, assessments of other risks, 
including safety and soundness, benefit from knowledge of basic 
principles, trends, and emerging issues related to consumer protection. 
Separating consumer protection regulation and supervision into 
different organizations would reduce information that is necessary for 
both entities to effectively perform their functions. Separating 
consumer protection from safety and soundness would result in similar 
problems.
    Our experience suggests that the development of policy must be 
closely coordinated and reflect a broad understanding of institutions' 
management, operations, policies, and practices--and the bank 
supervisory process as a whole. Placing consumer protection policy-
setting activities in a separate organization, apart from existing 
expertise and examination infrastructure, could ultimately result in 
less effective protections for consumers.
    One of the fundamental principles of the FDIC's mission is to serve 
as an independent agency focused on maintaining consumer confidence in 
the banking system. The FDIC plays a unique role as deposit insurer, 
federal supervisor of state nonmember banks and savings institutions, 
and receiver for failed depository institutions. These functions 
contribute to the overall stability of and consumer confidence in the 
banking industry. With this mission in mind, if given additional 
rulemaking authority, the FDIC is prepared to take on an expanded role 
in providing consumers with stronger protections that address products 
posing unacceptable risks to consumers and eliminate gaps in oversight.
    Under the Federal Trade Commission (FTC) Act, only the Federal 
Reserve Board (FRB) has authority to issue regulations applicable to 
banks regarding unfair or deceptive acts or practices, and the Office 
of Thrift Supervision (OTS) and the National Credit Union 
Administration (NCUA) have sole authority with regard to the 
institutions they supervise. The FTC has authority to issue regulations 
that define and ban unfair or deceptive acts or practices with respect 
to entities other than banks, savings and loan institutions, and 
federal credit unions. However, the FTC Act does not give the FDIC 
authority to write rules that apply to the approximately 5,000 entities 
it supervises--the bulk of state banks--nor to the OCC for their 1,700 
national banks. Section 5 of the FTC Act prohibits ``unfair or 
deceptive acts or practices in or affecting commerce.'' It applies to 
all persons engaged in commerce, whether banks or nonbanks, including 
mortgage lenders and credit card issuers. While the ``deceptive'' and 
``unfair'' standards are independent of one another, the prohibition 
against these practices applies to all types of consumer lending, 
including mortgages and credit cards, and to every stage and activity, 
including product development, marketing, servicing, collections, and 
the termination of the customer relationship.
    In order to further strengthen the use of the FTC Act's rulemaking 
provisions, the FDIC has recommended that Congress consider granting 
Section 5 rulemaking authority to all federal banking regulators. By 
limiting FTC rulemaking authority to the FRB, OTS and NCUA, current law 
excludes participation by the primary federal supervisors of about 
7,000 banks. The FDIC's perspective--as deposit insurer and as 
supervisor for the largest number of banks, many of whom are small 
community banks--would provide valuable input and expertise to the 
rulemaking process. The same is true for the OCC, as supervisor of some 
of the nation's largest banks. As a practical matter, these rulemakings 
would be done on an interagency basis and would benefit from the input 
of all interested parties.
    In the alternative, if Congress is inclined to establish an 
independent financial product commission, it should leverage the 
current regulatory authorities that have the resources, experience, and 
legislative power to enforce regulations related to institutions under 
their supervision, so it would not be necessary to create an entirely 
new enforcement infrastructure. In fact, in creating a financial 
products safety commission, it would be beneficial to include the FDIC 
and principals from other financial regulatory agencies on the 
commission's board. Such a commission should be required to submit 
periodic reports to Congress on the effectiveness of the consumer 
protection activities of the commission and the bank regulators.
    Whether or not Congress creates a new commission, it is essential 
that there be uniform standards for financial products whether they are 
offered by banks or nonbanks. These standards must apply across all 
jurisdictions and issuers, otherwise gaps create competitive pressures 
to reduce standards, as we saw with mortgage lending standards. Clear 
standards also permit consistent enforcement that protects consumers 
and the broader financial system.
    Finally, in the on-going process to improve consumer protections, 
it is time to examine curtailing federal preemption of state consumer 
protection laws. Federal preemption of state laws was seen as a way to 
improve efficiencies for financial firms who argued that it lowered 
costs for consumers. While that may have been true in the short run, it 
has now become clear that abrogating sound state laws, particularly 
regarding consumer protection, created an opportunity for regulatory 
arbitrage that frankly resulted in a ``race-to-the-bottom'' mentality. 
Creating a ``floor'' for consumer protection, based on either 
appropriate state or federal law, rather than the current system that 
establishes a ceiling on protections would significantly improve 
consumer protection. Perhaps reviewing the existing web of state and 
federal laws related to consumer protections and choosing the most 
appropriate for the ``floor'' could be one of the initial priorities 
for a financial products safety commission.
Changing the OTC Market and Protecting of Money Market Mutual Funds
    Two areas that require legislative changes to reduce systemic risk 
are the OTC derivatives market and the money market mutual fund 
industry.
Credit Derivatives Markets and Systemic Risk
    Beyond issues of size and resolution schemes for systemically 
important institutions, recent events highlight the need to revisit the 
regulation and oversight of credit derivative markets. Credit 
derivatives provide investors with instruments and markets that can be 
used to create tremendous leverage and risk concentration without any 
means for monitoring the trail of exposure created by these 
instruments. An individual firm or a security from a sub-prime, asset-
backed or other mortgage-backed pool of loans may have only $50 million 
in outstanding par value and yet, the over-the-counter markets for 
credit default swaps (CDS) may create hundreds of millions of dollars 
in individual CDS contracts that reference that same debt. At the same 
time, this debt may be referenced in CDS Index contracts that are 
created by OTC dealers which creates additional exposure. If the 
referenced firm or security defaults, its bond holders will likely lose 
some fraction of the $50 million par value, but CDS holders face losses 
that are many times that amount.
    Events have shown that the CDS markets are a source of systemic 
risk. The market for CDS was originally set up as an inter-bank market 
to exchange credit risk without selling the underlying loans, but it 
has since expanded massively to include hedge funds, insurance 
companies, municipalities, public pension funds and other financial 
institutions. The CDS market has expanded to include OTC index products 
that are so actively traded that they spawned a Chicago Board of Trade 
futures market contract. CDS markets are an important tool for hedging 
credit risk, but they also create leverage and can multiply underlying 
credit risk losses. Because there are relatively few CDS dealers, 
absent adequate risk management practices and safeguards, CDS markets 
can also create counterparty risk concentrations that are opaque to 
regulators and financial institutions.
    Our views on the need for regulatory reform of the CDS and related 
OTC derivatives markets are aligned with the recommendations made in 
the recent framework proposed by the Group of Thirty. OTC contracts 
should be encouraged to migrate to trade on a nationally regulated 
exchange with centralized clearing and settlement systems, similar in 
character to those of the futures and equity option exchange markets. 
The regulation of the contracts that remain OTC-traded should be 
subject to supervision by a national regulator with jurisdiction to 
promulgate rules and standards regarding sound risk management 
practices, including those needed to manage counterparty credit risk 
and collateral requirements, uniform close-out practices, trade 
confirmation and reporting standards, and other regulatory and public 
reporting standards that will need to be established to improve market 
transparency. For example, OTC dealers may be required to report 
selected trade information in a Trade Reporting and Compliance Engine 
(TRACE)-style system, which would be made publicly available. OTC 
dealers and exchanges should also be required to report information on 
large exposures and risk concentrations to a regulatory authority. This 
could be modeled in much the same way as futures exchanges regularly 
report qualifying exposures to the Commodities Futures Trading 
Commission. The reporting system would need to provide information on 
concentrations in both short and long positions.
Money Market Mutual Funds
    Money market mutual funds (MMMFs) have been shown to be a source of 
systemic risk in this crisis. Two similar models of reform have been 
suggested. One would place MMMFs under systemic risk regulation, which 
would provide permanent access to the discount window and establish a 
fee-based insurance fund to prevent losses to investors. The other 
approach, offered by the Group of 30, would segment the industry into 
MMMFs that offer bank-like services and assurances in maintaining a 
stable net asset value (NAV) at par from MMMFs that that have no 
explicit or implicit assurances that investors can withdraw funds on 
demand at par. Those that operate like banks would be required to 
reorganize as special-purpose banks, coming under all bank regulations 
and depositor-like protections. But, this last approach will only be 
viable if there are restrictions on the size of at-risk MMMFs so that 
they do not evolve into too-big-to-fail institutions.
Regulatory Issues
    Several issues can be addressed through the regulatory process 
including, the originate-to-distribute business model, executive 
compensation in banks, fair-value accounting, credit rating agency 
reform and counter-cyclical capital policies.
The Originate-To-Distribute Business Model
    One of the most important factors driving this financial crisis has 
been the decline in value, liquidity and underlying collateral 
performance of a wide swath of previously highly rated asset backed 
securities. In 2008, over 221,000 rated tranches of private-label 
asset-backed securitizations were downgraded. This has resulted in a 
widespread loss of confidence in agency credit ratings for securitized 
assets, and bank and investor write-downs on their holdings of these 
assets.
    Many of these previously highly rated securities were never traded 
in secondary markets, and were subject to little or no public 
disclosure about the characteristics and ongoing performance of 
underlying collateral. Financial incentives for short-term revenue 
recognition appear to have driven the creation of large volumes of 
highly rated securitization product, with insufficient attention to due 
diligence, and insufficient recognition of the risks being transferred 
to investors. Moreover, some aspects of our regulatory framework may 
have encouraged banks and other institutional investors in the belief 
that a highly rated security is, per se, of minimal risk.
    Today, in a variety of policy-making groups around the world, there 
is consideration of ways to correct the incentives that led to the 
failure of the originate-to-distribute model. One area of focus relates 
to disclosure. For example, rated securitization tranches could be 
subject to a requirement for disclosure, in a readily accessible format 
on the ratings-agency Web sites, of detailed loan-level characteristics 
and regular performance reports. Over the long term, liquidity and 
confidence might be improved if secondary market prices and volumes of 
asset backed securities were reported on some type of system analogous 
to the Financial Industry Regulatory Authority's Trade Reporting and 
Compliance Engine that now captures such data on corporate bonds.
    Again over the longer term, a more sustainable originate-to-
distribute model might result if originators were required to retain 
``skin-in-the-game'' by holding some form of explicit exposure to the 
assets sold. This idea has been endorsed by the Group of 30 and is 
being actively explored by the European Commission. Some in the United 
States have noted that there are implementation challenges of this 
idea, such as whether we can or should prevent issuers from hedging 
their exposure to their retained interests. Acknowledging these issues 
and correcting the problems in the originate-to-distribute model is 
very important, and some form of ``skin-in-the-game'' requirement that 
goes beyond the past practices of the industry should continue to be 
explored.
Executive Compensation In Banks
    An important area for reform includes the broad area of correcting 
or offsetting financial incentives for short-term revenue recognition. 
There has been much discussion of how to ensure financial firms' 
compensation systems do not excessively reward a short-term focus at 
the expense of longer term risks. I would note that in the Federal 
Deposit Insurance Act, Congress gave the banking agencies the explicit 
authority to define and regulate safe-and-sound compensation practices 
for insured banks and thrifts. Such regulation would be a potentially 
powerful tool but one that should be used judiciously to avoid 
unintended consequences.
Fair-Value Accounting
    Another broad area where inappropriate financial incentives may 
need to be addressed is in regard to the recognition of potentially 
volatile noncash income or expense items. For example, many problematic 
exposures may have been driven in part by the ability to recognize 
mark-to-model gains on OTC derivatives or other illiquid financial 
instruments. To the extent such incentives drove some institutions to 
hold concentrations of illiquid and volatile exposures, they should be 
a concern for the safety-and-soundness of individual institutions. 
Moreover, such practices can make the system as a whole more subject to 
boom and bust. Regulators should consider taking steps to limit such 
practices in the future, perhaps by explicit quantitative limits on the 
extent such gains could be included in regulatory capital or by 
incrementally higher regulatory capital requirements when exposures 
exceed specified concentration limits.
    For the immediate present, we are faced with a situation where an 
institution confronted with even a single dollar of credit loss on its 
available-for-sale and held-to-maturity securities, must write down the 
security to fair value, which includes not only recognizing the credit 
loss, but also the liquidity discount. We have expressed our support 
for the idea that FASB should consider allowing institutions facing an 
other-than-temporary impairment (OTTI) loss to recognize the credit 
loss in earnings but not the liquidity discount. We are pleased that 
the Financial Accounting Standards Board this week has issued a 
proposal that would move in this direction.
Credit Rating Agency Reform
    The FDIC generally agrees with the Group of 30 recommendation that 
regulatory policies with regard to Nationally Recognized Securities 
Rating Organizations (NRSROs) and the use their ratings should be 
reformed. Regulated entities should do an independent evaluation of 
credit risk products in which they are investing. NRSROs should 
evaluate the risk of potential losses from the full range of potential 
risk factors, including liquidity and price volatility. Regulators 
should examine the incentives imbedded in the current business models 
of NRSROs. For example, an important strand of work within the Basel 
Committee on Banking Supervision that I have supported for some time 
relates to the creation of operational standards for the use of 
ratings-based capital requirements. We need to be sure that in the 
future, our capital requirements do not incent banks to rely blindly on 
favorable agency credit ratings. Preconditions for the use of ratings-
based capital requirements should ensure investors and regulators have 
ready access to the loan level data underlying the securities, and that 
an appropriate level of due diligence has been performed.
Counter-Cyclical Capital Policies
    At present, regulatory capital standards do not explicitly consider 
the stage of the economic cycle in which financial institutions are 
operating. As institutions seek to improve returns on equity, there is 
often an incentive to reduce capital and increase leverage when 
economic conditions are favorable and earnings are strong. However, 
when a downturn inevitably occurs and losses arising from credit and 
market risk exposures increase, these institutions' capital ratios may 
fall to levels that no longer appropriately support their risk 
profiles.
    Therefore, it is important for regulators to institute counter-
cyclical capital policies. For example, financial institutions could be 
required to limit dividends in profitable times to build capital above 
regulatory minimums or build some type of regulatory capital buffer to 
cover estimated through-the-cycle credit losses in excess of those 
reflected in their loan loss allowances under current accounting 
standards. Through the Basel Committee on Banking Supervision, we are 
working to strengthen capital to raise its resilience to future 
episodes of economic and financial stress. Furthermore, we strongly 
encourage the accounting standard-setters to revise the existing 
accounting model for loan losses to better reflect the economics of 
lending activity and enable lenders to recognize credit impairment 
earlier in the credit cycle.
Conclusion
    The current financial crisis demonstrates the need for changes in 
the supervision and resolution of financial institutions, especially 
those that are systemically important to the financial system. The 
choices facing Congress in this task are complex, made more so by the 
fact that we are trying to address problems while the whirlwind of 
economic problems continues to engulf us. While the need for some 
reforms is obvious, such as a legal framework for resolving 
systemically important institutions, others are less clear and we would 
encourage a thoughtful, deliberative approach. The FDIC stands ready to 
work with Congress to ensure that the appropriate steps are taken to 
strengthen our supervision and regulation of all financial 
institutions--especially those that pose a systemic risk to the 
financial system.
    I would be pleased to answer any questions from the Committee.
                                 ______
                                 

                PREPARED STATEMENT OF MICHAEL E. FRYZEL
                               Chairman,
                  National Credit Union Administration
                             March 19, 2009
Introduction
    As Chairman of the National Credit Union Administration (NCUA), I 
appreciate this opportunity to provide my position on ``Modernizing 
Bank Supervision and Regulation.'' Federally insured credit unions 
comprise a small but important part of the financial institution 
community, and NCUA's perspective on this matter will add to the 
overall understanding of the needs of the credit union industry and the 
members they serve. \1\
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     \1\ 12 U.S.C. 1759. Unlike other financial institutions, credit 
unions may only serve individuals within a restricted field of 
membership. Other financial institutions serve customers that generally 
have no membership interest.
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    As NCUA Chairman, I agree with the need for establishing a 
regulatory oversight entity (systemic risk regulator) whose 
responsibilities would include monitoring the financial institution 
regulators and issuing principles-based regulations and guidance. I 
envision this entity would be responsible for establishing general 
safety and soundness guidance for federal financial regulators under 
its control while the individual federal financial regulators would 
implement and enforce the established guidelines in the institutions 
they regulate. This entity would also monitor systemic risk across 
institution types. For this structure to be effective for federally 
insured credit unions, the National Credit Union Share Insurance Fund 
(NCUSIF) must remain independent of the Deposit Insurance Fund to 
maintain the dual regulatory and insurance roles for the NCUA that have 
been tested and proven to work in the credit union industry for almost 
40 years.
    The NCUA's primary mission is to ensure the safety and soundness of 
federally insured credit unions. It performs this important public 
function by examining all federal credit unions, participating in the 
examination and supervision of federally insured state chartered credit 
unions in coordination with state regulators, and insuring federally 
insured credit union members' accounts. In its statutory role as the 
administrator of the NCUSIF, the NCUA insures and supervises 7,806 
federally insured credit unions, representing 98 percent of all credit 
unions and approximately 88 million members. \2\
---------------------------------------------------------------------------
     \2\ Approximately 162 state-chartered credit unions are privately 
insured and are not subject to NCUA oversight. Based on December 31, 
2008, Call Report (NCUA Form 5300) data.
---------------------------------------------------------------------------
    Overall, federally insured, natural person credit unions maintained 
reasonable financial performance in 2008. As of December 31, 2008, 
federally insured credit unions maintained a strong level of capital 
with an aggregate net worth ratio of 10.92 percent. \3\ While earnings 
decreased from prior levels due to the economic downturn, federally 
insured credit unions were able to post a 0.30 percent return on 
average assets in 2008. \4\ Delinquency was reported at 1.37 percent, 
while net charge-offs was 0.84 percent. \5\ Shares in federally insured 
credit unions grew at 7.71 percent with membership growing at 2.01 
percent, and loans growing at 7.08 percent. \6\
---------------------------------------------------------------------------
     \3\ Based on December 31, 2008, Call Report (NCUA Form 5300) data.
     \4\ Ibid.
     \5\ Ibid.
     \6\ Ibid.
---------------------------------------------------------------------------
Federally Insured Credit Unions Require Separate Oversight
    Federally insured credit unions' unique cooperative, not-for-profit 
structure and statutory mandate of serving people of modest means 
necessitate a customized approach to their regulation and supervision. 
The NCUA should remain an independent agency to preserve the credit 
union model and protect credit union members as mandated by Congress. 
An agency responsible for all financial institutions might focus on the 
larger financial institutions where the systemic risk predominates, 
potentially to the detriment of smaller federally insured credit 
unions. As federally insured credit unions are generally the smaller, 
less complex institutions in a consolidated financial regulator 
arrangement, the unique character of credit unions would quickly be 
lost, absorbed by the for-profit model and culture of the banking 
system.
    Federally insured credit unions fulfill a specialized role in the 
domestic marketplace; one that Congress acknowledged is important in 
assuring consumers have access to basic financial services such as 
savings and affordable credit products. Loss of federally insured 
credit unions as a type of financial institution would limit access to 
these affordable financial services for persons of modest means. 
Federally insured credit unions serve an important competitive check on 
for-profit institutions by providing low-cost products and services. 
Some researchers estimate the competitive presence of credit unions 
save bank customers $4.3 billion annually. \7\ Research also shows that 
in many markets, credit unions provide a lower cost alternative to 
abusive and predatory lenders. The research describes the fees, rates, 
and terms of the largest United States credit card providers in 
comparison to credit cards issued by credit unions with similar 
purchase interest rates but with fewer fees, lower fees, lower default 
rates, and clearer disclosures. The details of credit union credit card 
programs show credit card lending is sustainable without exorbitant 
penalties and misleading terms and conditions. \8\
---------------------------------------------------------------------------
     \7\ An Estimate of the Influence of Credit Unions on Bank CD and 
Money Market Deposits in the U.S.--Idaho State University, January 
2005. Also, An Analysis of the Benefits of Credit Unions to Bank Loan 
Customers--American University, January 2005.
     \8\ Blindfolded Into Debt: A Comparison of Credit Card Costs and 
Conditions at Banks and Credit Unions. The Woodstock Institute, July 
2005.
---------------------------------------------------------------------------
    Federally insured credit unions provide products geared to the 
modest consumer at a reasonable price, such as very small loans and 
low-minimum balance savings products that many banks do not offer. 
Credit unions enter markets that other financial institutions have not 
entered or abandoned because these markets were not profitable or there 
were more lucrative markets to pursue. \9\ Loss of credit unions would 
reduce service to underserved consumers and hinder outreach and 
financial literacy efforts.
---------------------------------------------------------------------------
     \9\ Increase in Bank Branches Shortchanges Lower-Income and 
Minority Communities: An Analysis of Recent Growth in Chicago Area Bank 
Branching. The Woodstock Institute, February 2005, Number 27.
---------------------------------------------------------------------------
    When comparing the size and complexity of federally insured credit 
unions to banks, even the largest federally insured credit unions are 
small in comparison. As shown in the graph below, small federally 
insured credit unions make up the majority of the institutions the NCUA 
insures. 


    Eighty-four percent of federally insured credit unions have less 
than $100 million in assets as opposed to 38 percent of the 
institutions that the Federal Deposit Insurance Corporation (FDIC) 
insures with the same asset size. \10\ Total assets in the entire 
federally insured credit union industry are less than the individual 
total assets of some of the nation's largest banks. \11\
---------------------------------------------------------------------------
     \10\ FDIC Quarterly Banking Profile--Fourth Quarter 2008.
     \11\ December 31, 2008, total assets for federally insured credit 
unions equaled $813.44 billion, while total assets for federally 
insured banks equaled $13.85 trillion. Based on December 31, 2008, Call 
Report (NCUA Form 5300) data and FDIC Quarterly Banking Profile--Fourth 
Quarter 2008.
---------------------------------------------------------------------------
Specialized Supervision
    In recognition of the importance of small federally insured credit 
unions to their memberships, the NCUA established an Office of Small 
Credit Union Initiatives to foster credit union development, 
particularly in the expansion of services provided by small federally 
insured credit unions to all eligible members. Special purpose programs 
have helped preserve the viability of several institutions by providing 
access to training, grant assistance, and mentoring. \12\
---------------------------------------------------------------------------
     \12\ NCUA 2007 Annual Report.
---------------------------------------------------------------------------
    The NCUA has developed expertise to effectively supervise federally 
insured credit unions. The agency has a highly trained examination 
force that understands the intricacies and nuances of federally insured 
credit unions and their operations.
    The NCUA's mission includes serving and maintaining a safe, secure 
credit union community. In order to accomplish this, the NCUA has put 
in place specialized programs such as the National Examination Team to 
supervise federally insured credit unions showing a higher risk to the 
NCUSIF, Subject Matter Examiners to address specific areas of risk, and 
Economic Development Specialists to provide hands-on assistance to 
small federally insured credit unions.
NCUA's Tailored Guidance Approach
    The systemic risk regulator would set the general safety and 
soundness guidelines, while the NCUA would monitor and enforce the 
specific rules for the federally insured credit union industry. For 
example, the NCUA has long recognized the safety and soundness issues 
regarding real estate lending. Real estate lending makes up fifty-four 
percent of federally insured credit unions' lending portfolio. As a 
result, the NCUA has provided federally insured credit unions detailed 
guidance regarding this matter. The below chart outlines the regulatory 
approach taken with real estate lending.



    As demonstrated by the guidance issued, the NCUA proactively 
addresses issues with the industry as they evolve and as they 
specifically apply to federally insured credit unions. Due to federally 
insured credit unions' unique characteristics, the NCUA should be 
maintained as a separate regulator under an overseeing entity to ensure 
the vital sector of federally insured credit unions is not ``lost in 
the shuffle'' of the financial institution industry as a whole.
Maintain Separate Insurance Fund
    Funds from federally insured credit unions have established the 
NCUSIF. The required deposit is calculated at least annually at one 
percent of each federally insured credit union's insured shares. The 
fund is commensurate with federally insured credit unions' equity 
interests and the risk level in the industry. The small institutions 
that make up the vast majority of federally insured credit unions 
should not be required to pay for the risk taken on by the large 
conglomerates. The NCUA has a successful record of regulating federal 
credit union charters and also serving as insurer for all federally 
insured credit unions. This structure has stood the test of time, 
encompassing various adverse economic cycles. The NCUA is the only 
regulator with this 100 percent dual regulator/insurer role. The 
overall reporting to a single regulatory body creates a level of 
efficiency for federally chartered credit unions in managing the 
regulatory relationship. This unique role has allowed the NCUA to 
develop economies of scale as a federal agency.
    The July 1991 Government Accountability Office (GAO) report to 
Congress considered whether NCUA's insurance function should be 
separated from the other functions of chartering, regulating, and 
supervising credit unions. The GAO concluded ``[s]eparation of NCUSIF 
from NCUA's chartering, regulation, and supervision responsibilities 
would not, on the basis of their analyses, by itself guarantee either 
strong supervision or insurance fund health. And such a move could 
result in additional and duplicative oversight costs. In addition, it 
could be argued that a regulator/supervisor without insurance 
responsibility has less incentive to concern itself with the insurance 
costs, should an institution fail.'' \16\
---------------------------------------------------------------------------
     \16\ GAO, July 1991 Study.
---------------------------------------------------------------------------
    The 1997 Treasury study reached conclusions similar to the GAO 
report. The Treasury study discussed the unique capitalization 
structure of the NCUSIF and how it fits the cooperative nature of 
federally insured credit unions and offered the following: \17\
---------------------------------------------------------------------------
     \17\ Treasury, December 1997 Study of Credit Unions.

        We found no compelling case for removing the Share Insurance 
        Fund from the NCUA's oversight and transferring it to another 
        federal agency such as the FDIC. The NCUA maintains some level 
        of separation between its insurance activities and its other 
        responsibilities by separating the operating costs of the Fund 
        from its noninsurance expenses. \18\
---------------------------------------------------------------------------
     \18\ Treasury, December 1997 Study of Credit Unions, page 52.

        Under the current structure, the NCUA can use supervision to 
        control risks taken by credit unions--providing an additional 
        measure of protection for the Fund. We also believe that 
        separating the Fund from the NCUA could: (1) reduce the 
        regulator's incentives to concern itself with insurance costs, 
        should an institution fail; (2) create possible confusion over 
        the roles and responsibilities of the insurer and of the 
        regulator; and (3) place the insurer in the situation of 
        safeguarding the insurance fund without having control over the 
        risks taken by the insured entities. \19\
---------------------------------------------------------------------------
     \19\ Ibid, page 52.

        The financing structure of the Share Insurance Fund fits the 
        cooperative character of credit unions. Because credit unions 
        must expense any losses to the Share Insurance Fund, they have 
        an incentive to monitor each other and the Fund. This financing 
        structure makes transparent the financial support that 
        healthier credit unions give to the members of failing credit 
        unions. Credit unions understand this aspect of the Fund and 
        embrace it as a reflection of their cooperative character. \20\
---------------------------------------------------------------------------
     \20\ Ibid, page 58.

    The unique dual regulatory role in which the NCUA operates has 
proven successful in the credit union industry. At no time under this 
structure has the credit union system cost the American taxpayers any 
money.
Federally Insured Credit Unions Demonstrate Unique Characteristics
    Federally insured credit unions are unique financial institutions 
that exist to serve the needs of their members. The statutory and 
regulatory frameworks in which federally insured credit unions operate 
reflect their uniqueness and are significantly different from that of 
other financial institutions. Comments that follow in this section 
provide specific examples for federal credit unions. However, most of 
the examples also apply to federally insured state chartered credit 
unions because of their similar organization as institutions designed 
to promote thrift. \21\
---------------------------------------------------------------------------
     \21\ 12 U.S.C. 1781(c)(1)(E).
---------------------------------------------------------------------------
One Member One Vote
    The federal credit union charter is the only federal financial 
charter in the United States that gives every member an equal voice in 
how their institution is operated regardless of the amount of shares on 
deposit with its ``one member, one vote'' cooperative structure. \22\ 
This option allows federal credit unions to be democratically governed. 
The federal credit union charter provides an important pro-consumer 
alternative in the financial services industry.
---------------------------------------------------------------------------
     \22\ 12 U.S.C. 1760.
---------------------------------------------------------------------------
Field of Membership
    Federal credit unions are not-for-profit, member-owned cooperatives 
that exist to provide their members with the best possible rates and 
service. A federal credit union is chartered to serve a field of 
membership that shares a common bond such as the employees of a 
company, members of an association, or a local community. Therefore, 
federal credit unions may not serve the general public like other 
financial institutions and the federal credit unions' activities are 
largely limited to domestic activities, which has minimized the impact 
of globalization in the federal credit union industry. Due to this 
defined and limited field of membership, federal credit unions have 
less ability to grow into large institutions as demonstrated by 84 
percent of federally insured credit unions having less than $100 
million in assets. \23\
---------------------------------------------------------------------------
     \23\ Based on December 31, 2008, Call Report (NCUA Form 5300) 
data.
---------------------------------------------------------------------------
Volunteer Board of Directors
    Federal credit unions are managed largely on a volunteer basis. The 
board of directors for each federal credit union consists of a 
volunteer board of directors elected by, and from the membership. \24\ 
By statute, no member of the board may be compensated as such; however, 
a federal credit union may compensate one individual who serves as an 
officer of the board. \25\
---------------------------------------------------------------------------
     \24\ 12 U.S.C. 1761(a).
     \25\ 12 U.S.C. 1761(c).
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Consumer Protection
    The Federal Credit Union Act requires federal credit union boards 
of directors to appoint not less than three members or more than five 
members to serve as members of the supervisory committee. \26\ The 
purpose of the supervisory committee is to ensure independent oversight 
of the board of directors and management and to advocate the best 
interests of the members. The supervisory committee either performs or 
contracts with a third-party to perform an annual audit of the federal 
credit union's books and records. \27\ The supervisory committee also 
plays an important role as the member advocate.
---------------------------------------------------------------------------
     \26\ 12 U.S.C. 1761b.
     \27\ 12 U.S.C. 1761d.
---------------------------------------------------------------------------
    As the member advocate, the supervisory committee is charged with 
reviewing member complaints. \28\ Complaints cover a broad spectrum of 
areas, including annual meeting procedures, dividend rates and terms, 
and credit union services. Regardless of the nature of the complaint, 
NCUA requires supervisory committees to conduct a full and complete 
investigation. When addressing member complaints, supervisory 
committees will determine the appropriate course of action after 
thoroughly reviewing the unique circumstances surrounding each 
complaint. \29\
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     \28\ As noted in the preamble of final rule incorporating the 
standard federal credit union bylaws into NCUA Rules and Regulations 
Part 701.
     \29\ Supervisory Committee Guide, Chapter 4, Publication 4017/8023 
Revised December 1999.
---------------------------------------------------------------------------
    This committee and function of member advocacy are unique to 
federal credit unions. No member of the supervisory committee can be 
compensated. \30\
---------------------------------------------------------------------------
     \30\ 12 U.S.C. 1761.
---------------------------------------------------------------------------
Regulatory Limitations
    While there have been significant changes in the financial services 
environment since 1934 when the Federal Credit Union Act was 
implemented, federal credit unions have only had modest gains in the 
breadth of services offered relative to the broad authorities and 
services of other financial institutions. By virtue of their enabling 
legislation along with regulations established by the NCUA, federal 
credit unions are more restricted in their operation than other 
financial institutions. A discussion of some of these limitations 
follows.
Investment Limitations
    Federal credit unions have relatively few permissible investment 
options. Investments are largely limited to United States debt 
obligations, federal government agency instruments, and insured 
deposits. \31\ Federal credit unions cannot invest in a diverse range 
of higher yielding products, including commercial paper and corporate 
debt securities. Also, federal credit unions have limited authority for 
broker-dealer relationships. \32\ These limitations have helped credit 
unions weather the current economic downturn.
---------------------------------------------------------------------------
     \31\ NCUA Rules and Regulations Part 703.
     \32\ NCUA Rules and Regulations Part 703.
---------------------------------------------------------------------------
Affiliation Limitations
    Federal credit unions are much more limited than other financial 
institutions in the types of businesses in which they engage and in the 
kinds of affiliates with which they deal. Federal credit unions cannot 
invest in the shares of an insurance company or control another 
financial depository institution. Also, they cannot be part of a 
financial services holding company and become affiliates of other 
depository institutions or insurance companies. Federal credit unions 
are limited to only the powers established in the Federal Credit Union 
Act. \33\
---------------------------------------------------------------------------
     \33\ 12 U.S.C. 1757.
---------------------------------------------------------------------------
Capital Limitations
    Unlike other financial institutions, federal credit unions cannot 
issue stock to raise additional capital. \34\ Also, federal credit 
unions have borrowing authority limited to 50 percent of paid-in and 
unimpaired capital and surplus. \35\
---------------------------------------------------------------------------
     \34\ 12 U.S.C. 1790d(b)(1)(B)(i).
     \35\ 12 U.S.C. 1757(9).
---------------------------------------------------------------------------
    A federal credit union can only build net worth through its 
retained earnings, unless it is a low-income designated credit union 
that can accept secondary capital contributions. \36\ Federally insured 
credit unions must also hold 200 basis points more in capital than 
other federally insured financial institutions in order to be 
considered ``well-capitalized'' under federal ``Prompt Corrective 
Action'' laws. \37\ In addition, federal credit unions must transfer 
their earnings to net worth and loss reserve accounts or distribute it 
to their membership through dividends, relatively lower loan rates, or 
relatively lower fees.
---------------------------------------------------------------------------
     \36\ 12 U.S.C. 1790d(o)(2)(B).
     \37\ 12 U.S.C. 1790d.
---------------------------------------------------------------------------
Lending Limitations
    Federal credit unions are not permitted to charge a prepayment 
penalty in any type of loan whether consumer or business. \38\ With the 
exception of certain consumer mortgage loans, federal credit unions 
cannot make loans with a maturity greater than 15 years. \39\ Also, 
federal credit unions are subject to a federal statutory usury, 
currently set at 18 percent, which is unique among federally chartered 
financial institutions and far more restrictive than state usury laws. 
\40\
---------------------------------------------------------------------------
     \38\ 12 U.S.C. 1757(5)(viii).
     \39\ 12 U.S.C. 1757(5).
     \40\ 12 U.S.C. 1757(5)(A)(vi).
---------------------------------------------------------------------------
    While federal credit unions have freedom in making consumer and 
mortgage loans to members, except with regard to limits to one borrower 
and loan-to-value restrictions, they are severely restricted in the 
kind and amount of member business loans they can underwrite. Some 
member business lending limits include restrictions on the total amount 
of loans, loan to value requirements, construction loan limits, and 
maturity limits. \41\
---------------------------------------------------------------------------
     \41\ 12 U.S.C. 1757a and NCUA Rules and Regulations Part 723.
---------------------------------------------------------------------------
Access to Credit
    Despite regulatory constraints, federally insured credit unions 
continue to follow their mission of providing credit to persons of 
modest means. Amid the tightening credit situation facing the nation, 
federally insured credit unions have continued to fulfill their 
members' borrowing needs. While other types of lenders severely 
curtailed credit, federally insured credit unions experienced a 7.08 
percent loan growth in 2008.
    Credit unions remain fundamentally different from other forms of 
financial institutions based on their member-owned, democratically 
operated, not-for-profit cooperative structure. Loss of credit unions 
as a type of financial institution would severely limit the access to 
financial services for many Americans.
Regulatory Framework Recommendation
    I agree with the need for establishing a regulatory oversight 
entity to help mitigate risk to our nation's financial system. It is my 
recommendation that Congress maintain multiple financial regulators and 
charter options to enable the continued checks and balances such a 
structure produces. The oversight entity's main functions should be to 
establish broad safety and soundness principles and then monitor the 
individual financial regulators to ensure the established principles 
are implemented. This structure also allows the oversight entity to set 
objective-based standards in a more proactive manner, and would help 
alleviate competitive conflict detracting from the resolution of 
economic downturns. This type of structure would also promote 
uniformity in the supervision of financial institutions while affording 
the preservation of the different segments of the financial industry, 
including the credit union industry.
Conclusions
    Federally insured credit union service remains focused on providing 
basic and affordable financial services to members. Credit unions are 
an important, but relatively small, segment of the financial 
institution industry serving a unique niche. \42\ As a logical 
extension to this, the NCUSIF, which is funded by the required 
insurance contributions of federally insured credit unions, should be 
kept separate from any bank insurance fund. This would maintain an 
appropriate level of diversification in the financial system.
---------------------------------------------------------------------------
     \42\ As of December 31, 2008, approximately $14.67 trillion in 
assets were held in federally insured depository institutions. Banks 
and other savings institutions insured by the FDIC held $13.85 
trillion, or 94.44 percent of these assets. Credit unions insured by 
the NCUSIF held $813.44 billion, or 5.56 percent of all federally 
insured assets.
---------------------------------------------------------------------------
    While the NCUA could be supportive of a regulatory oversight 
entity, the agency should maintain its dual regulatory functions of 
regulator and insurer in order to ensure the federally insured credit 
union segment of the financial industry is preserved.
                                 ______
                                 

                PREPARED STATEMENT OF DANIEL K. TARULLO
                                Member,
            Board of Governors of the Federal Reserve System
                             March 19, 2009
    Chairman Dodd, Ranking Member Shelby, and other Members of the 
Committee, I appreciate this opportunity to present the views of the 
Federal Reserve Board on the important issue of modernizing financial 
supervision and regulation.
    For the last year and a half, the U.S. financial system has been 
under extraordinary stress. Initially, this financial stress 
precipitated a sharp downturn in the U.S. and global economies. What 
has ensued is a very damaging negative feedback loop: The effects of 
the downturn--rising unemployment, declining profits, and decreased 
consumption and investment--have exacerbated the problems of financial 
institutions by reducing further the value of their assets. The 
impaired financial system has, in turn, been unable to supply the 
credit needed by households and businesses alike.
    The catalyst for the current crisis was a broad-based decline in 
housing prices, which has contributed to substantial increases in 
mortgage delinquencies and foreclosures and significant declines in the 
value of mortgage-related assets. However, the mortgage sector is just 
the most visible example of what was a much broader credit boom, and 
the underlying causes of the crisis run deeper than the mortgage 
market. They include global imbalances in savings and capital flows, 
poorly designed financial innovations, and weaknesses in both the risk-
management systems of financial institutions and the government 
oversight of such institutions.
    While stabilizing the financial system to set the stage for 
economic recovery will remain its top priority in the near term, the 
Federal Reserve has also begun to evaluate regulatory and supervisory 
changes that could help reduce the incidence and severity of future 
financial crises. Today's Committee hearing is a timely opportunity for 
us to share our thinking to date and to contribute to your 
deliberations on regulatory modernization legislation.
    Many conclusions can be drawn from the financial crisis and the 
period preceding it, ranging across topics as diverse as capital 
adequacy requirements, risk measurement and management at financial 
institutions, supervisory practices, and consumer protection. In the 
Board's judgment, one of the key lessons is that the United States must 
have a comprehensive strategy for containing systemic risk. This 
strategy must be multifaceted and involve oversight of the financial 
system as a whole, and not just its individual components, in order to 
improve the resiliency of the system to potential systemic shocks. In 
pursuing this strategy, we must ensure that the reforms we enact now 
are aimed not just at the causes of our current crisis, but at other 
sources of risk that may arise in the future.
    Systemic risk refers to the potential for an event or shock 
triggering a loss of economic value or confidence in a substantial 
portion of the financial system, with resulting major adverse effects 
on the real economy. A core characteristic of systemic risk is the 
potential for contagion effects. Traditionally, the concern was that a 
run on a large bank, for example, would lead not only to the failure of 
that bank, but also to the failure of other financial firms because of 
the combined effect of the failed bank's unpaid obligations to other 
firms and market uncertainty as to whether those or other firms had 
similar vulnerabilities. In fact, most recent episodes of systemic risk 
have begun in markets, rather than through a classic run on a bank. A 
sharp downward movement in asset prices has been magnified by certain 
market practices or vulnerabilities. Soon market participants become 
uncertain about the values of those assets, an uncertainty that spreads 
to other assets as liquidity freezes up. In the worst case, liquidity 
problems become solvency problems. The result has been spillover 
effects both within the financial sector and from the financial sector 
to the real economy.
    In my remarks, I will discuss several components of a broad policy 
agenda to address systemic risk: consolidated supervision, the 
development of a resolution regime for systemically important nonbank 
financial institutions; more uniform and robust authority for the 
prudential supervision of systemically important payment and settlement 
systems; consumer protection; and the potential benefits of charging a 
governmental entity with more express responsibility for monitoring and 
addressing systemic risks in the financial system. In elaborating this 
agenda, I will both discuss the actions the Federal Reserve is taking 
under existing authorities and identify areas in which we believe 
legislation is needed.
Effective Consolidated Supervision of Systemically Important Firms
    For the reasons I have just stated, supervision of individual 
financial firms is not a sufficient condition for fostering financial 
stability. But it is surely a necessary condition. Thus a first 
component of an agenda for systemic risk regulation is that each 
systemically important financial firm be subject to effective 
consolidated supervision. This means ensuring both that regulatory 
requirements apply to each such firm and that the consequent 
supervision is effective.
    As to the issue of effectiveness, many of the current problems in 
the banking and financial system stem from risk-management failures at 
a number of financial institutions, including some firms under federal 
supervision. Clearly, these lapses are unacceptable. The Federal 
Reserve has been involved in a number of exercises to understand and 
document the risk-management lapses and shortcomings at major financial 
institutions, including those undertaken by the Senior Supervisors 
Group, the President's Working Group on Financial Markets, and the 
multinational Financial Stability Forum. \1\
---------------------------------------------------------------------------
     \1\  See Senior Supervisors Group (2008), ``Observations on Risk 
Management Practices during the Recent Market Turbulence'' March 6, 
www.newyorkfed.org/newsevents/news/banking/2008/
SSG_Risk_Mgt_doc_final.pdf; President's Working Group on Financial 
Markets (2008), ``Policy Statement on Financial Market Developments,'' 
March 13, www.treas.gov/press/releases/reports/
pwgpolicystatemktturmoil_03122008.pdf; and Financial Stability Forum 
(2008), ``Report of the Financial Stability Forum on Enhancing Market 
and Institutional Resilience,'' April 7, www.fsforum.org/publications/
FSF_Report_to_G7_11_April.pdf.
---------------------------------------------------------------------------
    Based on the results of these and other efforts, the Federal 
Reserve is taking steps to improve regulatory requirements and risk 
management at regulated institutions. Our actions have covered 
liquidity risk management, capital planning and capital adequacy, firm-
wide risk identification, residential lending, counterparty credit 
exposures, and commercial real estate. Liquidity and capital have been 
given special attention.
    The crisis has undermined previous conventional wisdom that a 
company, even in stressed environments, may readily borrow funds if it 
can offer high-quality collateral. For example, the inability of Bear 
Stearns to borrow even against U.S. government securities helped cause 
its collapse. As a result, we have been working to bring about needed 
improvements in institutions' liquidity risk-management practices. 
Along with our U.S. supervisory colleagues, we are closely monitoring 
the liquidity positions of banking organizations--on a daily basis for 
the largest and most critical firms--and are discussing key market 
developments and our supervisory analyses with senior management. We 
use these analyses and findings from examinations to ensure that 
liquidity and funding management, as well as contingency funding plans, 
are sufficiently robust and incorporate various stress scenarios. 
Looking beyond the present period, we also have underway a broader-
ranging examination of liquidity requirements.
    Similarly, the Federal Reserve is closely monitoring the capital 
levels of banking organizations on a regular basis and discussing our 
evaluation with senior management. As part of our supervisory process, 
we have been conducting our own analysis of loss scenarios to 
anticipate the potential future capital needs of institutions. These 
needs may arise from, among other things, future losses or the 
potential for off-balance-sheet exposures and assets to come on balance 
sheet. Here, too, we have been discussing our analyses with bankers and 
ensuring that their own internal analyses reflect a broad range of 
scenarios and capture stress environments that could impair solvency. 
We have intensified efforts to evaluate firms' capital planning and to 
bring about improvements where needed.
    Going forward, we will need changes in the capital regime as the 
financial environment returns closer to normal conditions. Working with 
other domestic and foreign supervisors, we must strengthen the existing 
capital rules to achieve a higher level and quality of required 
capital. Institutions should also have to establish strong capital 
buffers above current regulatory minimums in good times, so that they 
can weather financial market stress and continue to meet customer 
credit needs. This is but one of a number of important ways in which 
the current pro-cyclical features of financial regulation should be 
modified, with the aim of counteracting rather than exacerbating the 
effects of financial stress. Finally, firms whose failure would pose a 
systemic risk must be subject to especially close supervisory oversight 
of their risk-taking, risk management, and financial condition, and be 
held to high capital and liquidity standards.
    Turning to the reach of consolidated supervision, the Board 
believes there should be statutory coverage of all systemically 
important financial firms--not just those affiliated with an insured 
bank as provided for under the Bank Holding Company Act of 1956 (BHC 
Act). The current financial crisis has highlighted a fact that had 
become more and more apparent in recent years--that risks to the 
financial system can arise not only in the banking sector, but also 
from the activities of financial firms that traditionally have not been 
subject to the type of consolidated supervision applied to bank holding 
companies. For example, although the Securities and Exchange Commission 
(SEC) had authority over the broker-dealer and other SEC-registered 
units of Bear Stearns and the other large investment banks, it did not 
have statutory authority to supervise the diversified operations of 
these firms on a consolidated basis. Instead, the SEC was forced to 
rely on a voluntary regime for monitoring and addressing the capital 
and liquidity risks arising from the full range of these firms' 
operations.
    In contrast, all holding companies that own a bank--regardless of 
size--are subject to consolidated supervision for safety and soundness 
purposes under the BHC Act. \2\ A robust consolidated supervisory 
framework, like the one embodied in the BHC Act, provides a supervisor 
the tools it needs to understand, monitor and, when appropriate, 
restrain the risks associated with an organization's consolidated or 
group-wide activities. These tools include the authority to establish 
consolidated capital requirements for the organization, obtain reports 
from and conduct examinations of the organization and any of its 
subsidiaries, and require the organization or its subsidiaries to alter 
their risk-management practices or take other actions to address risks 
that threaten the safety and soundness of the organization.
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     \2\ Through the exploitation of a loophole in the BHC Act, certain 
investment banks, as well as other financial and nonfinancial firms, 
acquired control of a federally insured industrial loan company (ILC) 
while avoiding the prudential framework that Congress established for 
the corporate owners of other full-service insured banks. For the 
reasons discussed in prior testimony before this Committee, the Board 
continues to believe that this loophole in current law should be 
closed. See Testimony of Scott G. Alvarez, General Counsel of the 
Board, before the Committee on Banking, Housing, and Urban Affairs, 
U.S. Senate, Oct. 4, 2007.
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    Application of a similar regime to systemically important financial 
institutions that are not bank holding companies would help promote the 
safety and soundness of these firms and the stability of the financial 
system generally. It also is worth considering whether a broader 
application of the principle of consolidated supervision would help 
reduce the potential for risk taking to migrate from more-regulated to 
less-regulated parts of the financial sector. To be fully effective, 
consolidated supervisors must have clear authority to monitor and 
address safety and soundness concerns in all parts of an organization. 
Accordingly, specific consideration should be given to modifying the 
limits currently placed on the ability of consolidated supervisors to 
monitor and address risks at an organization's functionally regulated 
subsidiaries.
Improved Resolution Processes
    The importance of extending effective consolidated supervision to 
all systemically important firms is, of course, linked to the 
perception of market participants that such firms will be considered 
too-big-to-fail, and will thus be supported by the government if they 
get into financial difficulty. This perception has obvious undesirable 
effects, including possible moral hazard effects if firms are able to 
take excessive risks because of market beliefs that they can fall back 
on government assistance. In addition to effective supervision of these 
firms, the United States needs improved tools to allow the orderly 
resolution of systemically important nonbank financial firms, including 
a mechanism to cover the costs of the resolution if government 
assistance is required to prevent systemic consequences. In most cases, 
federal bankruptcy laws provide an appropriate framework for the 
resolution of nonbank financial institutions. However, this framework 
does not sufficiently protect the public's strong interest in ensuring 
the orderly resolution of nondepository financial institutions when a 
failure would pose substantial systemic risks.
    Developing appropriate resolution procedures for potentially 
systemic financial firms, including bank holding companies, is a 
complex and challenging task that will take some time to complete. We 
can begin, however, by learning from other models, including the 
process currently in place under the Federal Deposit Insurance Act 
(FDIA) for dealing with failing insured depository institutions and the 
framework established for Fannie Mae and Freddie Mac under the Housing 
and Economic Recovery Act of 2008. Both models allow a government 
agency to take control of a failing institution's operations and 
management, act as conservator or receiver for the institution, and 
establish a ``bridge'' institution to facilitate an orderly sale or 
liquidation of the firm. The authority to ``bridge'' a failing 
institution through a receivership to a new entity reduces the 
potential for market disruption, limits the value-destruction impact of 
a failure, and--when accompanied by haircuts on creditors and 
shareholders--mitigates the adverse impact of government intervention 
on market discipline.
    Any new resolution regime would need to be carefully crafted. For 
example, clear guidelines are needed to define which firms could be 
subject to the new, alternative regime and the process for invoking 
that regime, analogous perhaps to the procedures for invoking the so 
called systemic risk exception under the FDIA. In addition, given the 
global operations of many large and diversified financial firms and the 
complex regulatory structures under which they operate, any new 
resolution regime must be structured to work as seamlessly as possible 
with other domestic or foreign insolvency regimes that might apply to 
one or more parts of the consolidated organization.
    In addition to developing an alternative resolution regime for 
systemically critical financial firms, policymakers and experts should 
carefully review whether improvements can be made to the existing 
bankruptcy framework that would allow for a faster and more orderly 
resolution of financial firms generally. Such improvements could reduce 
the likelihood that the new alternative regime would need to be invoked 
or government assistance provided in a particular instance to protect 
financial stability and, thereby, could promote market discipline.
Oversight of Payment and Settlement Systems
    As suggested earlier, a comprehensive strategy for controlling 
systemic risk must focus not simply on the stability of individual 
firms. Another element of such a strategy is to provide close oversight 
of important arenas in which firms interact with one another. Payment 
and settlement systems are the foundation of our financial 
infrastructure. Financial institutions and markets depend upon the 
smooth functioning of these systems and their ability to manage 
counterparty and settlement risks effectively. Such systems can have 
significant risk-reduction benefits--by improving counterparty credit 
risk management, reducing settlement risks, and providing an orderly 
process to handle participant defaults--and can improve transparency 
for participants, financial markets, and regulatory authorities. At the 
same time, these systems inherently centralize and concentrate clearing 
and settlement risks. Thus, if a system is not well designed and able 
to appropriately manage the risks arising from participant defaults or 
operational disruptions, significant liquidity or credit problems could 
result.
    Well before the current crisis erupted, the Federal Reserve was 
working to strengthen the financial infrastructure that supports 
trading, payments, clearing, and settlement in key financial markets. 
Because this infrastructure acts as a critical link between financial 
institutions and markets, ensuring that it is able to withstand--and 
not amplify--shocks is an important aspect of reducing systemic risk, 
including the very real problem of institutions that are too big or 
interconnected to be allowed to fail in a disorderly manner.
    The Federal Reserve Bank of New York has been leading a major joint 
initiative by the public and private sectors to improve arrangements 
for clearing and settling credit default swaps (CDS) and other over-
the-counter (OTC) derivatives. As a result, the accuracy and timeliness 
of trade information has improved significantly. In addition, the 
Federal Reserve, working with other supervisors through the President's 
Working Group on Financial Markets, has encouraged the development of 
well-regulated and prudently managed central clearing counterparties 
for OTC trades. Along these lines, the Board has encouraged the 
development of two central counterparties for CDS in the United 
States--ICE Trust and the Chicago Mercantile Exchange. In addition, in 
2008, the Board entered into a memorandum of understanding with the SEC 
and the Commodity Futures Trading Commission to promote the application 
of common prudential standards to central counterparties for CDS and to 
facilitate the sharing of information among the agencies with respect 
to such central counterparties. The Federal Reserve also is consulting 
with foreign financial regulators regarding the development and 
oversight of central counterparties for CDS in other jurisdictions to 
promote the application of consistent prudential standards.
    The New York Federal Reserve Bank, in conjunction with other 
domestic and foreign supervisors, continues its effort to establish 
increasingly stringent targets and performance standards for OTC market 
participants. In addition, we are working with market participants to 
enhance the resilience of the triparty repurchase agreement (repo) 
market. Through this market, primary dealers and other major banks and 
broker-dealers obtain very large amounts of secured financing from 
money market mutual funds and other short-term, risk-averse investors. 
\3\ We are exploring, for example, whether a central clearing system or 
other improvements might be beneficial for this market, given the 
magnitude of exposures generated and the vital importance of the market 
to both dealers and investors.
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     \3\ Primary dealers are broker-dealers that trade in U.S. 
government securities with the Federal Reserve Bank of New York. The 
New York Reserve Bank's Open Market Desk engages in trades on behalf of 
the Federal Reserve System to implement monetary policy.
---------------------------------------------------------------------------
    Even as we pursue these and similar initiatives, however, the Board 
believes additional statutory authority is needed to address the 
potential for systemic risk in payment and settlement systems. 
Currently, the Federal Reserve relies on a patchwork of authorities, 
largely derived from our role as a banking supervisor, as well as on 
moral suasion to help ensure that critical payment and settlement 
systems have the necessary procedures and controls in place to manage 
their risks. By contrast, many major central banks around the world 
have an explicit statutory basis for their oversight of these systems. 
Given how important robust payment and settlement systems are to 
financial stability, and the functional similarities between many 
payment and settlement systems, a good case can be made for granting 
the Federal Reserve explicit oversight authority for systemically 
important payment and settlement systems.
    The Federal Reserve has significant expertise regarding the risks 
and appropriate risk management practices at payment and settlement 
systems, substantial direct experience with the measures necessary for 
the safe and sound operation of such systems, and established working 
relationships with other central banks and regulators that we have used 
to promote the development of strong and internationally accepted risk 
management standards for the full range of these systems. Providing 
such authority would help ensure that these critical systems are held 
to consistent and high prudential standards aimed at mitigating 
systemic risk.
Consumer Protection
    Another lesson of this crisis is that pervasive consumer protection 
problems can signal, and even lead to, trouble for the safety and 
soundness of financial institutions and for the stability of the 
financial system as a whole. Consumer protection in the area of 
financial services is not, and should not be, limited to practices with 
potentially systemic consequences. However, as we evaluate the range of 
measures that can help contain systemic problems, it is important to 
recognize that good consumer protection can play a supporting role by--
among other things--promoting sound underwriting practices.
    Last year the Board adopted new regulations under the Home 
Ownership and Equity Protection Act to enhance the substantive 
protections provided high-cost mortgage customers, such as requiring 
tax and insurance escrows in certain cases and limiting the use of 
prepayment penalties. These rules also require lenders providing such 
high-cost loans to verify the income and assets of a loan applicant and 
prohibit lenders from making such a loan without taking into account 
the ability of the borrower to repay the loan from income or assets 
other than the home's value. More recently, the Board adopted new rules 
to protect credit card customers from a variety of unfair and deceptive 
acts and practices. The Board will continue to update its consumer 
protection regulations as appropriate to provide households with the 
information they need to make informed credit decisions and to address 
new unfair and deceptive practices that may develop as practices and 
products change.
Systemic Risk Authority
    One issue that has received much attention recently is the possible 
benefit of establishing a systemic risk authority that would be charged 
with monitoring, assessing and, if necessary, curtailing systemic risks 
across the entire U.S. financial system.
    At a conceptual level, expressly empowering a governmental 
authority with responsibility to help contain systemic risks should, if 
implemented correctly, reduce the potential for large adverse shocks 
and limit the spillover effects of those shocks that do occur, thereby 
enhancing the resilience of the financial system. However, no one 
should underestimate the challenges involved with developing or 
implementing a supervisory and regulatory program for systemic risks. 
Nor should the establishment of such an authority be viewed as a 
panacea that will eliminate periods of significant stress in the 
financial markets and so reduce the need for the other important 
reforms that I have discussed.
    The U.S. financial sector is extremely large and diverse--with 
value added amounting to nearly $1.1 trillion or 8 percent of gross 
domestic product in 2007. Systemic risks may arise across a broad range 
of firms or markets, or they may be concentrated in just a few key 
institutions or activities. They can occur suddenly, such as from a 
rapid and substantial decline in asset prices, even if the probability 
of their occurrence builds up slowly over time. Moreover, as the 
current crisis has illustrated, systemic risks may arise at nonbank 
entities (for example, mortgage brokers), from sectors outside the 
traditional purview of federal supervision (for example, insurance 
firms), from institutions or activities that are based in other 
countries or operate across national boundaries, or from the linkages 
and interdependencies among financial institutions or between financial 
institutions and markets. And, while the existence of systemic risks 
may be apparent in hindsight, identifying such risks ex ante and 
determining the proper degree of regulatory or supervisory action 
needed to counteract a particular risk without unnecessarily hampering 
innovation and economic growth is a very challenging assignment for any 
agency or group of agencies. \4\
---------------------------------------------------------------------------
     \4\ For example, while the existence of supranormal profits in a 
market segment may be an indicator of supranormal risks, it also may be 
the result of innovation on the part of one or more market participants 
that does not create undue risks to the system.
---------------------------------------------------------------------------
    For these reasons, any systemic risk authority would need a 
sophisticated, comprehensive and multi-disciplinary approach to 
systemic risk. Such an authority likely would require knowledge and 
experience across a wide range of financial institutions and markets, 
substantial analytical resources to identify the types of information 
needed and to analyze the information obtained, and supervisory 
expertise to develop and implement the necessary supervisory programs.
    To be effective, however, these skills would have to be combined 
with a clear statement of expectations and responsibilities, and with 
adequate powers to fulfill those responsibilities. While the systemic 
risk authority should be required to rely on the information, 
assessments, and supervisory and regulatory programs of existing 
financial supervisors and regulators whenever possible, it would need 
sufficient powers of its own to achieve its broader mission--monitoring 
and containing systemic risk. These powers likely would include broad 
authority to obtain information--through data collection and reports, 
or when necessary, examinations--from a range of financial market 
participants, including banking organizations, securities firms, key 
financial market intermediaries, and other financial institutions that 
currently may not be subject to regular federal supervisory reporting 
requirements.
    How might a properly constructed systemic risk authority use its 
expertise and authorities to help monitor, assess, and mitigate 
potentially systemic risks within the financial system? There are 
numerous possibilities. One area of natural focus for a systemic risk 
authority would be the stability of systemically critical financial 
institutions. It also likely would need some role in the setting of 
standards for capital, liquidity, and risk-management practices for 
financial firms, given the importance of these matters to the aggregate 
level of risk within the financial system. By bringing its broad 
knowledge of the interrelationships between firms and markets to bear, 
the systemic risk authority could help mitigate the potential for 
financial firms to be a source of, or be negatively affected by, 
adverse shocks to the system.
    It seems most sensible that the role of the systemic risk authority 
be to complement, not displace, that of a firm's consolidated 
supervisor (which, as I noted earlier, all systemically critical 
financial institutions should have). Under this model, the firm's 
consolidated supervisor would continue to have primary responsibility 
for the day-to-day supervision of the firm's risk management practices, 
including those relating to compliance risk management, and for 
focusing on the safety and soundness of the individual institution.
    Another key issue is the extent to which a systemic risk authority 
would have appropriately calibrated ability to take measures to address 
specific practices identified as posing a systemic risk--in 
coordination with other supervisors when possible, or independently if 
necessary. For example, there may be practices that appear sound when 
considered from the perspective of a single firm, but that appear 
troublesome when understood to be widespread in the financial system, 
such as if these practices reveal the shared dependence of firms on 
particular forms of uncertain liquidity.
    Other activities that a systemic risk authority might undertake 
include: (1) monitoring large or rapidly increasing exposures--such as 
to subprime mortgages--across firms and markets; (2) assessing the 
potential for deficiencies in evolving risk-management practices, 
broad-based increases in financial leverage, or changes in financial 
markets or products to increase systemic risks; (3) analyzing possible 
spillovers between financial firms or between firms and markets, for 
example through the mutual exposures of highly interconnected firms; 
(4) identifying possible regulatory gaps, including gaps in the 
protection of consumers and investors, that pose risks for the system 
as a whole; and (5) issuing periodic reports on the stability of the 
U.S. financial system, in order both to disseminate its own views and 
to elicit the considered views of others.
    Thus, there are numerous important decisions to be made on the 
substantive reach and responsibilities of a systemic risk regulator. 
How such an authority, if created, should be structured and located 
within the federal government is also a complex issue. Some have 
suggested the Federal Reserve for this role, while others have 
expressed concern that adding this responsibility would overburden the 
central bank. The extent to which this new responsibility might be a 
good match for the Federal Reserve, acting either alone or as part of a 
collective body, depends a great deal on precisely how the Congress 
defines the role and responsibilities of the authority, and how well 
they complement those of the Federal Reserve's long-established core 
missions.
    Nevertheless, as Chairman Bernanke has noted, effectively 
identifying and addressing systemic risks would seem to require some 
involvement of the Federal Reserve. As the central bank of the United 
States, the Federal Reserve has a critical part to play in the 
government's responses to financial crises. Indeed, the Federal Reserve 
was established by the Congress in 1913 largely as a means of 
addressing the problem of recurring financial panics. The Federal 
Reserve plays such a key role in part because it serves as liquidity 
provider of last resort, a power that has proved critical in financial 
crises throughout modern history. In addition, the Federal Reserve has 
broad expertise derived from its other activities, including its role 
as umbrella supervisor for bank and financial holding companies and its 
active monitoring of capital markets in support of its monetary policy 
and financial stability objectives.
    It seems equally clear that each financial regulator must be 
involved in a successful overall strategy for containing systemic risk. 
In the first place, of course, appropriate attention to systemic issues 
in the normal regulation of financial firms, markets, and practices may 
itself support this strategy. Second, the information and insight 
gained by financial regulators in their own realms of expertise will be 
important contributions to the demanding job of analyzing inchoate 
risks to financial stability. Still, while a collective process will 
surely be valuable in assessing systemic risk, it will be important to 
assign clearly any responsibilities and authorities for actual systemic 
risk regulation, since shared authority without clearly delineated 
responsibility for action is sometimes a prescription for inaction.
Conclusion
    I have tried today to identify the elements of an agenda for 
limiting the potential for financial crises, including actions that the 
Federal Reserve is taking to address systemic risks and several 
measures that Congress should consider to make our financial system 
stronger and safer. In doing so, we must avoid responding only to the 
current crisis, but must instead fashion a system that will be up to 
the challenge of regulating a dynamic and innovative financial system. 
We at the Federal Reserve look forward to working with the Congress on 
legislation that meets these objectives.



                                 ______
                                 

                PREPARED STATEMENT OF SCOTT M. POLAKOFF
                            Acting Director,
                      Office of Thrift Supervision
                             March 19, 2009
Introduction
    Good morning Chairman Dodd, Ranking Member Shelby, and Members of 
the Committee. Thank you for inviting me to testify on behalf of the 
Office of Thrift Supervision (OTS) on Modernizing Bank Supervision and 
Regulation.
    It has been pointed out many times that our current system of 
financial supervision is a patchwork with pieces that date to the Civil 
War. If we were to start from scratch, no one would advocate 
establishing a system like the one we have cobbled together over the 
last century and a half. The complexity of our financial markets has in 
some cases reached mind-boggling proportions. To effectively address 
the risks in today's financial marketplace, we need a modern, 
sophisticated system of regulation and supervision that applies evenly 
across the financial services landscape.
    The economic crisis gripping this nation and much of the rest of 
the world reinforces the theme that the time is right for an in-depth, 
careful review and meaningful, fundamental change. Any restructuring 
should take into account the lessons learned from this crisis.
    Of course, the notion of regulatory reform is not new. When 
financial crisis strikes, it is natural to look for the root causes and 
logical fixes, asking whether the nation's regulatory framework allowed 
problems to occur, either because of gaps in oversight, a lack of 
vigilance, or overlaps in responsibilities that bred a lack of 
accountability.
    Since last year, a new round of studies, reports and 
recommendations have entered the public arena. In one particularly 
notable study in January 2009--Financial Regulation: A Framework for 
Crafting and Assessing Proposals to Modernize the Outdated U. S. 
Financial Regulatory System--the Government Accountability Office (GAO) 
listed four broad goals of financial regulation:

    Ensure adequate consumer protections,

    Ensure integrity and fairness of markets,

    Monitor the safety and soundness of institutions, and

    Ensure the stability of the overall financial system.

    The OTS recommendations discussed in this testimony align with 
those goals.
    Although a review of the current financial services regulatory 
framework is a necessary exercise, the OTS recommendations do not 
represent a realignment of the current regulatory system. Rather, these 
recommendations represent a fresh start, using a clean slate. They 
present the OTS vision for the way financial services regulation in 
this country should be. Although they seek to remedy some of the 
problems of the past, they do not simply rearrange the current 
regulatory boxes. What we are proposing is fundamental change that 
would affect virtually all of the current federal financial regulators.
    It is also important to note that these are high-level 
recommendations. Before adoption and implementation, many details would 
need to be worked out and many questions would need to be answered. To 
provide all of those details and answer all of those questions would 
require reams beyond the pages of this testimony.
    The remaining sections of the OTS testimony begin by describing the 
problems that led to the current economic crisis. We also cite some of 
the important lessons learned from the OTS's perspective. The testimony 
then outlines several principles for a new regulatory framework before 
describing the heart of the OTS proposal for reform.
What Went Wrong?
    The problems at the root of the financial crisis fall into two 
groups, nonstructural and structural. The nonstructural problems relate 
to lessons learned from the current economic crisis that have been, or 
can be, addressed without changes to the regulatory structure. The 
structural problems relate to gaps in regulatory coverage for some 
financial firms, financial workers and financial products.
Nonstructural Problems
    In assessing what went wrong, it is important to note that several 
key issues relate to such things as concentration risks, extraordinary 
liquidity pressures, weak risk management practices, the influence of 
unregulated entities and product markets, and an over-reliance on 
models that relied on insufficient data and faulty assumptions. All of 
the regulators, including the OTS, were slow to foresee the effects 
these risks could have on the institutions we regulate. Where we have 
the authority, we have taken steps to deal with these issues.
    For example, federal regulators were slow to appreciate the 
severity of the problems arising from the increased use of mortgage 
brokers and other unregulated entities in providing consumer financial 
services. As the originate-to-distribute model became more prevalent, 
the resulting increase in competition changed the way all mortgage 
lenders underwrote loans, and assigned and priced risk. During the then 
booming economic environment, competition to originate new loans was 
fierce between insured institutions and less well regulated entities. 
Once these loans were originated, the majority of them were removed 
from bank balance sheets and sold into the securitization market. These 
events seeded many residential mortgage-backed securities with loans 
that were not underwritten adequately and that would cause significant 
problems later when home values fell, mortgages became delinquent and 
the true value of the securities became increasingly suspect.
    Part of this problem stemmed from a structural issue described in 
the next section--inadequate and uneven regulation of mortgage 
companies and brokers--but some banks and thrifts that had to compete 
with these companies also started making loans that were focused on the 
rising value of the underlying collateral, rather than the borrower's 
ability to repay. By the time the federal bank regulators issued the 
nontraditional mortgage guidance in September 2006, reminding insured 
depository institutions to consider borrowers' ability to repay when 
underwriting adjustable-rate loans, numerous loans had been made that 
could not withstand a severe downturn in real estate values and payment 
shock from changes in adjustable rates.
    When the secondary market stopped buying these loans in the fall of 
2007, too many banks and thrifts were warehousing loans intended for 
sale that ultimately could not be sold. Until this time, bank examiners 
had historically looked at internal controls, underwriting practices 
and serviced loan portfolio performance as barometers of safety and 
soundness. In September 2008, the OTS issued guidance to the industry 
reiterating OTS policy that for all loans originated for sale or held 
in portfolio, savings associations must use prudent underwriting and 
documentation standards. The guidance emphasized that the OTS expects 
loans originated for sale to be underwritten to comply with the 
institution's approved loan policy, as well as all existing regulations 
and supervisory guidance governing the documentation and underwriting 
of residential mortgages. Once loans intended for sale were forced to 
be kept in the institutions' portfolios, it reinforced the supervisory 
concern that concentrations and liquidity of assets, whether 
geographically or by loan type, can pose major risks.
    One lesson from these events is that regulators should consider 
promulgating requirements that are counter-cyclical, such as conducting 
stress tests and lowering loan-to-value ratios during economic 
upswings. Similarly, in difficult economic times, when house prices are 
not appreciating, regulators could permit loan-to-value (LTV) ratios to 
rise. Other examples include increasing capital and allowance for loan 
and lease losses in times of prosperity, when resources are readily 
available.
    Another important nonstructural problem that is recognizable in 
hindsight and remains a concern today is the magnitude of the liquidity 
risk facing financial institutions and how that risk is addressed. As 
the economic crisis hit banks and thrifts, some institutions failed and 
consumers whose confidence was already shaken were overtaken in some 
cases by panic about the safety of their savings in insured accounts at 
banks and thrifts. This lack of consumer confidence resulted in large 
and sudden deposit drains at some institutions that had serious 
consequences. The federal government has taken several important steps 
to address liquidity risk in recent months, including an increase in 
the insured threshold for bank and thrift deposits.
    Another lesson learned is that a lack of transparency for consumer 
products and complex instruments contributed to the crisis. For 
consumers, the full terms and details of mortgage products need to be 
understandable. For investors, the underlying details of their 
investments must be clear, readily available and accurately evaluated. 
Transparency of disclosures and agreements should be addressed.
    Some of the blame for the economic crisis has been attributed to 
the use of ``mark-to-market'' accounting under the argument that this 
accounting model contributes to a downward spiral in asset prices. The 
theory is that as financial institutions write down assets to current 
market values in an illiquid market, those losses reduce regulatory 
capital. To eliminate their exposure to further write-downs, 
institutions sell assets into stressed, illiquid markets, triggering a 
cycle of additional sales at depressed prices. This in turn results in 
further write-downs by institutions holding similar assets. The OTS 
believes that refining this type of accounting is better than 
suspending it. Changes in accounting standards can address the concerns 
of those who say fair value accounting should continue and those 
calling for its suspension.
    These examples illustrate that nonstructural problems, such as weak 
underwriting, lack of transparency, accounting issues and an over-
reliance on performance rather than fundamentals, all contributed to 
the current crisis.
Structural Problems
    The crisis has also demonstrated that gaps in regulation and 
supervision that exist in the mortgage market have had a negative 
impact on the world of traditional and complex financial products. In 
recent years, the lack of consistent regulation and supervision in the 
mortgage lending area has become increasingly apparent.
    Independent mortgage banking companies are state-chartered and 
regulated. Currently, there are state-by-state variations in the 
authorities of supervising agencies, in the level of supervision by the 
states and in the licensing processes that are used. State regulation 
of mortgage banking companies is inconsistent and varies on a number of 
factors, including where the authority for chartering and oversight of 
the companies resides in the state regulatory structure.
    The supervision of mortgage brokers is even less consistent across 
the states. In response to calls for more stringent oversight of 
mortgage lenders and brokers, a number of states have debated and even 
enacted licensing requirements for mortgage originators. Last summer, a 
system requiring the licensing of mortgage originators in all states 
was enacted into federal law. The S.A.F.E. Mortgage Licensing Act in 
last year's Housing and Economic Recovery Act is a good first step. 
However, licensing does not go far enough. There continues to be 
significant variation in the oversight of these individuals and 
enforcement against the bad actors.
    As the OTS has advocated for some time, one of the paramount goals 
of any new framework should be to ensure that similar bank or bank-like 
products, services and activities are scrutinized in the same way, 
whether they are offered by a chartered depository institution, or an 
unregulated financial services provider. The product should receive the 
same review, oversight and scrutiny regardless of the entity offering 
the product. Consumers do not understand--nor should they need to 
understand--distinctions between the types of lenders offering to 
provide them with a mortgage. They deserve the same service, care and 
protection from any lender. The ``shadow bank system,'' where bank or 
bank-like products are offered by nonbanks using different standards, 
should be subject to as rigorous supervision as banks. Closing this gap 
would support the goals cited in the GAO report.
    Another structural problem relates to unregulated financial 
products and the confluence of market factors that exposed the true 
risk of credit default swaps (CDS) and other derivative products. CDS 
are unregulated financial products that lack a prudential derivatives 
regulator or standard market regulation, and pose serious challenges 
for risk management. Shortcomings in data and in modeling certain 
derivative products camouflaged some of those risks. There frequently 
is heavy reliance on rating agencies and in-house models to assess the 
risks associated with these extremely complicated and unregulated 
products. In hindsight, the banking industry, the rating agencies and 
prudential supervisors, including OTS, relied too heavily on stress 
parameters that were based on insufficient historical data. This led to 
an underestimation of the economic shock that hit the financial sector, 
misjudgment of stress test parameters and an overly optimistic view of 
model output.
    We have also learned there is a need for consistency and 
transparency in over-the-counter (OTC) CDS contracts. The complexity of 
CDS contracts masked risks and weaknesses. The OTS believes 
standardization and simplification of these products would provide more 
transparency to market participants and regulators. We believe many of 
these OTC contracts should be subject to exchange-traded oversight, 
with daily margining required. This kind of standardization and 
exchange-traded oversight can be accomplished when a single regulator 
is evaluating these products. Congress should consider legislation to 
bring such OTC derivative products under appropriate regulatory 
oversight.
    One final issue on the structural side relates to the problem of 
regulating institutions that are considered to be too big and 
interconnected to fail, manage, resolve, or even formally deem as 
problem institutions when they encounter serious trouble. We will 
discuss the pressing need for a systemic risk regulator with the 
authority and resources adequate to the meet this enormous challenge 
later in this testimony.
    The array of lessons learned from the crisis will be debated for 
years. One simple lesson is that all financial products and services 
should be regulated in the same manner regardless of the issuer. 
Another lesson is that some institutions have grown so large and become 
so essential to the economic well-being of the nation that they must be 
regulated in a new way.
Guiding Principles for Modernizing Bank Supervision and Regulation
    The discussion on how to modernize bank supervision and regulation 
should begin with basic principles to apply to a bank supervision and 
consumer protection structure. Safety and soundness and consumer 
protection are fundamental elements of any regulatory regime. Here are 
recommendations for four other guiding principles:

  1.  Dual banking system and federal insurance regulator--The system 
        should contain federal and state charters for banks, as well as 
        the option of federal and state charters for insurance 
        companies. The states have provided a charter option for banks 
        and thrifts that have not wanted to have a national charter. A 
        number of innovations have resulted from the kind of focused 
        product development that can occur on a local level. Banks 
        would be able to choose whether to hold a federal charter or 
        state charter. For large insurance companies, a federal 
        insurance regulator would be available to provide more 
        comprehensive, coordinated and effective oversight than a 
        collection of individual state insurance regulators.

  2.  Choice of charter, not of regulator--A depository institution 
        should be able to choose between state or federal banking 
        charters, but if it selects a federal charter, its charter type 
        and regulator should be determined by its operating strategy 
        and business model. In other words, there would be an option to 
        choose a business plan and resulting charter, but that decision 
        would then dictate which regulator would supervise the 
        institution.

  3.  Organizational and ownership options--Financial institutions 
        should be able to choose the organizational and ownership form 
        that best suits their needs. Mutual, public or private stock 
        and subchapter S options should continue to be available.

  4.  Self-sustaining regulators--Each regulator should be able to 
        sustain itself financially through assessments. Funding the 
        agencies differently could expose bank supervisory decisions to 
        political pressures, or create conflicts of interest within the 
        entity controlling the purse strings. An agency that supervises 
        financial institutions must control its funding to make 
        resources available quickly to respond to supervision and 
        enforcement needs. For example, when the economy declines, the 
        safety-and-soundness ratings of institutions generally drop and 
        enforcement actions rise. These changes require additional 
        resources and often an increase in hiring to handle the larger 
        workload.

  5.  Consistency--Each federal regulator should have the same 
        enforcement tools and the authority to use those tools in the 
        same manner. Every entity offering financial products should 
        also be subject to the same set of laws and regulations.
Federal Bank Regulation
    The OTS proposes two federal bank regulators, one for banks 
predominately focused on consumer-and-community banking products, 
including lending, and the other for banks primarily focused on 
commercial products and services. The business models of a commercial 
bank and a consumer-and-community bank are fundamentally different 
enough to warrant these two distinct federal banking charters.
    The consumer-and-community bank regulator would supervise 
depository institutions of all sizes and other companies that are 
predominately engaged in providing financial products and services to 
consumers and communities. Establishing such a regulator would address 
the gaps in regulatory oversight that led to a shadow banking system of 
unevenly regulated mortgage companies, brokers and consumer lenders 
that were significant causes of the current crisis.
    The consumer-and-community bank regulator would also be the primary 
federal regulator of all state-chartered banks with a consumer-and-
community business model. The regulator would work with state 
regulators to collaborate on examinations of state-chartered banks, 
perhaps on an alternating cycle for annual state and federal 
examinations. State-chartered banks would pay a prorated federal 
assessment to cover the costs of this oversight.
    In addition to safety and soundness oversight, the consumer-and-
community bank regulator would be responsible for developing and 
implementing all consumer protection requirements and regulations. 
These regulations and requirements would be applicable to all entities 
that offer lending products and services to consumers and communities. 
The same standards would apply for all of these entities, whether a 
state-licensed mortgage company, a state bank or a federally insured 
depository institution. Noncompliance would be addressed through 
uniform enforcement applied to all appropriate entities.
    The current crisis has highlighted consumer protection as an area 
where reform is needed. Mortgage brokers and others who interact with 
consumers should meet eligibility requirements that reinforce the 
importance of their jobs and the level of trust consumers place in 
them. Although the recently enacted licensing requirements are a good 
first step, limitations on who may have a license are also necessary.
    Historically, federal consumer protection policy has been based on 
the premise that if consumers are provided with enough information, 
they will be able to choose products and services that meet their 
needs. Although timely and effective disclosure remains necessary, 
disclosure alone may not be sufficient to protect consumers against 
abuses. This is particularly true as products and services, including 
mortgages, have become more complex.
    The second federal bank regulator--the commercial bank regulator--
would charter and supervise banks and other entities that primarily 
provide products and services to corporations and companies. The 
commercial bank regulator would have the expertise to supervise banks 
and other entities predominately involved in commercial transactions 
and offering complex products. This regulator would develop and 
implement the regulations necessary to supervise these entities. The 
commercial bank regulator would supervise issuers of derivative 
products. Nonbank providers of the same products and services would be 
subject to the same rules and regulations.
    The commercial bank regulator would not only have the tools 
necessary to understand and supervise the complex products already 
mentioned, but would also possess the expertise to evaluate the safety 
and soundness of loans that are based on suchthings as income streams 
and occupancy rates, which are typical of loans for projects such as 
shopping centers and commercial buildings.
    The commercial bank regulator would also be the primary federal 
supervisor of state-chartered banks with a commercial business model, 
coordinating with the states on supervision and imposing federal 
assessments just as the consumer-and-communityregulator would.
    Because most depositories today are engaged in some of each of 
these business lines, the predominant business focus of the institution 
would govern which regulator would be the primary federal regulator. In 
determining the federal supervisor, a percentage of assets test could 
apply. If the operations of the institution or entity changed for a 
significant period of time, the primary federal regulator would change. 
More discussion and analysis would be needed to determine where to draw 
the line between institutions qualifying as commercial banks and 
institutions qualifying as consumer and community banks.
Holding Company Regulation
    The functional regulator of the largest entity within a diversified 
financial company would be the holding company regulator. The holding 
company regulator would have authority to monitor the activities of all 
affiliates, to exercise enforcement authority and to impose 
information-sharing arrangements between entities in the holding 
company structure and their functional regulators. To the extent 
necessary for the safety and soundness of the depository subsidiary or 
the holding company, the regulator would have the authority to impose 
capital requirements, restrict activities, issue source-of support 
requirements and otherwise regulate the operations of the holding 
company and the affiliates.
Systemic Risk Regulation
    The establishment of a systemic risk regulator is an essential 
outcome of any initiative to modernize bank supervision and regulation. 
OTS endorses the establishment of a systemic risk regulator with broad 
authority to monitor and exercise supervision over any company whose 
actions or failure could pose a risk to financial stability. The 
systemic risk regulator should have the ability and the responsibility 
for monitoring all data about markets and companies, including but not 
limited to companies involved inbanking, securities and insurance.
    For systemically important institutions, the systemic risk 
regulator would supplement, not supplant, the holding company regulator 
and the primary federal bank supervisor.
    A systemic regulator would have the authority and resources to 
supervise institutions and companies during a crisis situation. The 
regulator should have ready access to funding sources that would 
provide the capability to resolve problems at these institutions, 
including providing liquidity when needed.
    Given the events of the past year, it is essential that such a 
regulator have the ability to act as a receiver and to provide an 
orderly resolution to companies. Efficiently resolving a systemically 
important institution in a measured, well-managed manner is an 
important element in restructuring the regulatory framework. A lesson 
learned from recent events is that the failure or unwinding of 
systemically important companies has a far reaching impact on the 
economy, not just on financial services.
    The continued ability of banks and other entities in the United 
States to compete in today's global financial services marketplace is 
critical. The systemic risk regulator would be charged with 
coordinating the supervision of conglomerates that have international 
operations. Safety and soundness standards, including capital adequacy 
and other factors, should be as comparable as possible for entities 
that have multinational businesses.
    Although the systemic risk regulator would not have supervisory 
authority over nonsystemically important banks, the systemic regulator 
would need access to data regarding the health and activities of these 
institutions for purposes of monitoring trendsand other matters.
Conclusion
    Thank you again, Mr. Chairman, Ranking Member Shelby, and Members 
of the Committee, for the opportunity to testify on behalf of the OTS 
on Modernizing Bank Supervision and Regulation.
    We look forward to continuing to work with the members of this 
Committee and others to fashion a system of financial services 
regulation that better serves all Americans and helps to ensure the 
necessary clarity and stability for this nation's economy.
                                 ______
                                 

               PREPARED STATEMENT OF JOSEPH A. SMITH, JR.
               North Carolina Commissioner of Banks, and
        Chair-Elect of the Conference of State Bank Supervisors
                             March 19, 2009
Introduction
    Good morning Chairman Dodd, Ranking Member Shelby, and Members of 
the Committee. My name is Joe Smith, and I am the North Carolina 
Commissioner of Banks. I also serve as incoming Chairman of the 
Conference of State Bank Supervisors (CSBS) and a member of the CSBS 
Task Force on Regulatory Restructuring. I am pleased to be here today 
to offer a state perspective on our nation's financial regulatory 
structure--its strengths and its deficiencies, and suggestions for 
reform.
    As we work through a federal response to this financial crisis, we 
need to carry forward a renewed understanding that the concentration of 
financial power and a lack of transparency are not in the long-term 
interests of our financial system, our economic system or our 
democracy. This lesson is one our country has had to learn in almost 
every generation, and I hope that the current lesson will benefit 
future generations. While our largest and most complex institutions are 
no doubt central to a resolution of the current crisis, my colleagues 
and I urge you to remember that the health and effectiveness of our 
nation's financial system also depends on a diverse and competitive 
marketplace that includes community and regional institutions.
    While changing our regulatory system will be far from simple, some 
fairly simple concepts should guide these reforms. In evaluating any 
governmental reform, we must ask if our financial regulatory system:

    Ushers in a new era of cooperative federalism, recognizing 
        the rights of states to protect consumers and reaffirming the 
        state role in chartering and supervising financial 
        institutions;

    Fosters supervision tailored to the size, scope and 
        complexity of an institution and the risk it poses to the 
        financial system;

    Assures the promulgation and enforcement of consumer 
        protection standards that are applicable to both state and 
        federally chartered institutions and are enforceable by state 
        officials;

    Encourages a diverse universe of financial institutions as 
        a method of reducing risk to the system, encouraging 
        competition, furthering innovation, insuring access to 
        financial markets, and promoting efficient allocation of 
        credit;

    Supports community and regional banks, which provide 
        relationship lending and fuel local economic development; and

    Requires financial institutions that are recipients of 
        governmental assistance or pose systemic risk to be subject to 
        safety and soundness and consumer protection oversight.

    We have often heard the consolidation of financial regulation at 
the federal level is the ``modern'' answer to the challenges our 
financial system. We need to challenge this assumption. For reasons 
more fully discussed below, my colleagues and I would suggest to you 
that an appropriately coordinated system of state and federal 
supervision and regulation will promote a more effective system of 
financial regulation and a more diverse, stable and responsive 
financial system.
The Role of the States in Financial Services Supervision and Regulation
    The states charter and supervise more than 70 percent of all U.S. 
banks (Exhibit A), in coordination with the FDIC and Federal Reserve. 
The rapid consolidation of the industry over the past decade, however, 
has created a system in which a handful of large national banks control 
the vast majority of assets in the system. The more than 6,000 banks 
supervised and regulated by the states now represent less than 30 
percent of the assets of the banking system (Exhibit B). While these 
banks are smaller than the global institutions now making headlines, 
they are important to all of the markets they serve and are critical in 
the nonmetropolitan markets where they are often the major sources of 
credit for local households, small businesses and farms.
    Since the enactment of nationwide banking in 1994, the states, 
working through CSBS, have developed a highly coordinated system of 
state-to-state and state-to-federal bank supervision. This is a model 
that has served this nation well, embodying our uniquely American 
dynamic of checks and balances--a dynamic that has been missing from 
certain areas of federal financial regulation, with devastating 
consequences.
    The dynamic of state and federal coordinated supervision for state-
chartered banks allows for new businesses to enter the market and grow 
to meet the needs of the markets they serve, while maintaining 
consistent nationwide standards. Community and regional banks are a 
vital part of America's economic fabric because of the state system.
    As we continue to work through the current crisis, we need to do 
more to support community and regional banks. The severe economic 
recession and market distortions caused by bailing out the largest 
institutions have caused significant stress on these institutions. 
While some community and regional banks have had access to the TARP's 
capital purchase program, the processing and funding has grown 
cumbersome and slow. We need a more nimble and effective program for 
these institutions. This program must be administered by an entity with 
an understanding of community and regional banking. This capital will 
enhance stability and provide support for consumer and small business 
lending.
    In addition to supervising banks, I and many of my colleagues 
regulate the residential mortgage industry. All 50 states and the 
District of Columbia now provide some regulatory oversight of the 
residential mortgage industry. The states currently manage over 88,000 
mortgage company licenses, over 68,000 branch licenses, and 
approximately 357,000 loan officer licenses. In 2003, the states, 
acting through the CSBS and the American Association of Residential 
Mortgage Regulators, first proposed a nationwide mortgage licensing 
system and database to coordinate our efforts in regulating the 
residential mortgage market. The system launched on January 2, 2008, on 
time and on budget. The Nationwide Mortgage Licensing System (NMLS) was 
incorporated in the federal S.A.F.E. Act and, as a result, has 
established a new and important partnership with the United States 
Department of Housing and Urban Development, the federal banking 
agencies and the Farm Credit Administration. We are confident that this 
partnership will result in an efficient and effective combination of 
state and federal resources and a nimble, responsive and comprehensive 
system of regulation. This is an example of what we mean by ``a new era 
of cooperative federalism.''
Where Federalism Has Fallen Short
    For the past decade it has been clear to the states that our system 
of mortgage finance and mortgage regulation was flawed and that a 
destructive and widening chasm had formed between the interests of 
borrowers and of lenders. Over that decade, through participation in 
GAO reports and through congressional testimony, one can observe an 
ever-increasing level of state concern over this growing chasm and its 
reflection in the state and federal regulatory relationship.
    Currently, 35 states plus the District of Columbia have enacted 
predatory lending laws. \1\ First adopted by North Carolina in 1999, 
these state laws supplement the federal protections of the Home 
Ownership and Equity Protection Act of 1994 (HOEPA). The innovative 
actions taken by state legislatures have prompted significant changes 
in industry practices, as the largest multi-state lenders have adjusted 
their practices to comply with the strongest state laws. All too often, 
however, we are frustrated in our efforts to protect consumers by the 
preemption of state consumer protection laws by federal regulations. 
Preemption must be narrowly targeted and balance the interest of 
commerce and consumers.
---------------------------------------------------------------------------
     \1\ Source: National Conference of State Legislatures.
---------------------------------------------------------------------------
    In addition to the extensive regulatory and legislative efforts, 
state attorneys general and state regulators have cooperatively pursued 
unfair and deceptive practices in the mortgage market. Through several 
settlements, state regulators have returned nearly one billion dollars 
to consumers. A settlement with Household resulted in $484 million paid 
in restitution, a settlement with Ameriquest resulted in $295 million 
paid in restitution, and a settlement with First Alliance Mortgage 
resulted in $60 million paid in restitution. These landmark settlements 
further contributed to changes in industry lending practices.
    But successes are sometimes better measured by actions that never 
receive media attention. States regularly exercise their authority to 
investigate or examine mortgage companies for compliance not only with 
state law, but with federal law as well. These examinations are an 
integral part of a balanced regulatory system. Unheralded in their 
everyday routine, enforcement efforts and examinations identify 
weaknesses that, if undetected, might be devastating to the company and 
its customers. State examinations act as a check on financial problems, 
evasion of consumer protections and sales practices gone astray. 
Examinations can also serve as an early warning system of a financial 
institution conducting misleading, predatory or fraudulent practices. 
Attached as Exhibit C is a chart of enforcement actions taken by state 
regulatory agencies against mortgage providers. In 2007, states took 
nearly 6,000 enforcement actions against mortgage lenders and brokers.
    These actions could have resulted in a dialog between state and 
federal authorities about the extent of the problems in the mortgage 
market and the best way to address the problem. That did not happen. 
The committee should consider how the world would look today if the 
ratings agencies and the OCC had not intervened and the assignee 
liability and predatory lending provisions of the Georgia Fair Lending 
Act had been applicable to all financial institutions. I would suggest 
we would have far fewer foreclosures and may have avoided the need to 
bailout our largest financial institutions. It is worth noting that the 
institutions whose names were attached to the OCC's mortgage preemption 
initiative--National City, First Franklin, and Wachovia--were all 
brought down by the mortgage crisis. That fact alone should indicate 
how out of balance the system has become.
    From the state perspective, it has not been clear for many years 
exactly who was setting the risk boundaries for the market. What is 
clear is that the nation's largest and most influential financial 
institutions have been major contributing factors in our regulatory 
system's failure to respond to this crisis. At the state level, we 
sometimes perceived an environment at the federal level that is skewed 
toward facilitating the business models and viability of our largest 
financial institutions rather than promoting the strength of the 
consumer or our diverse economy.
    It was the states that attempted to check the unhealthy evolution 
of the mortgage market and apply needed consumer protections to 
subprime lending. Regulatory reform must foster a system that 
incorporates the early warning signs that state laws and regulations 
provide, rather than thwarting or banning them.
    Certainly, significant weaknesses exist in our current regulatory 
structure. As GAO has noted, incentives need to be better aligned to 
promote accountability, a fair and competitive market, and consumer 
protection.
Needed Regulatory Reforms: Mortgage Origination
    I would like to thank this committee for including the Secure and 
Fair Enforcement for Mortgage Licensing Act (S.A.F.E.) in the Housing 
and Economic Recovery Act of 2008 (HERA). It has given us important 
tools that continue our efforts to reform mortgage regulation.
    CSBS and the states are working to enhance the regulatory regime 
for the residential mortgage industry to ensure legitimate lending 
practices, provide adequate consumer protection, and to once again 
instill both consumer and investor confidence in the housing market and 
the economy as a whole. The various state initiatives are detailed in 
Exhibit D.
Needed Regulatory Reforms: Financial Services Industry
    Many of the problems we are experiencing are both the result of 
``bad actors'' and bad assumptions by the architects of our modern 
mortgage finance system. Enhanced supervision and improved industry 
practices can successfully weed out the bad actors and address the bad 
assumptions. If regulators and the industry do not address both causes 
of our current crisis, we will have only the veneer of reform and will 
eventually repeat our mistakes. Some lessons learned from this crisis 
must be to prevent the following: the over-leveraging that was allowed 
to occur in the nation's largest institutions; outsourcing of loan 
origination with no controls in place; and industry consolidation to 
allow institutions to become so large and complex that they become 
systemically vital and too big to effectively supervise or fail.
    While much is being done to enhance supervision of the mortgage 
market, more progress must be made towards the development of a 
coordinated and cooperative system of state-federal supervision.
Preserve and Enhance Checks and Balances/Forge a New Era of Federalism
    The state system of chartering and regulating has always been a key 
check on the concentration of financial power, as well as a mechanism 
to ensure that our banking system remains responsive to local 
economies' needs and accountable to the public. The state system has 
fostered a diversity of institutions that has been a source of 
stability and strength for our country, particularly locally owned and 
controlled community banks. To promote a strong and diverse system of 
banking-one that can survive the inevitable economic cycles and absorb 
failures-preservation of state-chartered banking should be a high 
priority for Congress. The United States boasts one of the most 
powerful and dynamic economies in the world because of those checks and 
balances, not despite them.
    Consolidation of the industry and supervision and preemption of 
applicable state law does not address the cause of this crisis, and has 
in fact exacerbated the problem.
    The flurry of state predatory lending laws and new state regulatory 
structures for lenders and mortgage brokers were indicators that 
conditions and practices were deteriorating in our mortgage lending 
industry. It would be incongruous to eliminate the early warning signs 
that the states provide. Just as checks and balances are a vital part 
of our democratic government, they serve an equally important role in 
our financial regulatory structure. Put simply, states have a lower 
threshold for crisis and will most likely act sooner. This is an 
essential systemic protection.
    Most importantly, it serves the consumer interest that the states 
continue to have a role in financial regulation. While CSBS recognizes 
the financial services market is a nationwide industry that has 
international implications, local economies and individual consumers 
are most drastically affected by mortgage market fluctuations. State 
regulators must remain active participants in mortgage supervision 
because of our knowledge of local economies and our ability to react 
quickly and decisively to protect consumers.
    Therefore, CSBS urges Congress to implement a recommendation made 
by the Congressional Oversight Panel in their ``Special Report on 
Regulatory Reform'' to eliminate federal preemption of the application 
of state consumer protection laws to national banks. In its report, the 
Panel recommends Congress ``amend the National Banking Act to provide 
clearly that state consumer protection laws can apply to national banks 
and to reverse the holding that the usury laws of a national bank's 
state of incorporation govern that bank's operation through the 
nation.'' \2\ We believe the same policy should apply to the Office of 
Thrift Supervision. To preserve a responsive system, states must be 
able to continue to produce innovative solutions and regulations to 
provide consumer protection.
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     \2\ The Congressional Oversight Panel's ``Special Report on 
Regulatory Reform'' can be viewed at http://cop.senate.gov/documents/
cop-012909-report-regulatoryreform.pdf
---------------------------------------------------------------------------
    The federal government would better serve our economy and our 
consumers by advancing a new era of cooperative federalism. The 
S.A.F.E. Act enacted by Congress requiring licensure and registration 
of mortgage loan originators through the Nationwide Mortgage Licensing 
System provides a model for achieving systemic goals of high regulatory 
standards and a nationwide regulatory roadmap and network, while 
preserving state authority for innovation and enforcement. The Act sets 
expectations for greater state-to-state and state-to-federal regulatory 
coordination.
    Congress should complete this process by enacting a federal 
predatory lending standard. A federal standard should allow for further 
state refinements in lending standards and be enforceable by state and 
federal regulators. Additionally, a federal lending standard should 
clarify expectations of the obligations of securitizers.
Consumer Protection/Enforcement
    Consolidated regulation minimizes resources dedicated to 
supervision and enforcement. As FDIC Chairman Sheila Bair recently told 
the states' Attorneys General, ``if ever there were a time for the 
states and the feds to work together, that time is right here, right 
now. The last thing we need is to preempt each other.'' Congress should 
establish a mechanism among the financial regulators for identifying 
and responding to emerging consumer issues. This mechanism, perhaps 
through the Federal Financial Institutions Examination Council (FFIEC), 
should include active state regulator and law enforcement participation 
and develop coordinated responses. The coordinating federal entity 
should report to Congress regularly. The states must retain the right 
to pursue independent enforcement actions against all financial 
institutions as an appropriate check on the system.
Systemic Supervision/Capital Requirements
    As Congress evaluates our regulatory structure, I urge you to 
examine the linkages between the capital markets, the traditional 
banking sector, and other financial services providers. Our top 
priority for reform must be a better understanding of systemic risks. 
The federal government must facilitate the transparency of financial 
markets to create a financial system in which stakeholders can 
understand and manage their risks. Congress should establish clear 
expectations about which regulatory authority or authorities are 
responsible for assessing risk. The regulator must have the necessary 
tools to identify and mitigate risk, and resolve failures.
    Congress, the administration, and federal regulators must also 
consider how the federal government itself may inadvertently contribute 
to systemic risk--either by promoting greater industry consolidation or 
through policies that increase risk to the system. Perhaps we should 
contemplate that there are some institutions whose size and complexity 
make their risks too large to effectively manage or regulate. Congress 
should aggressively address the sources of systemic risk to our 
financial system.
    While this crisis has demanded a dramatic response from the federal 
government, the short-term result of many of these programs, including 
the Troubled Asset Relief Program (TARP), has been to create even 
larger and more complex institutions and greater systemic risk. These 
responses have created extreme disparity in the treatment of financial 
institutions, with the government protecting those deemed to be too big 
or too complex to fail, perhaps at the expense of smaller institutions 
and the diversity of our financial system.
    At the federal level, our state-chartered banks may be too-small-
to-care but in our cities and communities, they are too important to 
ignore. It is exactly the same dynamic that told us that the plight of 
the individual homeowner trapped in a predatory loan was less important 
than the needs of an equity market hungry for new mortgage-backed 
securities.
    There is an unchallenged assumption that federal regulatory reforms 
can address the systemic risk posed by our largest and most complex 
institutions. If these institutions are too large or complex to fail, 
the government must give preferential treatment to prevent these 
failures, and that preferential treatment distorts and harms the 
marketplace, with potentially disastrous consequences.
    Our experience with Fannie Mae and Freddie Mac exemplifies this 
problem. Large systemic institutions such as Fannie and Freddie 
inevitably garner advantages and political favor, and the lines between 
government and industry blur in ways that do not reflect American 
values of fair competition and merit-based success.
    My fellow state supervisors and I have long believed capital and 
leverage ratios are essential tools for managing risk. For example, 
during the debate surrounding the advanced approach under Basel II, 
CSBS supported FDIC Chairman Sheila Bair in her call to institute a 
leverage ratio for participating institutions. Federal regulation needs 
to prevent capital arbitrage among institutions that pose systemic 
risks, and should require systemic risk institutions to hold more 
capital to offset the grave risks their collapse would pose to our 
financial system.
    Perhaps most importantly, Congress must strive to prevent 
unintended consequences from doing irreparable harm to the community 
and regional banking system in the United States. Federal policy to 
prevent the collapse of those institutions considered too big to fail 
should ultimately strengthen our system, not exacerbate the weaknesses 
of the system. Throughout the current recession, community and regional 
banks have largely remained healthy and continued to provide much 
needed credit in the communities where they operate. The largest banks 
have received amazing sums of capital to remain solvent, while the 
community and regional banks have continued to lend in this difficult 
environment with the added challenge of having to compete with 
federally subsidized entities.
    Congress should consider creating a bifurcated system of 
supervision that is tailored to the size, scope, and complexity of 
financial institutions. The largest, most systemically significant 
institutions should be subject to much more stringent oversight that is 
comprehensive enough to account for the complexity of the institution. 
Community and regional banks should be subject to regulations that are 
tailored to the size and sophistication of the institutions. In 
financial supervision, one size should no longer fit all.
Roadmap for Unwinding Federal Liquidity Assistance and Systemic 
        Responses
    The Treasury Department and the Federal Reserve should be required 
to provide a plan for how to unwind the various programs established to 
provide liquidity and prevent systemic failure. Unfortunately, the 
attempts to avert crisis through liquidity programs have focused 
predominantly upon the needs of the nation's largest institutions, 
without consideration for the unintended consequences for our diverse 
financial industry as a whole, particularly community and regional 
banks. Put simply, the government is now in the business of picking 
winners and losers. In the extreme, these decisions determine survival, 
but they also affect the overall competitive landscape and relative 
health and profitability of institutions. The federal government should 
develop a plan that promotes fair and equal competition, rather than 
sacrificing the diversity of our financial industry to save those 
deemed too big to fail.
Conclusion
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
the task before us is a daunting one. The current crisis is the result 
of well over a decade's worth of policies that promoted consolidation, 
uniformity, preemption and the needs of the global marketplace over 
those of the individual consumer.
    If we have learned nothing else from this experience, we have 
learned that big organizations have big problems. As you consider your 
responses to this crisis, I ask that you consider reforms that promote 
diversity and create new incentives for the smaller, less troubled 
elements of our financial system, rather than rewarding the largest and 
most reckless.
    At the state level, we are constantly pursuing methods of 
supervision and regulation that promote safety and soundness while 
making the broadest possible range of financial services available to 
all members of our communities. We appreciate your work toward this 
common goal, and thank you for inviting us to share our views today.



                             APPENDIX ITEMS

Exhibit D: State Initiatives To Enhance Supervision of the Mortgage
        Industry
CSBS-AARMR Nationwide Mortgage Licensing System
    The states first recognized the need for a tool to license mortgage 
originators several years ago. Since then, states have dedicated 
tremendous monetary and staff resources to develop and enact the 
Nationwide Mortgage Licensing System (NMLS). First proposed among state 
regulators in late 2003, NMLS launched on time and on budget on January 
2, 2008. The Nationwide Mortgage Licensing System is more than a 
database. It serves as the foundation of modern mortgage supervision by 
providing dramatically improved transparency for regulators, the 
industry, investors, and consumers. Seven inaugural participating 
states began using the system on January 2, 2008. Only 15 months later, 
23 states are using NMLS and by January 2010--just 2 years after its 
launch--CSBS expects 40 states to be using NMLS.
    NMLS currently maintains a single record for every state-licensed 
mortgage company, branch, and individual that is shared by all 
participating states. This single record allows companies and 
individuals to be definitively tracked across state lines and over time 
as entities migrate among companies, industries, and federal and state 
jurisdictions. Additionally, this year consumers and industry will be 
able to check on the license status and history of the companies and 
individuals with which they wish to do business.
    NMLS provides profound benefits to consumers, state supervisory 
agencies, and the mortgage industry. Each state regulatory agency 
retains its authority to license and supervise, but NMLS shares 
information across state lines in real-time, eliminates any duplication 
and inconsistencies, and provides more robust information to state 
regulatory agencies. Consumers will have access to a central repository 
of licensing and publicly adjudicated enforcement actions. Honest 
mortgage lenders and brokers will benefit from the removal of 
fraudulent and incompetent operators, and from having one central point 
of contact for submitting and updating license applications.
    The hard work and dedication of the states was ultimately 
recognized by Congress as they enacted the Housing and Economic 
Recovery Act of 2008 (HERA). The bill acknowledged and built upon the 
work that had been done in the states to protect consumers and restore 
the public trust in our mortgage finance and lending industries.
    Title V of HERA, titled the Secure and Fair Enforcement for 
Mortgage Licensing Act of 2008 (S.A.F.E. Act), is designed to increase 
uniformity, reduce regulatory burden, enhance consumer protection, and 
reduce fraud by requiring all mortgage loan originators to be licensed 
or registered through NMLS.
    In addition to loan originator licensing and mandatory use of NMLS, 
the S.A.F.E. Act requires the states to do the following:

  1.  Eliminate exemptions from mortgage loan originator licensing that 
        currently exist in state law;

  2.  Screen and deny mortgage loan originator licenses for felonies of 
        any kind within 7 years and certain financially related 
        felonies permanently;

  3.  Screen and deny licenses to individuals who have ever had a loan 
        originator license revoked;

  4.  Require loan originators to submit personal history information 
        and authorize background checks to determine the applicant's 
        financial responsibility, character, and general fitness;

  5.  Require mortgage loan originators to take 20 hours of pre-
        licensure education in order to enter the state system of 
        licensure;

  6.  Require mortgage loan originators to pass a national mortgage 
        loan originator test developed by NMLS;

  7.  Establish either a bonding or net worth requirement for companies 
        employing mortgage loan originators or a recovery fund paid 
        into by mortgage loan originators or their employing company in 
        order to protect consumers;

  8.  Require companies licensed or registered through NMLS to submit a 
        Mortgage Call Report on at least an annual basis;

  9.  Adopt specific confidentiality and information sharing 
        provisions; and

  10.  Establish effective authority to investigate, examine, and 
        conduct enforcement of licensees.

    Taken together, these background checks, testing, and education 
requirements will promote a higher level of professionalism and 
encourage best practices and responsible behavior among all mortgage 
loan originators. Under the legislative guidance provided by Congress, 
the states drafted the Model State Law for uniform implementation of 
the S.A.F.E. Act. The Model State Law not only achieves the minimum 
licensing requirements under the federal law, but also accomplishes 
Congress' ten objectives addressing uniformity and consumer protection.
    The Model State Law, as implementing legislation at the state 
level, assures Congress that a framework of localized regulatory 
controls are in place at least as stringent as those pre-dating the 
S.A.F.E. Act, while setting new uniform standards aimed at responsible 
behavior, compliance verification and protecting consumers. The Model 
State Law enhances the S.A.F.E. Act by providing significant 
examination and enforcement authorities and establishing prohibitions 
on specific types of harmful behavior and practices.
    The Model State Law has been formally approved by the Secretary of 
the U.S. Department of Housing and Urban Development and endorsed by 
the National Conference of State Legislatures and the National 
Conference of Insurance Legislators. The Model State Law is well on its 
way to approval in almost all state legislatures, despite some 
unfortunate efforts by industry associations to frustrate, weaken or 
delay the passage of this important Congressional mandate.
Nationwide Cooperative Protocol and Agreement for Mortgage Supervision
    In December 2007, CSBS and AARMR launched the Nationwide 
Cooperative Protocol and Agreement for Mortgage Supervision to assist 
state mortgage regulators by outlining a basic framework for the 
coordination and supervision of Multi-State Mortgage Entities (those 
institutions conducing business in two or more states). The goals of 
this initiative are to protect consumers; ensure the safety and 
soundness of institutions; identify and prevent mortgage fraud; 
supervise in a seamless, flexible, and risk-focused manner; minimize 
regulatory burden and expense; and foster consistency, coordination, 
and communication among state regulators. Currently, 48 states plus the 
District of Columbia and Puerto Rico have signed the Protocol and 
Agreement.
    The states have established risk profiling procedures to determine 
which institutions are in the greatest need of a multi-state presence 
and we are scheduled to begin the first multi-state examinations next 
month. Perhaps the most exciting feature of this initiative is the 
planned use of robust software programs to screen the institutions 
portfolios for risk, compliance, and consumer protection issues. With 
this software, the examination team will be able to review 100 percent 
of the institution's loan portfolio, thereby replacing the ``random 
sample'' approach that left questions about just what may have been 
missed during traditional examinations.
CSBS-AARMR Reverse Mortgage Initiatives
    In early 2007, the states identified reverse mortgage lending as 
one of the emerging threats facing consumers, financial institutions, 
and supervisory oversight. In response, the states, through CSBS and 
AARMR, formed the Reverse Mortgage Regulatory Council and began work on 
several initiatives:

    Reverse Mortgage Examination Guidelines (RMEGs). In 
        December 2008, CSBS and AARMR released the RMEGs to establish 
        uniform standards for regulators in the examination of 
        institutions originating and funding reverse mortgage loans. 
        The states also encourage industry participants to adopt these 
        standards as part of an institution's ongoing internal review 
        process.

    Education materials. The Reverse Mortgage Regulatory 
        Council is also developing outreach and education materials to 
        assist consumers in understanding these complex products before 
        the loan is made.
CSBS-AARMR Guidance on Nontraditional Mortgage Product Risks
    In October 2006, the federal financial agencies issued the 
Interagency Guidance on Nontraditional Mortgage Product Risks which 
applies to insured depository institutions. Recognizing that the 
interagency guidance does not apply to those mortgage providers not 
affiliated with a bank holding company or an insured financial 
institution, CSBS and AARMR developed parallel guidance in November 
2006 to apply to state-supervised residential mortgage brokers and 
lenders, thereby ensuring all residential mortgage originators were 
subject to the guidance.
CSBS-AARMR-NACCA Statement on Subprime Mortgage Lending
    The federal financial agencies also issued the Interagency 
Statement on Subprime Mortgage Lending. Like the Interagency Guidance 
on Nontraditional Mortgage Product Risks, the Subprime Statement 
applies only to mortgage providers associated with an insured 
depository institution. Therefore, CSBS, AARMR, and the National 
Association of Consumer Credit Administrators (NACCA) again developed a 
parallel statement that is applicable to all mortgage providers. The 
Nontraditional Mortgage Guidance and the Subprime Statement strike a 
fair balance between encouraging growth and free market innovation and 
draconian restrictions that will protect consumers and foster fair 
transactions.
AARMR-CSBS Model Examination Guidelines
    Further, to promote consistency, CSBS and AARMR developed state 
Model Examination Guidelines (MEGs) for field implementation of the 
Guidance on Nontraditional Mortgage Product Risks and the Statement on 
Subprime Mortgage Lending.
    Released on July 31, 2007, the MEGs enhance consumer protection by 
providing state regulators with a uniform set of examination tools for 
conducting examinations of subprime lenders and mortgage brokers. Also, 
the MEGs were designed to provide consistent and uniform guidelines for 
use by lender and broker compliance and audit departments to enable 
market participants to conduct their own review of their subprime 
lending practices. These enhanced regulatory guidelines represent a new 
and evolving approach to mortgage supervision.
Mortgage Examinations With Federal Regulatory Agencies
    Late in 2007, CSBS, the Federal Reserve System (Fed), the Federal 
Trade Commission (FTC), and the Office of Thrift Supervision (OTS) 
engaged in a pilot program to examine the mortgage industry. Under this 
program, state examiners worked with examiners from the Fed and OTS to 
examine mortgage businesses over which both state and federal agencies 
had regulatory jurisdiction. The FTC also participated in its capacity 
as a law enforcement agency. In addition, the states separately 
examined a mortgage business over which only the states had 
jurisdiction. This pilot is truly the model for coordinated state-
federal supervision.
                                 ______
                                 

                 PREPARED STATEMENT OF GEORGE REYNOLDS
                               Chairman,
      National Association of State Credit Union Supervisors, and
                      Senior Deputy Commissioner,
               Georgia Department of Banking and Finance
                             March 19, 2009
NASCUS History and Purpose
    Good morning, Chairman Dodd, and distinguished Members of the 
Senate Committee on Banking, Housing, and Urban Affairs. I am George 
Reynolds, Senior Deputy Commissioner of Georgia Department of Banking 
and Finance and chairman of the National Association of State Credit 
Union Supervisors (NASCUS). \1\ I appear today on behalf of NASCUS, the 
professional association of state credit union regulators.
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     \1\ NASCUS is the professional association of the 47 state credit 
union regulatory agencies that charter and supervise the nation's 3,300 
state-chartered credit unions.
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    The mission of NASCUS is to enhance state credit union supervision 
and advocate for a safe and sound state credit union system. We achieve 
our mission by serving as an advocate for the dual chartering system, a 
system that recognizes the traditional and essential role of state 
governments in the national system of depository financial 
institutions.
    Thank you for holding this important hearing today to explore 
modernizing financial institution supervision and regulation. The 
regulatory structure in this country has been a topic of discussion for 
many years. The debate began when our country's founders held healthy 
dialogue about how to protect the power of the states. More recently, 
commissions have been created to study the issue and several 
administrations have devoted further time to examine the financial 
regulatory system. Most would agree that if the regulatory system were 
created by design, the current system may not have been deliberately 
engineered; however, one cannot overlook the benefits offered by the 
current system. It has provided innovation, competition and diversity 
to our nation's financial institutions and consumers.
    In light of our country's economic distress, many suggest that 
regulatory reform efforts should focus, in part, on improving the 
structure of the regulatory framework. However, I suggest that it is 
not the structure of our regulatory system that has failed our country, 
but rather the functionality and accountability within the regulatory 
system.
    A financial regulatory system, regardless of its structure, must 
delineate clear lines of responsibility and provide the necessary 
authority to take action. Accountability and transparency must also be 
inherent in our financial system. This system must meet these 
requirements while remaining sufficiently competitive and responsive to 
the evolving financial service needs of American consumers and our 
economy. Credit union members and the American taxpayer are demanding 
each of these qualities be present in the nation's business operations 
and they must be present in a modernized financial regulatory system.
    These regulatory principles must exist in a revised regulatory 
system. This is accomplished by an active system of federalism, a 
system in which the power to govern is shared between national and 
state governments allowing for clear communication and coordination 
between state and federal regulators. Further, this system provides 
checks and balances and the necessary accountability for a strong 
regulatory system. I detail more about this system in my comments.
NASCUS Priorities for Regulatory Restructuring
    NASCUS' priorities for regulatory restructuring focus on reforms 
that strengthen the state system of credit union supervision and 
enhance the capabilities of state-chartered credit unions. The ultimate 
goal is to meet the financial needs of consumer members while assuring 
that the state system is operating in a safe and sound manner. This 
provides consumer confidence and contributes to a sound national and 
global financial system.
    In this testimony, I discuss the following philosophies that we 
believe Congress must address in developing a revised financial 
regulatory system. These philosophies are vital to the future growth 
and safety and soundness of state-chartered credit unions.

    Preserve Charter Choice and Dual Chartering

    Preserve States' Role in Financial Regulation

    Modernize the Capital System for Credit Unions

    Maintain Strong Consumer Protections, which often Originate 
        at the State Level

    My comments today will focus solely on the credit union regulatory 
system; I will highlight successful aspects and areas Congress should 
carefully consider for refinement.
Preserving Charter Choice and Dual Chartering
    The goal of prudential regulation is to ensure safety and soundness 
of depositors' funds, creating both consumer confidence and stability 
within the financial regulatory system.
    Today's regulatory system is structured so that states and the 
federal government act independently to charter and supervise financial 
institutions. The dual chartering system for financial institutions has 
successfully functioned for more than 140 years, since the National 
Bank Act was passed in 1863, allowing the option of chartering banks 
nationally. It is important that Congress continue to recognize the 
distinct roles played by state and federal regulatory agencies.
    Dual chartering remains viable in the financial marketplace because 
of the distinct benefits provided by charter choice and due to the 
interaction between state and federal regulatory agencies. This 
structure works effectively and creates the confidence and stability 
needed for the national credit union system.
Importance of Dual Chartering
    The first credit union in the United States was chartered in New 
Hampshire in 1909. State chartering remained the sole means for 
establishing credit unions for the next 25 years, until Congress passed 
the Federal Credit Union Act (FCUA) in 1934.
    Dual chartering allows an institution to select its primary 
regulator. For credit unions, it is either the state agency that 
regulates state-chartered credit unions in a particular state or the 
National Credit Union Administration (NCUA) that regulates federal 
credit unions. Forty-seven states have laws that permit state-chartered 
credit unions, as does the U.S. territory of Puerto Rico.
    Any modernized regulatory restructuring must recognize charter 
choice. The fact that laws differ for governing state and federal 
credit unions is positive for credit unions and consumers. A key 
feature of the dual chartering system is that individual institutions 
can select the charter that will benefit their members or consumers the 
most. Credit union boards of directors and CEOs have the ability to 
examine the advantages of each charter and determine which charter 
matches the goals of the institution and its members.
    Congress intended state and federal credit union regulators to work 
closely together, as delineated in the FCUA. Section 201 of the FCUA 
states, `` . . . examinations conducted by State regulatory agencies 
shall be utilized by the Board for such purposes to the maximum extent 
feasible.'' \2\ NCUA accepts examinations conducted by state regulatory 
agencies, demonstrating the symbiotic relationship between state and 
federal regulators.
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     \2\ 12 U.S. Code 1781(b)(1).
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    Congress must continue to recognize and to affirm the distinct 
roles played by state and federal regulatory agencies. The U.S. 
regulatory structure must enable state credit union regulators to 
retain regulatory authority over state-chartered credit unions. This 
system is tried and it has worked for the state credit union system for 
100 years. It has been successful because dual chartering for credit 
unions provides a system of ``consultation and cooperation'' between 
state and federal regulators. \3\ This system creates the appropriate 
balance of power between state and federal credit union regulators.
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     \3\ The Consultation and Cooperation With State Credit Union 
Supervisors provision contained in The Federal Credit Union Act, 12 
U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).
---------------------------------------------------------------------------
    A recent example of state and federal credit union examiners 
working together and sharing information is the bimonthly 
teleconferences held since October of 2008 to discuss liquidity in the 
credit union system. Further, state regulators and the NCUA meet in-
person several times a year to discuss national policy issues. The 
intent of Congress was that these regulators share information and work 
together and in practice, we do work together.
    Another exclusive aspect of the credit union system is that both 
state and federal credit unions have access to the National Credit 
Union Share Insurance Fund (NCUSIF). Federally insured credit unions 
capitalize this fund by depositing one percent of their shares into the 
fund. This concept is unique to credit unions and it minimizes taxpayer 
exposure. Any modernized regulatory system should recognize the NCUSIF. 
The deposit insurance system has been funded by the credit union 
industry and has worked well for credit unions. We believe that credit 
unions should have access to this separate and distinct deposit 
insurance fund. A separate federal regulator for credit unions has also 
worked well and effectively since the FCUA was passed in 1934. NASCUS 
and others are concerned about any proposal to consolidate regulators 
and state and federal credit union charters.
    Charter choice also creates healthy competition and provides an 
incentive for regulators (both state and federal) to maximize 
efficiency in their examinations and reduce costs. It allows regulators 
to take innovative approaches to regulation while maintaining high 
standards for safety and soundness.
    The dual chartering system is threatened by the preemption of state 
laws and the push for a more uniform regulatory system. As new 
challenges arise, it is critical that the benefits of each charter are 
recognized. As Congress discusses regulatory modernization, it is 
important that new policies do not squelch the innovation and enhanced 
regulatory structure provided by the dual chartering system. As I 
stated previously, dual chartering benefits consumers, provides 
enhanced regulation and allows for innovation in our nation's credit 
unions.
    Ideally, the best of each charter should be recognized and enhanced 
to allow competition in the marketplace. NASCUS believes dual 
chartering is an essential component to the balance of power and 
authority in the regulatory structure. The strength and health of the 
credit union system, both state and federal, rely on the preservation 
of the principles of the dual chartering system.
Strengths of the State System
    State-chartered credit unions make many contributions to the 
economic vitality of consumers in individual states. Our current 
regulatory system benefits citizens and provides consumer confidence.
    To begin, one of the strengths of the state system is that states 
operate as the ``laboratories'' of financial innovation. Many consumer 
protection programs were designed by state legislators and state 
regulators to recognize choice and innovation. The successes of state 
programs have been recognized at the federal level, when like programs 
are introduced to benefit consumers at the federal level. It is crucial 
that state legislatures maintain the primary authority to enact 
consumer protection statutes for residents in their states and to 
promulgate and enforce state consumer protection regulations, without 
the threat of federal preemption.
    We caution Congress about putting too much power in the hands of 
the federal regulatory structure. Dual chartering allows power to be 
distributed throughout the system and it provides a system of checks 
and balances between state and federal authorities. A system where the 
primary regulatory authority is given to the federal government may not 
provide what is in the best interest of consumers.
Preserve States' Role in Financial Regulation
    The dual chartering system is predicated on the rights of states to 
authorize varying powers for their credit unions. NASCUS supports state 
authority to empower credit unions to engage in activities under state-
specific rules, deemed beneficial in a particular state. States should 
continue to have the authority to create and to maintain appropriate 
credit union powers in any new regulatory reform structure debated by 
Congress.
    However, we are cognizant that our state systems are continuously 
challenged by modernization, globalization and new technologies. We 
believe that any regulatory structure considered by Congress should not 
limit state regulatory authority and innovation. Preemption of state 
laws and the push for more uniform regulatory systems will negatively 
impact our nation's financial services industry, and ultimately 
consumers.
    Congress should ensure that states have the authority to supervise 
state credit unions and that supervision is tailored to the size, scope 
and complexity of the credit union and the risk they may pose to their 
members. Further, Congress should reaffirm state legislatures' role as 
the primary authority to enact consumer protection statutes in their 
states.
    Added consumer protections at the state level can better serve and 
better protect the consumer and provide greater influence on public 
policy than they can at the federal level. This has proved true with 
data security and mortgage lending laws, to name a few. It is crucial 
that states maintain authority to pursue enforcement actions for state-
chartered credit unions. Congress' regulatory restructuring efforts 
should expand the states' high standards of consumer protection.
    Recently, Chairman Barney Frank (D, Mass.) of the House Financial 
Services Committee, said, ``States do a better job,'' when referring to 
consumer protection. NASCUS firmly believes this, too.
Comprehensive Capital Reform for Credit Unions
    The third principle I want to highlight is modernizing the capital 
system for credit unions. Congress should recognize capital reform as 
part of regulatory modernization. Capital sustains the viability of 
financial institutions. It is necessary for their survival.
    NASCUS has long supported comprehensive capital reform for credit 
unions. Credit unions need access to supplemental credit union capital 
and risk-based capital requirements; these related but distinctly 
different concepts are not mutually exclusive. The current economic 
environment necessitates that now is the time for capital reform for 
credit unions.
Access to Supplemental Capital
    State credit union regulators are committed to protecting credit 
union safety and soundness. Allowing credit unions access to 
supplemental capital would protect the safety and soundness of the 
credit union system and provide a tool to use if a credit union faces 
declining net worth or liquidity needs.
    A simple fix to the FCUA would authorize state and federal 
regulators the discretion, when appropriate, to allow credit unions to 
use supplemental capital.
    NASCUS follows several guiding principles in our quest for 
supplemental capital for credit unions. First, a capital instrument 
must preserve the not-for-profit, mutual, member-owned and cooperative 
structure of credit unions. Next, it must preserve credit unions' tax-
exempt status. \4\ Finally, regulatory approval would be required 
before a credit union could access supplemental capital. We realize 
that supplemental capital will not be allowed for every credit union, 
nor would every credit union need access to supplemental capital.
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     \4\ State-chartered credit unions are exempt from federal income 
taxes under Section 501(c)(14) of the Internal Revenue Code, which 
requires that (a) credit union cannot access capital stock; (b) they 
are organized/operated for mutual purposes; and without profit. The 
NASCUS white paper, ``Alternative Capital for Credit Unions . . . Why 
Not?'' addresses Section 501(c)(14).
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    Access to supplemental capital will enhance the safety and 
soundness of credit unions and provide further stability in this 
unpredictable market. Further, supplemental capital will provide an 
additional layer of protection to the NCUSIF thereby maintaining credit 
unions' independence from the federal government and taxpayers.
    Allowing credit unions access to supplemental capital with 
regulatory approval and oversight will enhance their ability to react 
to market conditions, grow safely into the future, serve their nearly 
87 million members and provide further stability for the credit union 
system. We feel strongly that now is the time to permit this important 
change. Unlike other financial institutions, credit union access to 
capital is limited to reserves and retained earnings from net income. 
Since net income is not easily increased in a fast-changing 
environment, state regulators recommend additional capital-raising 
capabilities for credit unions. Access to supplemental capital will 
enable credit unions to respond proactively to changing market 
conditions, enhancing their future viability and strengthening their 
safety and soundness.
    Supplemental capital is not new to the credit union system; several 
models are already in use. Low-income credit unions are authorized to 
raise uninsured secondary capital. Corporate credit unions have access, 
too; they have both membership capital shares and permanent capital 
accounts, known as paid-in capital. These models work and could be 
adjusted for natural-person credit unions.
Risk-Based Capital for Credit Unions
    Today, every insured depository institution, with the exception of 
credit unions, uses risk-based capital requirements to build and to 
monitor capital levels. Risk-based capital requirements enable 
financial institutions to better measure capital adequacy and to avoid 
excessive risk on their balance sheets. A risk-based capital system 
acknowledges the diversity and complexity between financial 
institutions. It requires increased capital levels for financial 
institutions that choose to maintain a more complex balance sheet, 
while reducing the burden of capital requirements for institutions 
holding assets with lower levels or risk. This system recognizes that a 
one-size-fits-all capital system does not work.
    The financial community continues to refine risk-based capital 
measures as a logical and an important part of evaluating and 
quantifying capital adequacy. Credit unions are the only insured 
depository institutions not allowed to use risk-based capital measures 
as presented in the Basel Accord of 1988 in determining required levels 
or regulatory capital. A risk-based capital regime would require credit 
unions to more effectively monitor risks in their balance sheets. It 
makes sense that credit unions should have access to risk-based 
capital; it is a practical and necessary step in addressing capital 
reform for credit unions.
Systemic Risk Regulation
    The Committee asked for comment regarding the need for systemic 
risk regulation. Certainly, the evolution of the financial services 
industry and the expansion of risk outside of the more regulated 
depository financial institutions into the secondary market, investment 
banks and hedge funds reflect that further consideration needs to be 
given to having expanded systemic risk supervision. Many suggest that 
the Federal Reserve System due to its structural role in the financial 
services industry might be well suited to be assigned an expanded role 
in this area.
The Role of Proper Risk Management
    During this period of economic disruption, Congress should consider 
regulatory restructuring and also areas where risk management 
procedures might need to be strengthened or revised to enhance 
systemic, concentration and credit risk in the financial services 
industry.
    Congress needs to address the reliance on credit rating agencies 
and credit enhancement features in the securitization of mortgage-
backed securities in the secondary market.
    These features were used to enhance the marketability of securities 
backed by subprime mortgages. Reliance on more comprehensive structural 
analysis of such securities and expanded stress testing would have 
provided more accurate and transparent information to market analysts 
and investors.
    Further, there is a debate occurring about the impact of ``mark-to-
market'' accounting on the financial services industry as the secondary 
market for certain investment products has been adversely impacted by 
market forces. While this area deserves further consideration, we urge 
Congress to approach this issue carefully in order to maintain 
appropriate transparency and loss recognition in the financial services 
industry.
    Finally, consideration needs to be given to compensation practices 
that occurred in the financial services industry, particularly in the 
secondary market for mortgage-backed securities. Georgia requires 
depository financial institutions that are in Denovo status or subject 
to supervisory actions that use bonus features in their management 
compensation structure not to simply pay bonuses based on production or 
sales, but also to include an asset quality component. Such a feature 
will ``claw back'' bonuses if production or sales result in excessive 
volumes of problematic or nonperforming assets. If such a feature were 
used in the compensation structure for the marketing of asset-backed 
securities, perhaps this would have been a deterrent to the excessive 
risk taking that occurred in this industry and resulted in greater 
market discipline.
Conclusion
    Modernizing our financial regulatory system is a continuous 
process, one that will need to be fine-tuned over time. It will take 
careful study and foresight to ensure a safe and sound regulatory 
structure that allows enhanced products and services while ensuring 
consumer protections. NASCUS recognizes this is not an easy process.
    To protect state-chartered credit unions in a modernized regulatory 
system, we encourage Congress to consider the following points:

    Enhancing consumer choice provides a stronger financial 
        regulatory system; therefore charter choice and dual chartering 
        must be preserved.

    Preserve states' role in financial regulation.

    Modernize the capital system for credit unions to protect 
        safety and soundness.

    Maintain strong consumer protections, which often originate 
        at the state level.

    It is important that Congress take the needed time to scrutinize 
proposed financial regulatory systems.
    NASCUS appreciates the opportunity to testify today and share our 
priorities for a modernized credit union regulatory framework. We urge 
this Committee to be watchful of federal preemption and to remember the 
importance of dual chartering and charter choice in regulatory 
modernization. We welcome questions from Committee Members.
    Thank you.
    
    
    
        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                       FROM JOHN C. DUGAN

Q.1. Consumer Protection Regulation--Some have advocated that 
consumer protection and prudential supervision should be 
divorced, and that a separate consumer protection regulation 
regime should be created. They state that one source of the 
financial crisis emanated from the lack of consumer protection 
in the underwriting of loans in the originate-to-distribute 
space.
    What are the merits of maintaining it in the same agency? 
Alternatively, what is the best argument each of you can make 
for a new consumer protection agency?

A.1. Effective protection for consumers of financial products 
and services is a vital part of financial services regulation. 
The attractiveness of the single financial product protection 
agency model is that it would presumably centralize authority 
and functions in this area in a single agency, which could 
write and apply rules that would apply uniformly to all 
financial services providers, whether or not they are 
depository institutions. Because the agency would focus 
exclusively on consumer protection, proponents of the concept 
also argue that such a model eliminates the concerns sometimes 
expressed that prudential supervisors neglect consumer 
protection in favor of safety and soundness supervision. These 
asserted attributes need to be closely evaluated, however. In 
the case of federally regulated depository institutions, the 
benefits could well be outweighed by the costs of diminishing 
the real consumer protections that flow from the Federal 
banking agencies' comprehensive supervision and oversight of 
depository institutions.
    In the OCC's experience, and as the mortgage crisis 
illustrates, safe and sound lending practices are integral to 
consumer protection. Indeed, I believe that the best way to 
implement consumer protection regulation of banks--and the best 
way to protect their customers--is to do so through 
comprehensive prudential supervision.
    Effective consumer protection of financial institutions 
includes three vital components: (1) strong regulatory 
standards; (2) consistent and thorough oversight of compliance 
with these standards; and (3) an effective corrective/
enforcement response when it is determined that those standards 
are not met.
    The appropriate structure for the rulemaking function can 
be debated. With respect to federally supervised banks that are 
subject to regular, ongoing supervision by the Federal banking 
agencies, there are good reasons why these agencies, by virtue 
of their familiarity with the issues these institutions 
present, should have a role in the rulemaking process. They 
bring expertise regarding potentially complex issues, and they 
are in a position to warn against potential unintended 
consequences of rulemaking initiatives under consideration. At 
the very least, if rulemaking for financial product consumer 
protection is vested in any single agency, there should be a 
requirement to consult with the Federal banking agencies with 
respect to the impact of proposed rules on federally regulated 
depository institutions.
    Next is the question of consistent and thorough oversight 
of applicable consumer protection standards. Here, significant 
differences exist in the manner in which federally regulated 
depository institutions are examined and supervised, and the 
oversight schemes applicable to the ``shadow banking system''--
nonbank firms that provide products and services comparable to 
those offered by depository institutions. I think it would be a 
mistake to displace the extensive role of the Federal banking 
agencies in examination and supervision of the operations of 
depository institutions--including their compliance with 
consumer protection standards.
    The Federal banking agencies' regular and continual 
presence in institutions through the process of examination and 
supervision puts them in the best position to ensure compliance 
with applicable consumer protection laws and regulations. 
Examiners are trained to detect weaknesses in institutions' 
policies, systems, and procedures for implementing consumer 
protection mandates, as well as substantive violations of laws 
and regulations. Their regular communication with institutions 
occurs through examinations at least once every 18 months for 
smaller institutions, supplemented by quarterly contacts, and 
for the largest banks, the consumer compliance examination 
function is conducted continuously, by examiners on site at 
large banks every day. The extensive examination and 
supervisory presence creates especially effective incentives 
for achieving consumer protection compliance, and allows 
examiners to detect compliance weaknesses much earlier than 
would otherwise be the case.
    Moreover, in many respects, for purposes of examination and 
supervision by the Federal banking agencies, safety and 
soundness and consumer protection issues are inextricably 
linked. Take, for example, mortgage lending. Safe and sound 
credit underwriting for a mortgage loan requires sound credit 
judgments about a borrower's ability to repay a loan, while the 
same sound underwriting practices help protect a borrower from 
an abusive loan with terms that the borrower does not 
understand and cannot repay. Bank examiners see both 
perspectives and require corrections that respond to both 
aspects of the problem. This system did not fail in the current 
mortgage crisis. It is well recognized the overwhelming source 
of toxic mortgages precipitating the mortgage crisis were 
originated by lenders that were not federally supervised banks.
    To shift the responsibility for examining for and reacting 
to the consumer protection issues to an entirely separate 
agency is less efficient than the integrated approach bank 
examiners apply today. Shifting the examination and supervision 
role to a new and separate agency also would seem to require 
the establishment of a very substantial new workforce, with a 
major budget, to carry out those responsibilities.
    Where substantial enhancement of examination and 
supervision is warranted, however, is for nonbank firms that 
are not subject to federal examination and supervision. Again, 
it is important to remember that these nondepository 
institutions were the predominant source of the toxic subprime 
mortgages that fueled the current mortgage crisis. The 
providers of these mortgages--part of the ``shadow banking 
system''--are not subject to examination and supervision 
comparable to that received by federally supervised depository 
institutions. Rather than displace the extensive consumer 
protection examination and supervisory functions of the federal 
banking agencies, any new financial product protection agency 
should focus on ensuring that the ``shadow banking system'' is 
subject to the same robust consumer protection standards as are 
applicable to depository institutions, and that those standards 
are in fact effectively applied and enforced.
    Finally, in the area of enforcement, the Federal banking 
agencies have strong enforcement powers and exceptional 
leverage over depository institutions to achieve correction 
actions. As already mentioned, depository institutions are 
among the most extensively supervised firms in any type of 
industry, and bankers understand very well the range of 
negative consequences that can ensue from failing to be 
response to their regulator. As a result, when examiners detect 
consumer compliance weaknesses or failures, they have a broad 
range of tools to achieve corrective action, and banks have 
strong incentives to achieve compliance as promptly as 
possible. It is in the interests of consumers that this 
authority not be undermined by the role and responsibilities of 
any new consumer protection agency.

Q.2. Regulatory Gaps or Omissions--During a recent hearing, the 
Committee has heard about massive regulatory gaps in the 
system. These gaps allowed unscrupulous actors like AIG to 
exploit the lack of regulatory oversight. Some of the 
counterparties that AIG did business with were institutions 
under your supervision.
    Why didn't your risk management oversight of the AIG 
counterparties trigger further regulatory scrutiny? Was there 
flawed assumption that AIG was adequately regulated, and 
therefore no further scrutiny was necessary?

A.2. A critical focus of our examination of trading activities 
at our large national banks is to assess how well the bank 
manages its counterparty exposures. We regularly review large 
counterparty exposures at our large national banks; however, 
the counterparty exposure to AIG did not trigger heightened 
regulatory scrutiny by the OCC because it was a AAA-rated 
company, was generally well-respected in the financial services 
industry, and was not a meaningful risk concentration to any of 
the banks under our supervision. Because AIG had such a strong 
credit rating, many counterparties, including national banks, 
did not require AIG to post collateral on its exposures. A key 
lesson learned for bankers and supervisors is the need to 
carefully manage all counterparty exposures, especially those 
that may have sizable unsecured exposures, regardless of the 
counterparty's rating. In particular, regulators need to 
revisit the issue of the extent to which collateral should be 
required in counterparty relationships, merely due to AAA 
ratings.

Q.3. Was there dialogue between the banking regulators and the 
state insurance regulators? What about the SEC?

A.3. We did not have any meaningful dialogue with state 
insurance regulators or the SEC about AIG since we had no 
compelling reason to do so, given the lack of supervisory 
concerns at the time with regard to the exposure to AIG.

Q.4. If the credit default swap contracts at the heart of this 
problem had been traded on an exchange or cleared through a 
clearinghouse, with requirement for collateral and margin 
payments, what additional in formation would have been 
available? How would you have used it?

A.4. Because the transactions between AIG and its 
counterparties were highly customized to specific CDOs, it is 
unlikely that they would have been eligible for trading on an 
exchange or clearing through a clearinghouse. Transactions that 
use exchanges or clearinghouses generally require a fairly high 
degree of standardization. In addition, for a contract to trade 
on an exchange, the exchange/clearinghouse needs to be able to 
determine prices for the underlying reference entities, in this 
case super-senior ABS CDOs, yet, even the most sophisticated 
market participants had great difficulty valuing these 
securities. If the transactions could have been traded on an 
exchange, then AIG would have been forced to post initial and 
variation margin. These margin requirements would likely have 
limited the volume of trades that AIG could have done, or 
forced them to exit the transactions prior to the losses 
becoming so significant that they threatened the firm's 
solvency. In addition, because an exchange or clearinghouse 
provides for more price transparency, if these transactions had 
been cleared through a clearinghouse, market participants may 
have had greater knowledge of the pricing of the underlying CDO 
assets.

Q.5. Over-Reliance on Credit Rating Agencies--While many 
national banks did not engage in substandard underwriting for 
the loans they originated, many of these institutions bought 
and held these assets in the form of triple-A rated mortgage-
backed securities.
    Why was it inappropriate for these institutions to 
originate these loans, but it was acceptable for them to hold 
the securities collateralized by them?

A.5. National banks are allowed to purchase and hold as 
investments various highly rated securities that are supported 
by a variety of asset types. Examples of such asset types 
include mortgages, autos, credit cards, equipment leases, and 
commercial and student loans. National banks are expected to 
conduct sufficient due diligence to understand and control the 
risks associated with such investment securities and the 
collateral that underlies those securities. In recent years, 
many national banks increased their holdings of highly rated 
senior ABS CDO securitization exposures. These senior positions 
were typically supported by subordinated or mezzanine tranches 
and equity or first-loss positions, as well as other forms of 
credit enhancement such as over-collateralization and, in 
certain instances, credit default swaps provided by highly 
rated counterparties. In hindsight, bankers, regulators, and 
the rating agencies put too much reliance on these credit 
enhancements and failed to recognize the leverage and 
underlying credit exposures embedded in these securities, 
especially with respect to a systematic decline in value of the 
underlying loans based on a nationwide decline in house prices. 
Our supervisory approach going forward will emphasize an 
increased need for banks to consider the underwriting on the 
underlying loans in a securitization and understand the 
potential effect of those underlying exposures on the 
performance of the securitized asset.
    In addition, as previously noted, another key lesson 
learned from the recent financial turmoil is the need for firms 
to enhance their ability to identify and aggregate risk 
exposures across business, product lines, and legal entities. 
With regard to subprime mortgage exposures, many national banks 
thought they had avoided subprime risk exposures by 
deliberately choosing to not originate such loans in the bank, 
only to find out after the fact that their investment bank 
affiliates had purchased subprime loans elsewhere to structure 
them into collateralized debt obligations.

Q.6. What changes are you capable of making absent statutory 
changes, and have you made those changes yet?

A.6. As noted above, while we expect bankers to conduct 
sufficient due diligence on their investment holdings, in 
recent years both bankers and regulators became too complacent 
in relying on NSRO ratings and various forms of credit 
enhancements for complex structured products, which often were 
based on various modeled scenarios.
    The market disruptions have made bankers and regulators 
much more aware of the risk within models, including over-
reliance on historical information and inappropriate 
correlation assumptions. Because of our heightened appreciation 
of the limitation of models and the NSRO ratings that were 
produced from those models, we are better incorporating 
quantitative and qualitative factors to adjust for these 
weaknesses. We are also emphasizing the need for bankers to 
place less reliance on models and NSRO ratings and to better 
stress-test internal model results. We also have told banks 
that they need a better understanding of the characteristics of 
the assets underlying these securities.
    Finally, enhancements to the Basel II capital framework 
that were announced by the Basel Committee on Banking 
Supervision in January 2009 will require banks to hold 
additional capital for re-securitizations, such as 
collateralized debt obligations comprised of asset-back 
securities. In addition to the higher capital that banks will 
be required to hold, these enhancements will also require banks 
that use credit ratings in their measurement of required 
regulatory capital for securitization exposures to have:

    A comprehensive understanding on an ongoing basis 
        of the risk characteristics of their individual 
        securitization exposures.

    Access to performance information on the underlying 
        pools on an ongoing basis in a timely manner. For re-
        securitizations, banks should have information not only 
        on the underlying securitization tranches, such as the 
        issuer name and credit quality, but also on the 
        characteristics and performance of the pools underlying 
        the securitization tranches.

    A thorough understanding of all structural features 
        of a securitization transaction that would materially 
        impact the performance of the bank's exposures to the 
        transaction, such as the contractual waterfall and 
        waterfall-related triggers, credit enhancements, 
        liquidity enhancements, market value triggers, and 
        deal-specific definitions of default.

    The comment period for the proposed enhancements has ended, 
and the Basel Committee is expected to adopt the final changes 
before year-end 2009. The U.S. federal banking agencies will 
consider whether to propose adding these or similar standards 
to their Basel II risk-based capital requirements.

Q.7. Liquidity Management--A problem confronting many financial 
institutions currently experiencing distress is the need to 
roll-over short-term sources of funding. Essentially these 
banks are facing a shortage of liquidity. I believe this 
difficulty is inherent in any system that funds long-term 
assets, such as mortgages, with short-term funds. Basically the 
harm from a decline in liquidity is amplified by a bank's level 
of ``maturity-mismatch.''
    I would like to ask each of the witnesses, should 
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to 
do so?

A.7. There are a myriad of a factors that influence a bank's 
liquidity risk profile and that need to be effectively managed. 
Some of these factors include the stability and level of a 
bank's core deposits versus its dependence on more volatile 
wholesale and retail funds; the diversification of the bank's 
overall funding base in terms of instrument types, nature of 
funds providers, repricing, and maturity characteristics; and 
the level of readily available liquid assets that could be 
quickly converted to cash. We do use a number of metrics, such 
as net short-term liabilities to total assets, to identify 
banks that may have significant liquidity risk. However, we 
believe that it has been difficult to distill all of the 
factors that influence a bank's liquidity risk into a single 
regulatory metric that is applicable to all types and sizes of 
financial institutions. As a result, we direct banks to develop 
a robust process for measuring and controlling their liquidity 
risk. A key component of an effective liquidity risk management 
process are cash flow projections that include discrete and 
cumulative cash flow mismatches or gaps over specified future 
time horizons under both expected and adverse business 
conditions. We expect bankers to have effective strategies in 
place to address any material mismatches under both normal and 
adverse operating scenarios.
    The Basel Working Group on Liquidity (WGL) issued revised 
principles last year that emphasized the importance of cash 
flow projections, diversified funding sources, comprehensive 
stress testing, a cushion of liquid assets, and a well-
developed contingency funding plan. Financial institutions are 
in the process of implementing these additional principles into 
their existing risk management practices. The WGL is currently 
reviewing proposals for enhanced supervisory metrics to monitor 
a financial institution's liquidity position and the OCC is 
actively involved in those efforts.

Q.8. What Is Really Off-Balance Sheet--Chairman Bair noted that 
structured investment vehicles (SIVs) played an important role 
in funding credit risk that are at the core of our current 
crisis. While the banks used the SIVs to get assets off their 
balance sheet and avoid capital requirements, they ultimately 
wound up reabsorbing assets from these SIV's.
    Why did the institutions bring these assets back on their 
balance sheet? Was there a discussion between the OCC and those 
with these off-balance sheet assets about forcing the investor 
to take the loss?

A.8. For much of the past two decades, SIVs provided a cost 
effective way for financial companies to use the short-term 
commercial paper and medium term note (MTN) markets to fund 
various types of loans and credit receivables. Beginning in 
August 2007, as investor concerns about subprime mortgage 
exposures spilled over into the general asset-backed commercial 
paper (ABCP) and MTN markets, banks were facing increased 
difficulties in rolling over these funding sources for their 
SIVs. As a result, banks began purchasing their sponsored SIVs' 
ABCP as a short term solution to the market disruption. In some 
instances, banks had pre-approved liquidity facilities 
established for this purpose. Over time, it became apparent 
that market disruptions would continue for an extended period, 
making it impossible for SIVs to roll ABCP or MTNs as they 
matured. In order to avoid possible rating downgrades of senior 
SIV debt and to maintain investor relationships, banks 
supported their sponsored SIV structures by either purchasing 
SIV assets or maturing ABCP. As a result of these purchases, 
many banks were required to consolidate SIV assets under GAAP.
    The OCC had ongoing discussions with banks on this topic, 
and OCC examiners emphasized the need for bank management to 
consider all potential ramifications of their actions, 
including liquidity and capital implications, as well as other 
strategic business objectives.

Q.9. How much of these assets are now being supported by the 
Treasury and the FDIC?

A.9. Treasury's TAW Capital Purchase Program and the FDIC's 
Temporary Liquidity Guaranty Program are providing funds that 
are helping to bolster participating banks' overall capital and 
liquidity levels and thus may be indirectly supporting some of 
these assets that banks may still be holding on their balance 
sheets. However, given the fungible nature of this funding, it 
is not possible to identify specific assets that may be 
supported.

Q.10. Based on this experience, would you recommend a different 
regulatory treatment for similar transactions in the future? 
What about accounting treatment?

A.10. Regulatory capital requirements for securitization 
exposures generally are based on whether the underlying assets 
held by the securitization structure are reported on- or off-
balance sheet of the bank under generally accepted accounting 
principles (GAAP). Most SIVs have been structured to qualify 
for off-balance sheet treatment under GAAP. As such, bank 
capital requirements are based on the bank's actual exposures 
to the structure, which may include, for example, recourse 
obligations, residual interests, liquidity facilities, and 
loans, and which typically are far less than the amount of 
assets held in the structure.
    The Financial Accounting Standards Board (FASB), in part as 
a response to banks' supporting SIV structures beyond their 
contractual obligation to do so, proposed changes to the 
standards that require banks to consolidate special purpose 
vehicles and conduits such as SIVs. Under the proposed new 
standards, which are expected to become effective January 1, 
2010, the criteria for consolidation would require banks to 
conduct a qualitative analysis, based on facts and 
circumstances (power, rights, and obligations), to determine if 
the bank is the primary beneficiary of the structure. One 
factor in determining whether the bank sponsoring a SIV 
structure is the primary beneficiary would be whether the risk 
to the bank's reputation in the marketplace if the structure 
entity does not operate as designed would create an implicit 
financial responsibility for the bank to support the structure. 
The proposed new standards likely would require banks to 
consolidate more SIV structures than they are required to 
consolidate under current GAAP. The U.S. banking agencies are 
evaluating what changes, if any, to propose to our regulatory 
capital rules in response to the proposed FASB changes.
    In addition, in January 2009, the Basel Committee on 
Banking Supervision proposed enhancements to the Basel II 
framework that include increasing the credit conversion factor 
for short-term liquidity facilities from 20 percent to 50 
percent. This change would make the conversion factor for 
short-term liquidity facilities equal to the credit conversion 
factor for long-term liquidity facilities. The U.S. banking 
agencies are evaluating whether to propose a rule change to 
increase the credit conversion factor for short-term liquidity 
facilities to 50 percent for banks operating in the United 
States under both Basel I and Basel II.

Q.11. Regulatory Conflict of Interest--Federal Reserve Banks 
which conduct bank supervision are run by bank presidents that 
are chosen in part by bankers that they regulate.
    Mr. Dugan and Mr. Polakoff does the fact that your 
agencies' funding stream is affected by how many institutions 
you are able to keep under your charters affect your ability to 
conduct supervision?

A.11. No. Receiving funding through assessments on regulated 
entities is the norm in the financial services industry. In the 
case of the OCC and OTS, Congress has determined that 
assessments and fees on national banks and thrifts, 
respectively, will fund supervisory activities, rather than 
appropriations from the United States Treasury. Neither the 
Federal Reserve Board nor the FDIC receives appropriations. 
State banking regulators typically are also funded by 
assessments on the entities they charter and supervise.
    Since enactment of the National Bank Act in 1864, the OCC 
has been funded by various types of fees imposed on national 
banks. Over the more than 145 years that the OCC has regulated 
national banks, in times of prosperity and times of economic 
stress, there has never been any evidence that this funding 
mechanism has caused the OCC to fail to hold national banks 
responsible for unsafe or unsound practices or violations of 
law, including laws that protect consumers.
    Rather, through comprehensive examination processes, the 
OCC's track record is one of proactively addressing both 
consumer protection and safety and soundness issues. Among the 
banking agencies, we have pioneered enforcement approaches, 
including utilization of section 5 of the Federal Trade 
Commission Act, to protect consumers. Indeed, the OCC 
frequently has been criticized for being too ``tough,'' and we 
have seen institutions leave the national banking system to 
seek more favorable regulatory treatment of their operations. 
\1\
---------------------------------------------------------------------------
     \1\ Applebaum, Washington Post, By Switching Their Charters, Banks 
Skirt Supervision, January 22, 2009; A01.
---------------------------------------------------------------------------
    Simply put, the OCC never has compromised robust bank 
supervision, including enforcement of consumer protection laws, 
to attract or retain bank charters.

Q.12. Too-Big-To-Fail--Chairman Bair stated in her written 
testimony that ``the most important challenge is to find ways 
to impose greater market discipline on systemically important 
institutions. The solution must involve, first and foremost, a 
legal mechanism for the orderly resolution of those 
institutions similar to that which exists for FDIC-insured 
bank. In short we need to end too big to fail.''
    I would agree that we need to address the too-big-to-fail 
issue, both for banks and other financial institutions. Could 
each of you tell us whether putting a new resolution regime in 
place would address this issue? How would we be able to 
convince the market that these systemically important 
institutions would not be protected by taxpayer resources as 
they had been in the past?

A.12. As noted in the previous responses to Senator Crapo, 
there is currently no system for the orderly resolution of 
nonbank firms. This needs to be addressed with an explicit 
statutory regime for facilitating the resolution of 
systemically important nonbank companies. This new statutory 
regime should provide tools that are similar to those the FDIC 
currently has for resolving banks, including the ability to 
require certain actions to stabilize a firm; access to a 
significant funding source if needed to facilitate orderly 
dispositions, such as a significant line of credit from the 
Treasury; the ability to wind down a firm if necessary, and the 
flexibility to guarantee liabilities and provide open 
institution assistance if necessary to avoid serious risk to 
the financial system. In addition, there should be clear 
criteria for determining which institutions would be subject to 
this resolution regime, and how to handle the foreign 
operations of such institutions. While such changes would make 
orderly resolutions of systemically important firms more 
feasibly, they would not eliminate the possibility of using 
extraordinary government assistance to protect the financial 
system.

Q.13. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank 
capital regulation. Some commentators have endorsed a concept 
requiring banks to hold more capital when good conditions 
prevail, and then allow banks to temporarily hold less capital 
in order not to restrict access to credit during a downturn. 
Advocates of this system believe that counter cyclical policies 
could reduce imbalances within financial markets and smooth the 
credit cycle itself.
    What do you see as the costs and benefits of adopting a 
more counter-cyclical system of regulation ?

A.13. The question as to how best to address pro-cyclicality 
concerns associated with our present system of accounting and 
capital regulation is an area of significant focus for policy 
makers domestically and internationally. In addressing this 
matter, it is important to distinguish between cyclicality and 
pro-cyclicality. Due to their sensitivity to risk, the current 
accounting and capital regimes are clearly, and intentionally, 
cyclical, broadly reflecting the prevailing trends in the 
economy. The more difficult and unresolved issue is whether 
those regimes are also ``pro-cyclical,'' by amplifying 
otherwise normal business fluctuations.
    As noted, there are ongoing efforts to assess pro-
cyclicality issues with respect to both our current accounting 
and regulatory capital regimes. The most recent public 
statement on this matter is found in the Financial Stability 
Board's April 2, 2009 document ``Report of the Financial 
Stability Forum on Addressing Pro-cyclicality in the Financial 
System'' (FSB Report). \2\ In this report, the FSB makes 
numerous policy recommendations to address pro-cyclicality 
concerns in three broad areas: regulatory capital; bank loan 
loss provisioning practices; and valuation.
---------------------------------------------------------------------------
     \2\ The FSB Report was developed as a result of collaborative work 
carried out by working groups composed of staff from: banking agencies 
from the U.S. and other jurisdictions; securities regulators from the 
U.S. and other jurisdictions; accounting standard setters; the Basel 
Committee on Banking Supervision; International Organization of 
Securities Commissions; and other organizations.
---------------------------------------------------------------------------
    With respect to capital, the FSB Report set forth various 
recommendations to address potential pro-cyclicality, including 
the establishment of counter-cyclical capital buffers. In that 
regard, the Report encouraged the Basel Committee to ``develop 
mechanisms by which the quality of the capital base and the 
buffers above the regulatory minimum are built up during 
periods of strong earnings growth so that they are available to 
absorb greater losses in stressful environments.'' In terms of 
benefits, building such a counter-cyclical capital buffer on 
banks' earnings capacity would provide a simple and practical 
link between: (i) the portfolio composition and risk profile of 
individual banks; (ii) the build-up of risk in the banking 
system; and (iii) cycles of credit growth, financial innovation 
and leverage in the broader economy. We also believe it is 
critically important to focus on the quality of capital, with 
common stock, retained earnings, and reserves for loan losses, 
being the predominant form of capital within the Tier 1 
requirement.
    The establishment of counter-cyclical capital buffers do 
present challenges, the most significant of which relate to 
international consistency and operational considerations. In 
normal cyclical downturns, there are clear differences in 
national economic cycles, with certain regions experiencing 
material deterioration in economic activity, while other 
regions are completely unaffected. In such an environment, it 
will be extremely difficult to balance the need for 
international consistency while reflecting differences in 
national economic cycles.
    With respect to loan loss reserves, the FSB Report stated 
that earlier recognition of loan losses could have dampened 
cyclical moves in the current crisis. Under the current 
accounting requirements of an incurred loss model, a provision 
for loan losses is recognized only when a loss impairment event 
or events have taken place that are likely to result in 
nonpayment of a loan in the future. Earlier identification of 
credit losses is consistent both with financial statement 
users' needs for transparency regarding changes in credit 
trends and with prudential objectives of safety and soundness. 
To address this issue, the FSB Report set forth recommendations 
to accounting standard setters and the Basel Committee. 
Included in the Report was a recommendation to accounting 
standard setters to reconsider their current loan loss 
provisioning requirements and related disclosures.
    The OCC and other Federal banking agencies continue to 
discuss these difficult issues within the Basel Committee and 
other international forums.

Q.14. Do you see any circumstances under which your agencies 
would take a position on the merits of counter-cyclical 
regulatory policy?

A.14. The OCC has actively participated in various efforts to 
assess and mitigate possible pro-cyclical effects of current 
accounting and regulatory capital regimes and I served as a 
chairperson of the FSB's Working Group on Provisioning 
discussed in the FSB Report discussed above. Consistent with 
recommendations in the FSB Report, I have publicly endorsed 
enhancements to existing provisions of regulatory capital rules 
and generally accepted accounting principles (GAAP) to address 
pro-cyclicality concerns.

Q.15. G20 Summit and International Coordination--Many foreign 
officials and analysts have said that they believe the upcoming 
G20 summit will endorse a set of principles agreed to by both 
the Financial Stability Forum and the Basel Committee, in 
addition to other government entities. There have also been 
calls from some countries to heavily re-regulate the financial 
sector, pool national sovereignty in key economic areas, and 
create powerful supranational regulatory institutions. 
(Examples are national bank resolution regimes, bank capital 
levels, and deposit insurance.) Your agencies are active 
participants in these international efforts.
    What do you anticipate will be the result of the G20 
summit?
A.15. The materials subsequent to the April 2, 2009, G20 Summit 
offer a constructive basis for a coordinated international 
response to the current economic crisis. The documents issued 
by the G20 working groups, especially Working Group 1: 
Enhancing Sound Regulation and Strengthening Transparency; and 
Working Group 2: Reinforcing International Cooperation and 
Promoting Integrity in Financial Markets, will be a particular 
focus of attention for the OCC and the other Federal banking 
agencies.

Q.16. Do you see any examples or areas where supranational 
regulation of financial services would be effective?

A.16. Issues uniquely related to the activities and operations 
of internationally active banking organizations compel a higher 
level of coordination among international supervisors. In fact, 
the Standards Implementation Group of the Basel Committee is 
designed to provide international supervisors a forum to 
discuss such issues and, to the extent possible, harmonize 
examination activities and supervisory policies related to 
those institutions.

Q.17. How far do you see your agencies pushing for or against 
such supranational initiatives?

A.17. The OCC is supportive of continued efforts to harmonize 
activities and policies related to the supervision of 
internationally active banks. The actions of the G20 and its 
working groups present the opportunity to continue current 
dialogue with a broader array of jurisdictions. However, we are 
keenly aware of the need to protect U.S. sovereignty over the 
supervision of national banks, and will not delegate that 
responsibility.

Q.18. What steps has the OCC taken to promote the use of 
central counterparties for credit default swap transactions by 
national banks?

A.18. The OCC is an active participant in the Derivatives 
Infrastructure Project. One of the key accomplishments of this 
project is working with industry participants in developing a 
central counterparty solution for credit derivatives. 
Representatives from the OCC previously testified that credit 
derivatives risk mitigation is encouraged including the use of 
a central clearing party. The industry committed in its July 
31, 2008, letter to use central clearing for eligible index, 
single name, and tranche index CDS where practicable. The 
industry renewed this commitment in October of 2008. Our 
ongoing supervision efforts continue to track the progress of 
this commitment in the institutions where the OCC is the 
primary supervisor. As a result, central clearinghouses have 
been established and central clearing of index trades began in 
March of this year.
    The OCC granted national banks the legal authority to 
become members of a central clearing house for credit 
derivatives. The legal approval is also subject to stringent 
safety and soundness requirements to ensure banks can 
effectively manage and measure their exposures to central 
counterparties.
    The OCC continues to work with market participants and 
other regulators on increasing the volume and types of credit 
derivatives cleared via a central counterparty. In a meeting on 
April 1 at the Federal Reserve Bank of New York, market 
participants discussed broadening the use of a central clearing 
party to include a wider range of firms and credit derivative 
products. Participants agreed to form an industry group to 
address challenges to achieving these objectives and associated 
issues surrounding initial margin segregation and portability. 
The industry will report back to regulators with plans on how 
to progress.

Q.19. What other classes of OTC derivatives are good candidates 
for central clearing and what steps is the OCC taking to 
encourage the development and use of central clearing 
counterparties?

A.19. The OCC believes that all types of OTC derivative 
products, including foreign exchange, interest rate, 
commodities, and equities, will have some contracts that are 
appropriate candidates for central clearing. The key to 
increasing the volume of centrally cleared derivatives is 
increasing product standardization. Some OTC derivatives 
products are more amenable to this standardization than others. 
Over time, a central question for policymakers will be the 
extent to which the risks of customized OTC derivatives 
products can be effectively managed off of centralized 
clearinghouses or exchanges, and whether the benefits exceed 
the risks.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                       FROM JOHN C. DUGAN

Q.1. It is clear that our current regulatory structure is in 
need of reform. At my subcommittee hearing on risk management, 
March 18, 2009, GAO pointed out that regulators often did not 
move swiftly enough to address problems they had identified in 
the risk management systems of large, complex financial 
institutions.
    My questions may be difficult, but please answer the 
following:

    If this lack of action is a persistent problem 
        among the regulators, to what extent will changing the 
        structure of our regulatory system really get at the 
        issue?

    Along with changing the regulatory structure, how 
        can Congress best ensure that regulators have clear 
        responsibilities and authorities, and that they are 
        accountable for exercising them ``effectively and 
        aggressively''?

A.1. As was discussed in Senior Deputy Comptroller Long's March 
18th testimony before the Subcommittee on Securities, 
Insurance, and Investment, looking back on the events of the 
past two years, there are clearly things we may have done 
differently or sooner, but I do not believe our supervisory 
record indicates that there was a ``lack of action'' by the 
OCC. For example, we began alerting national banks to our 
concerns about increasingly liberal underwriting practices in 
certain loan products as early as 2003. Over the next few 
years, we progressively increased our scrutiny and responses, 
especially with regard to credit cards, residential mortgages, 
and commercial real estate loans even though the underlying 
``fundamentals'' for these products and market segments were 
still robust. Throughout this period, our examiners were 
diligent in identifying risks and directing banks to take 
corrective action. Nonetheless, we and the industry initially 
underestimated the magnitude and severity of the disruptions 
that we have subsequently seen in the market and the rapidity 
at which these disruptions spilled over into the overall 
economy. In this regard, we concur with the GAO that regulators 
and large, complex banking institutions need to develop better 
stress test mechanisms that evaluate risks across the entire 
firm and that identify interconnected risks and potential tail 
events. We also agree that more transparency and capital is 
needed for certain off-balance sheet conduits and products that 
can amplify a bank's risk exposure.
    While changes to our regulatory system are warranted--
especially in the area of systemic risk--I do not believe that 
fundamental changes are required to the structure for 
conducting banking supervision.
Q.2. How do we overcome the problem that in the boom times no 
one wants to be the one stepping in to tell firms they have to 
limit their concentrations of risk or not trade certain risky 
products?
    What thought has been put into overcoming this problem for 
regulators overseeing the firms? Is this an issue that can be 
addressed through regulatory restructure efforts?

A.2. A key issue for bankers and supervisors is determining 
when the accumulation of risks either within an individual firm 
or across the system has become too high, such that corrective 
or mitigating actions are needed. Knowing when and how to 
strike this balance is one of the most difficult jobs that 
supervisors face. Taking action too quickly can constrain 
economic growth and impede access to credit by credit-worthy 
borrowers. Waiting too long can result in an overhang of risk 
becoming embedded into banks that can lead to failure and, in 
the marketplace, that can lead to the types of dislocations we 
have seen over the past year. This need to balance supervisory 
actions, I believe, is fundamental to bank supervision and is 
not an issue that can be addressed through regulatory 
restructure--the same issue will face whatever entity or agency 
is ultimately charged with supervision.
    There are, however, actions that I believe we can and 
should take to help dampen some of the effects of business and 
economic cycles. First, as previously noted, I believe we need 
to insist that large institutions establish more rigorous and 
comprehensive stress tests that can identify risks that may be 
accumulating across various business and product lines. As we 
have seen, some senior bank managers thought they had avoided 
exposure to subprime residential mortgages by deliberately 
choosing not to originate such loans in the bank, only to find 
out after the fact that their investment banks affiliates had 
purchased subprime loans elsewhere. For smaller, community 
banks, we need to develop better screening mechanisms that we 
can use to help identify banks that are building up 
concentrations in a particular product line and where 
mitigating actions may be necessary. We have been doing just 
that for our smaller banks that may have significant commercial 
real estate exposures.
    We also need to ensure that banks have the ability to 
strengthen their loan loss reserves at an appropriate time in 
the credit cycle, as their potential future loans losses are 
increasing. A more forward-looking ``life of the loan'' or 
``expected loss'' concept would allow provisions to incorporate 
losses expected over a more realistic time horizon, and would 
not be limited to losses incurred as of the balance sheet date, 
as under the current regime. Such a revision would help to 
dampen the decidedly pro-cyclical effect that the current rules 
are having today. This is an issue that I am actively engaged 
in through my role as Chairman of the Financial Stability 
Board's Working Group on Provisioning.
    Similarly, the Basel Committee on Bank Supervision recently 
announced an initiative to introduce standards that would 
promote the build up of capital buffers that can be drawn upon 
in periods of stress. Such a measure could also potentially 
serve as a buffer or governor to the build up of risk 
concentrations.
    There are additional measures we could consider, such as 
establishing absolute limits on the concentration a bank could 
have to a particular industry or market segment, similar to the 
loan limits we currently have for loans to an individual 
borrower. The benefits of such actions would need to be 
carefully weighed against the potential costs this may impose. 
For example, such a regime could result in a de facto 
regulatory allocation of credit away from various industries or 
markets. Such limits could also have a disproportionate affect 
on smaller, community banks whose portfolios by their very 
nature, tend to be concentrated in their local communities and, 
often, particular market segments such as commercial real 
estate.

Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, 
some financial institution failures emanated from institutions 
that were under federal regulation. While I agree that we need 
additional oversight over and information on unregulated 
financial institutions, I think we need to understand why so 
many regulated firms failed.
    Why is it the case that so many regulated entities failed, 
and many still remain struggling, if our regulators in fact 
stand as a safety net to rein in dangerous amounts of risk-
taking?

A.3. As alluded to in Governor Tarullo and Chairman Bair's 
testimonies, most of the prominent failures that have occurred 
and contributed to the current market disruption primarily 
involved systemically important firms that were not affiliated 
with an insured bank and were thus not overseen by the Federal 
Reserve or subject to the provisions of the Bank Holding 
Company Act. Although portions of these firms may have been 
subject to some form of oversight, they generally were not 
subject to the type or scope of consolidated supervision 
applied to banks and bank holding companies.
    Nonetheless, large national banking companies clearly have 
not been immune to the problems we have seen over the past 
eighteen months and several have needed active supervisory 
intervention or the assistance of the capital and funding 
programs instituted by the U.S. Treasury, Federal Reserve, and 
FDIC. As I noted in my previous answer, prior to the recent 
market disruptions our examiners had been identifying risks and 
risk management practices that needed corrective action and 
were working with bank management teams to ensure that such 
actions were being implemented. We were also directing our 
large banks to shore up their capital levels and during the 
eight month period from October 2007 through early June 2008, 
the largest national banking companies increased their capital 
and debt levels through public and private offerings by over 
$100 billion.
    I firmly believe that our actions that resulted in banks 
strengthening their underwriting standards, increasing their 
capital and reserves, and shoring up their liquidity were 
instrumental to the resilience that the national banking system 
as whole has shown during this period of unprecedented 
disruption in bank funding markets and significant credit 
losses. Indeed several of the largest national banks have 
served as a source of strength to the financial system by 
acquiring significant problem thrift institutions (i.e., 
Countrywide and Washington Mutual) and broker-dealer operations 
(i.e., Bear Stearns and Merrill Lynch). In addition, we worked 
to successfully resolve via acquisition by other national 
banks, two large national banks--National City and Wachovia--
that faced severe funding pressures in the latter part of 2008. 
While both of these banks had adequate capital levels, they 
were unable to roll over their short term liabilities in the 
marketplace at a time when market perception and sentiment for 
many banking companies were under siege. Due to these funding 
pressures, both banks had to be taken over by companies with 
stronger capital and funding bases. As the breadth and depth of 
credit problems accelerated in late 2008, two other large 
banking companies, Citigroup and Bank of America, required 
additional financial assistance through Treasury's Asset 
Guarantee and Targeted Investment programs to help stabilize 
their financial condition. As part of the broader Supervisory 
Capital Assessment Program that the OCC, Federal Reserve, and 
FDIC recently conducted on the largest recipients of funds 
under the Treasury's Troubled Assets Relief Program, we are 
closely monitoring the adequacy of these firms' capital levels 
to withstand further adverse economic conditions and will be 
requiring them to submit capital plans to ensure that they have 
sufficient capital to weather such conditions. In almost all 
cases, our large national banking organizations are on track to 
meet any identified capital needs and have been able to raise 
private capital through the marketplace, a sign that investor 
confidence may be returning to these institutions.
    While the vast majority of national banks remain sound, 
many national banks will continue to face substantial credit 
losses as credit problems work through the banking system. In 
addition, until the capital and securitization markets are more 
fully restored, larger banks will continue to face potential 
liquidity pressures and funding constraints. As I have stated 
in previous testimonies, we do expect that the number of 
problem banks and bank failures will continue to increase for 
some time given current economic conditions. In problem bank 
situations, our efforts focus on developing a specific plan 
that takes into consideration the ability and willingness of 
management and the board to correct deficiencies in a timely 
manner and return the bank to a safe and sound condition. In 
most instances our efforts, coupled with the commitment of bank 
management, result in a successful rehabilitation of the bank. 
There will be cases, however, where the situation is of such 
significance that we will require the sale, merger, or 
liquidation of the bank, if possible. Where that is not 
possible, we will appoint the FDIC as receiver.

Q.4. While we know that certain hedge funds, for example, have 
failed, have any of them contributed to systemic risk?

A.4. The failure of certain hedge funds, while not by 
themselves systemically important (in contrast to the failure 
of Long Term Capital Management in 1998), led to a reduction in 
market liquidity as leveraged investors accelerated efforts to 
reduce exposures by selling assets. Given significant 
uncertainty over asset values, reflecting sharply reduced 
market liquidity, this unwinding of leveraged positions has put 
additional strains on the financial system and contributed to 
lack of investor confidence in the markets.

Q.5. Given that some of the federal banking regulators have 
examiners on-site at banks, how did they not identify some of 
these problems we are facing today?

A.5. At the outset, it is important to be clear that bank 
examiners do not have authority over the nonbank companies in a 
holding company. These nonbank firms were the source of many of 
the issues confronting large banking firms. With respect to 
banks, as noted above, we were identifying issues and taking 
actions to address problems that we were seeing in loan 
underwriting standards and other areas. At individual banks, we 
were directing banks to strengthen risk management and 
corporate governance practices and, at some institutions, were 
effecting changes in key managerial positions. Nonetheless, in 
retrospect, it is clear that we should have been more 
aggressive in addressing some of the practices and risks that 
were building up across the banking system during this period. 
For example, it is clear that we and many bank managers put too 
much reliance on the various credit enhancements used to 
support certain collateralized debt obligations and not enough 
emphasis on the quality of, and correlations across, the 
underlying assets supporting those obligations. Similarly, we 
were not sufficiently attuned to the systemic risk implications 
of the significant migration by large banks to an ``originate-
to-distribute model'' for commercial and leveraged loan 
products. Under this model, banks originated a significant 
volume of loans with the express purpose of packaging and 
selling them to institutional investors who generally were 
willing to accept more liberal underwriting standards than the 
banks themselves would accept, in return for marginally higher 
yields. In the fall of 2007, when the risk appetite of 
investors changed dramatically (and at times for reasons not 
directly related to the exposures they held), banks were left 
with significant pipelines of loans that they needed to fund, 
thus exacerbating their funding and capital pressures. As has 
been well-documented, similar pressures were leading to 
relaxation of underwriting standards within the residential 
mortgage loan markets. While the preponderance of the subprime 
and ``Alt-A'' loans that have been most problematic were 
originated outside of the national banking system, the 
subsequent downward spiral in housing prices that these 
practices triggered have clearly affected all financial 
institutions, including national banks.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                       FROM JOHN C. DUGAN

Q.1. The convergence of financial services providers and 
financial products has increased over the past decade. 
Financial products and companies may have insurance, banking, 
securities, and futures components. One example of this 
convergence is AIG. Is the creation of a systemic risk 
regulator the best method to fill in the gaps and weaknesses 
that AIG has exposed, or does Congress need to reevaluate the 
weaknesses of federal and state functional regulation for 
large, interconnected, and large firms like AIG?

A.1. The financial crisis has highlighted significant 
regulatory gaps in the oversight of our financial system. Large 
nonbank financial institutions like AIG, Fannie Mae and Freddie 
Mac, Bear Steams, and Lehman were subject to varying degrees 
and different kinds of government oversight. No one regulator 
had access to risk information from these nonbank firms in the 
same way that the Federal Reserve has with respect to bank 
holding companies. The result was that the risk these firms 
presented to the financial system as a whole could not be 
managed or controlled before their problems reached crisis 
proportions.
    Assigning to one agency the oversight of systemic risk 
throughout the financial system could address certain of these 
regulatory gaps. For example, such an approach would fix 
accountability, centralize data collection, and facilitate a 
unified approach to identifying and addressing large risks 
across the system. However, a single systemic regulator 
approach also would face challenges due to the diverse nature 
of the firms that could be labeled systemically significant. 
Key issues would include the type of authority that should be 
provided to the regulator; the types of financial firms that 
should be subject to its jurisdiction; and the nature of the 
new regulator's interaction with existing prudential 
supervisors. It would be important, for example, for the 
systemic regulatory function to build on existing prudential 
supervisory schemes, adding a systemic point of view, rather 
than replacing or duplicating regulation and supervisory 
oversight that already exists. How this would be done would 
need to be evaluated in light of other restructuring goals, 
including providing clear expectations for financial 
institutions and clear responsibilities and accountability for 
regulators; avoiding new regulatory inefficiencies; and 
considering the consequences of an undue concentration of 
responsibilities in a single regulator.
    Moreover, the contours of new systemic authority may need 
to vary depending on the nature of the systemically significant 
entity. For example, prudential regulation of banks involves 
extensive requirements with respect to risk reporting, capital, 
activities limits, risk management, and enforcement. The 
systemic supervisor might not need to impose all such 
requirements on all types of systemically important firms. The 
ability to obtain risk information would be critical for all 
such firms, but it might not be necessary, for example, to 
impose the full array of prudential standards, such as capital 
requirements or activities limits on all types of systemically 
important firms, e.g., hedge funds (assuming they were subject 
to the new regulator's jurisdiction). Conversely, firms like 
banks that are already subject to extensive prudential 
supervision would not need the same level of oversight as firms 
that are not--and if the systemic overseer were the Federal 
Reserve Board, very little new authority would be required with 
respect to banking companies, given the Board's current 
authority over bank holding companies.

Q.2. Recently there have been several proposals to consider for 
financial services conglomerates. One approach would be to move 
away from functional regulation to some type of single 
consolidated regulator like the Financial Services Authority 
model. Another approach is to follow the Group of 30 Report 
which attempts to modernize functional regulation and limit 
activities to address gaps and weaknesses. An in-between 
approach would be to move to an objectives-based regulation 
system suggested in the Treasury Blueprint. What are some of 
the pluses and minuses of these three approaches?

A.2. A number of options for regulatory reform have been put 
forward, including those mentioned in this question. Each 
raises many detailed issues.
    The Treasury Blueprint offers a thoughtful approach to the 
realities of financial services regulation in the 21st century. 
In particular, the Blueprint's recommendation to establish a 
new federal charter for systemically significant payment and 
settlement systems and authorizing the Federal Reserve Board to 
supervise them is appropriate given the Board's extensive 
experience with payment system regulation.
    The Group of 30 Report compares and analyzes the financial 
regulatory approaches of seventeen jurisdictions--including the 
United Kingdom, the United States and Australia--in order to 
illustrate the implications of the four principal models of 
supervisory oversight. The Group of 30 Report then sets forth 
18 proposals for banks and nonbanks. For all countries, the 
Report recommends that bank supervision be consolidated under 
one prudential regulator. Under the proposals, banks that are 
deemed systemically important would face restrictions on high-
risk proprietary activities. The report also calls for raising 
the level at which banks are considered to be well-capitalized, 
Proposals for nonbanks include regulatory oversight and the 
production or regular reports on leverage and performance. For 
banks and nonbanks alike, the Report calls for a more refined 
analysis of liquidity in stressed markets and more robust 
contingency planning.
    The Financial Services Authority model is one in which all 
supervision is consolidated in one agency.
    As debate on these and other proposals continues, the OCC 
believes two fundamental points are essential. First, it is 
important to preserve the Federal Reserve Board's role as a 
holding company supervisor. Second, it is equally if not more 
important to preserve the role of a dedicated, front-line 
prudential supervisor for our nation's banks.
    The Financial Services Authority model raises the 
fundamental problem that consolidating all supervision in a 
new, single independent agency would take bank supervisory 
functions away from the Federal Reserve Board. As the central 
bank and closest agency we have to a systemic risk regulator, 
the Board needs the window it has into banking organizations 
that it derives from its role as bank holding company 
supervisor. Moreover, given its substantial role and direct 
experience with respect to capital markets, payments systems, 
the discount window, and international supervision, the Board 
provides unique resources and perspective to bank holding 
company supervision.
    Second, and perhaps more important, is preserving the very 
real benefit of having an agency whose sole mission is bank 
supervision. The benefits of dedicated supervision are 
significant. Where it occurs, there is no confusion about the 
supervisor's goals and objectives, and no potential conflict 
with competing objectives. Responsibility is well defined, and 
so is accountability. Supervision does not take a back seat to 
any other part of the organization, and the result is a strong 
culture that fosters the development of the type of seasoned 
supervisors that are needed to confront the many challenges 
arising from today's banking business.

Q.3. If there are institutions that are too big to fail, how do 
we identify that? How do we define the circumstance where a 
single company is so systemically significant to the rest of 
our financial circumstances and our economy that we must not 
allow it to fail? We need to have a better idea of what this 
notion of too big to fail is--what it means in different 
aspects of our industry and what our proper response to it 
should be. How should the federal government approach large, 
multinational and systemically significant companies? What does 
``fail'' mean? In the context of AIG, we are talking about 
whether we should have allowed an orderly Chapter 11 bankruptcy 
proceeding to proceed. Is that failure?

A.3. There a number of ways ``too big to fail'' can be defined, 
including the size of an institution, assets under management, 
interrelationships or interconnections with other significant 
economic entities, or global reach. Likewise, ``failure'' could 
have several definitions, including bankruptcy. But whatever 
definition of these terms Congress may choose, it is important 
that there be an orderly process for resolving systemically 
significant firms.
    U.S. law has long provided a unique and well developed 
framework for resolving distressed and failing banks that is 
distinct from the federal bankruptcy regime. Since 1991, this 
unique framework, contained in the Federal Deposit Insurance 
Act, has also provided a mechanism to address the problems that 
can arise with the potential failure of a systemically 
significant bank--including, if necessary to protect financial 
stability, the ability to use the bank deposit insurance fund 
to prevent uninsured depositors, creditors, and other 
stakeholders of the bank from sustaining loss.
    No comparable framework exists for resolving most 
systemically significant financial firms that are not banks, 
including systemically significant holding companies of banks. 
Such firms must therefore use the normal bankruptcy process 
unless they can obtain some form of extraordinary government 
assistance to avoid the systemic risk that might ensue from 
failure or the lack of a timely and orderly resolution. While 
the bankruptcy process may be appropriate for resolution of 
certain types of firms, it may take too long to provide 
certainty in the resolution of a systemically significant firm, 
and it provides no source of funding for those situations where 
substantial resources are needed to accomplish an orderly 
solution.
    This gap needs to be addressed with an explicit statutory 
regime for facilitating the resolution of systemically 
important nonbank companies as well as banks. This new 
statutory regime should provide tools that are similar to those 
currently available for resolving banks, including the ability 
to require certain actions to stabilize a firm; access to a 
significant funding source if needed to facilitate orderly 
dispositions, such as a significant line of credit from the 
Treasury; the ability to wind down a firm if necessary; and the 
flexibility to guarantee liabilities and provide open 
institution assistance if needed to avoid serious risk to the 
financial system. In addition, there should be clear criteria 
for determining which institutions would be subject to this 
resolution regime, and how to handle the foreign operations of 
such institutions.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
                       FROM JOHN C. DUGAN

Q.1. Two approaches to systemic risk seem to be identified, (1) 
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to 
fail'' or ``too systemically important to fail'' or (2) impose 
an additional regulator and additional rules and market 
discipline on institutions that are considered systemically 
important. Which approach do you endorse?

A.1. The functions and authorities of a systemic risk regulator 
may need to differ depending on the nature of the systemically 
significant entity. Some types of firms, including banks, 
already are subject to federally imposed capital requirements, 
federal constraints on their activities, and the enforcement 
jurisdiction of a federal prudential regulator. These oversight 
functions should not be duplicated in the systemic supervisor. 
Doing so increases the potential for uncertainty about the 
standards to which firms will be held and for inconsistency 
between requirements administered by the primary and the 
systemic regulator.
    In practice, the role of a systemic risk overseer may vary 
at different points in time depending on whether financial 
markets are functioning normally, or are instead experiencing 
unusual stress or disruption. For example, in a stable economic 
environment, the systemic risk regulator might focus most on 
obtaining and analyzing information about risks. Such 
additional information and analysis would be valuable not only 
for the systemic risk regulator, but also for prudential 
supervisors in terms of their understanding of firms' exposure 
to risks occurring in other parts of the financial services 
system to which they have no direct access. And it could 
facilitate the implementation of supervisory strategies to 
address and contain such risk before it increased to 
unmanageable levels. On the other hand, in times of stress or 
disruption it may be desirable for the systemic regulator to 
take actions to stabilize a firm or apply stricter than normal 
standards to aspects of its operations.

Q.2. Please identify all regulatory or legal barriers to the 
comprehensive sharing of information among regulators including 
insurance regulators, banking regulators, and investment 
banking regulators. Please share the steps that you are taking 
to improve the flow of communication among regulators within 
the current legislative environment.

A.2. At the federal level, no barriers to information sharing 
exist between federal banking regulators because the Federal 
Deposit Insurance Act, at 12 U.S.C. 1821t, provides that ``a 
covered agency'' does not waive any privilege when it transfers 
information or permits information to be used by a covered 
agency or any other agency of the federal government. A 
``covered agency'' includes a federal banking agency, but not a 
state authority. This would also protect privilege when the OCC 
shares information with other federal agencies, such as the 
SEC, with which the OCC shares information pursuant to letter 
agreements in connection with the SEC's enforcement 
investigations and inspection functions.
    In 1984, a joint statement of policy was issued by the OCC, 
FRB, FDIC, and the FHLBB that contained agreements relating to 
confidentiality safeguards that would be observed in connection 
with the sharing of certain categories of confidential 
supervisory information between those agencies. Presently, 
these and other protocols are observed in connection with the 
sharing of broader and other categories of supervisory 
information with other federal agencies that occurs pursuant to 
OCC's regulations or, as indicated above with respect to the 
SEC, written agreements or memoranda of understanding. It is 
crucial that the confidentiality of any information shared 
between federal and state authorities concerning bank condition 
or personal consumer information be assured. The OCC has 
therefore entered into a number of agreements with various 
state regulators that govern the sharing, and protect the 
confidentiality, of information held by federal and state 
regulators:

    The OCC has entered into written sharing agreements 
        or memoranda with 48 of the 50 states, the District of 
        Columbia, and Puerto Rico. These documents, most of 
        which were executed between 1987 and 1992, generally 
        provide for the sharing of broad categories of 
        information when needed for supervisory purposes.

    The OCC has executed a model Memorandum of 
        Understanding with the Conference of State Bank 
        Supervisors (CSBS) that is intended to facilitate the 
        referral of customer complaints between the OCC and 
        individual states, and to share information about the 
        disposition of these complaints. As of December, 2008, 
        this model agreement has served as the basis for 
        information sharing agreements between the OCC and 44 
        states and Puerto Rico.

    In addition, the OCC has insurance information-
        sharing agreements with 49 States and the District of 
        Columbia.

    The OCC has entered into many case specific 
        agreements with states attorneys general in order to 
        obtain information relevant to misconduct within the 
        national banking system. We also encourage states 
        attorneys general to refer complaints of misconduct by 
        OCC regulated entities directly to the OCC's Customer 
        Assistance Group. Finally, the OCC Customer Assistance 
        Group refers consumer complaints that it receives with 
        respect to State regulated entities to the appropriate 
        state officials.

    The OCC exchanges information with state securities 
        regulators on a case-by-case basis pursuant to letter 
        agreements.

    Moreover, the OCC has worked cooperatively with the states 
to address specific supervisory and consumer protection issues. 
For example, in the area of supervisory guidance, federal and 
state regulators have worked constructively in connection with 
implementation of the nontraditional mortgage and subprime 
mortgage guidance issued initially by the federal banking 
agencies.
    More generally, under the auspices of the Federal Financial 
Institutions Examination Council (FFIEC), the OCC actively 
participates in the development and implementation of uniform 
principles, standards, and report forms for the examination of 
financial institutions by the federal agencies who are members 
of the FFIEC, which include (in addition to the OCC) the 
Federal Reserve Board, the FDIC, the OTS, and the NCUA. In 
2006, the Chair of the State Liaison Committee (SLC) was added 
to the FFIEC as a voting member. The SLC includes 
representatives of the Conference of State Bank Supervisors 
(CSBS), the American Council of State Savings Supervisors 
(ACSSS), and the National Association of State Credit Union 
Supervisors (NASCUS). Working through its Task Forces (such as 
the Task Force on Supervision and the Task Force on 
Compliance), the FFIEC also develops recommendations to promote 
uniformity in the supervision of financial institutions.
    The OCC also participates in the President's Working Group 
on Financial Markets, a group composed of the Treasury 
Department, the Federal Reserve Board, the SEC, and the CFTC, 
which considers significant financial institutions' policy 
issues on an ongoing basis.
                                ------                                


       RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
                       FROM JOHN C. DUGAN

Q.1. Will each of you commit to do everything within your power 
to prevent performing loans from being called by lenders? 
Please outline the actions you plan to take.

A.1. The OCC has and will continue to encourage bankers to work 
with borrowers and to meet the credit needs of credit-worthy 
borrowers. Ultimately, however, the decision about whether to 
call a particular loan is a business decision that a banker 
must make. Such decisions must be based on the specific facts 
and circumstances of the bank, including its overall risk 
profile and its relationship with the borrower.
    There has been a perception that examiners are requiring 
bankers to call or classify performing loans, resulting in what 
some have called a ``performing nonperforming loan.'' Let me be 
clear, examiners do not tell bankers to call or renegotiate a 
loan, nor will they direct bankers to classify a loan or 
borrowers who have the demonstrated ability to service their 
debts under reasonable repayment schedules. In an effort to 
clarify how examiners approach this issue, it is important to 
define the term ``performing loan.'' Some define performance as 
simply being contractually current on all principal and 
interest payments. In many cases this definition is sufficient 
for a particular credit relationship and accurately portrays 
the status of the loan. In other cases, however, being 
contractually current on payments can be a very misleading 
gauge of the credit risk embedded in the loan. This is 
especially the case where the loan's underwriting structure can 
mask credit weaknesses and obscure the fact that a borrower may 
be unable to meet the full terms of the loan. This phenomenon 
was vividly demonstrated in certain nontraditional rate 
residential mortgage products where a borrower may have been 
qualified at a low ``teaser'' rate or with interest-only 
payments, without regard as to whether they would be able to 
afford the loan once the rates or payments adjusted to a fully 
indexed rate or included principal repayments.
    Analysis of payment performance must consider under what 
terms the performance has been achieved. For example, in many 
acquisition, development and construction loans for residential 
developments, it is common for the loans to be structured with 
what is referred to as an ``interest reserve'' for the initial 
phase of the project. These interest reserves are established 
as part of the initial loan proceeds at the time the loan is 
funded and provide funds for interest payments as lots are 
being developed, with repayment of principal occurring as each 
lot or parcel is sold and released. However, if the development 
project stalls for any number of reasons, the interest will 
continue to be paid from the initial interest reserve even 
though the project is not generating any cash flows to repay 
loan principal. In such cases, the loan will be contractually 
current due to the interest payments being made from the 
reserves, but the repayment of principal is in jeopardy. We are 
seeing instances where projects such as these have completely 
stalled with lot sales significantly behind schedule or even 
nonexistent and the loan, including the interest reserve, is 
set to mature shortly. This is an example where a loan is 
contractually current, but is not performing as intended.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                      FROM SHEILA C. BAIR

Q.1. Consumer Protection Regulation--Some have advocated that 
consumer protection and prudential supervision should be 
divorced, and that a separate consumer protection regulation 
regime should be created. They state that one source of the 
financial crisis emanated from the lack of consumer protection 
in the underwriting of loans in the originate-to-distribute 
space.
    What are the merits of maintaining it in the same agency? 
Alternatively, what is the best argument each of you can make 
for a new consumer protection agency?

A.1. As I said in my testimony, there can no longer be any 
doubt about the link between protecting consumers from abusive 
products and practices and the safety and soundness of the 
financial system. Products and practices that strip individual 
and family wealth undermine the foundation of the economy. As 
the current crisis demonstrates, increasingly complex financial 
products combined with frequently opaque marketing and 
disclosure practices result in problems not just for consumers, 
but for institutions and investors as well.
    To protect consumers from potentially harmful financial 
products, a case has been made for a new independent financial 
product safety commission. Certainly, more must be done to 
protect consumers. The FDIC could support the establishment of 
a new entity to establish consistent consumer protection 
standards for banks and nonbanks. However, we believe that such 
a body should include the perspective of bank regulators as 
well as nonbank enforcement officials such as the FTC. However, 
as Congress considers the options, we recommend that any new 
plan ensure that consumer protection activities are aligned and 
integrated with other bank supervisory information, resources, 
and expertise, and that enforcement of consumer protection 
rules for banks be left to bank regulators.
    The current bank regulation and supervision structure 
allows the banking agencies to take a comprehensive view of 
financial institutions from both a consumer protection and 
safety-and-soundness perspective. Banking agencies' assessments 
of risks to consumers are closely linked with and informed by a 
broader understanding of other risks in financial institutions. 
Conversely, assessments of other risks, including safety and 
soundness, benefit from knowledge of basic principles, trends, 
and emerging issues related to consumer protection. Separating 
consumer protection regulation and supervision into different 
organizations would reduce information that is necessary for 
both entities to effectively perform their functions. 
Separating consumer protection from safety and soundness would 
result in similar problems. Our experience suggests that the 
development of policy must be closely coordinated and reflect a 
broad understanding of institutions' management, operations, 
policies, and practices--and the bank supervisory process as a 
whole.
    One of the fundamental principles of the FDIC's mission is 
to serve as an independent agency focused on maintaining 
consumer confidence in the banking system. The FDIC plays a 
unique role as deposit insurer, federal supervisor of state 
nonmember banks and savings institutions, and receiver for 
failed depository institutions. These functions contribute to 
the overall stability of and consumer confidence in the banking 
industry. With this mission in mind, if given additional 
rulemaking authority, the FDIC is prepared to take on an 
expanded role in providing consumers with stronger protections 
that address products posing unacceptable risks to consumers 
and eliminate gaps in oversight.

Q.2. Regulatory Gaps or Omissions--During a recent hearing, the 
Committee has heard about massive regulatory gaps in the 
system. These gaps allowed unscrupulous actors like AIG to 
exploit the lack of regulatory oversight. Some of the 
counterparties that AIG did business with were institutions 
under your supervision.
    Why didn't your risk management oversight of the AIG 
counterparties trigger further regulatory scrutiny? Was there a 
flawed assumption that AIG was adequately regulated, and 
therefore no further scrutiny was necessary?

A.2. The FDIC did not have supervisory authority over AIG. 
However, to protect taxpayers the FDIC recommends that a new 
resolution regime be created to handle the failure of large 
nonbanks such as AIG. This special receivership process should 
be outside bankruptcy and be patterned after the process we use 
for bank and thrift failures.

Q.3. Was there dialogue between the banking regulators and the 
state insurance regulators? What about the SEC?

A.3. The FDIC did not have supervisory authority for AIG and 
did not engage in discussions regarding the entity. However, 
the need for improved interagency communication demonstrates 
that the reform of the regulatory structure also should include 
the creation of a systemic risk council (SRC) to address issues 
that pose risks to the broader financial system. The SRC would 
be responsible for identifying institutions, practices, and 
markets that create potential systemic risks, implementing 
actions to address those risks, ensuring effective information 
flow, completing analyses and making recommendations on 
potential systemic risks, setting capital and other standards 
and ensuring that the key supervisors with responsibility for 
direct supervision apply those standards. The macro-prudential 
oversight of system-wide risks requires the integration of 
insights from a number of different regulatory perspectives--
banks, securities firms, holding companies, and perhaps others. 
Only through these differing perspectives can there be a 
holistic view of developing risks to our system.

Q.4. If the credit default swap contracts at the heart of this 
problem had been traded on an exchange or cleared through a 
clearinghouse, with requirement for collateral and margin 
payments, what additional information would have been 
available? How would you have used it?

A.4. As with other exchange traded instruments, by moving the 
contracts onto an exchange or central counterparty, the overall 
risk to any counterparty and to the system as a whole would 
have been greatly reduced. The posting of daily variance margin 
and the mutuality of the exchange as the counterparty to market 
participants would almost certainly have limited the potential 
losses to any of AIG's counterparties.
    For exchange traded contracts, counterparty credit risk, 
that is, the risk of a counterparty not performing on the 
obligation, would be substantially less than for bilateral OTC 
contracts. That is because the exchange becomes the 
counterparty for each trade.
    The migration to exchanges or central clearinghouses of 
credit default swaps and OTC derivatives in general should be 
encouraged and perhaps required. The opacity of CDS risks 
contributed to significant concerns about the transmission of 
problems with a single credit across the financial system. 
Moreover, the customized mark to model values associated with 
OTC derivatives may encourage managements to be overly 
optimistic in valuing these products during economic 
expansions, setting up the potential for abrupt and 
destabilizing reversals.
    The FDIC or other regulators could use better information 
derived from exchanges or clearinghouses to analyze both 
individual and systemic risk profiles. For those contracts 
which are not standardized, we urge complete reporting of 
information to trade repositories so that information would be 
available to regulators. With additional information, 
regulators may better analyze and ascertain concentrated risks 
to the market participants. This is particularly true for large 
counterparty exposures that may have systemic ramifications if 
the contracts are not well collateralized among counterparties.

Q.5. Liquidity Management--A problem confronting many financial 
institutions currently experiencing distress is the need to 
roll-over short-term sources of funding. Essentially these 
banks are facing a shortage of liquidity. I believe this 
difficulty is inherent in any system that funds long-term 
assets, such as mortgages, with short-term funds. Basically the 
harm from a decline in liquidity is amplified by a bank's level 
of ``maturity-mismatch.''
    I would like to ask each of the witnesses, should 
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to 
do so?

A.5. The funding of illiquid assets, whose cash flows are 
realized over time and with uncertainty, with shorter-maturity 
volatile or credit sensitive funding, is at the heart of the 
liquidity problems facing some financial institutions. If a 
regulator determines that a bank is assuming amounts of 
liquidity risk that are excessive relative to its capital 
structure, then the regulator should require the bank to 
address this issue.
    In recognition of the significant role that liquidity risks 
have played during this crisis, regulators the world over are 
considering ways to enhance supervisory approaches. There is 
better recognition of the need for banks to have an adequate 
cushion of liquid assets, supported by pro forma cash flow 
analysis under stressful scenarios, well diversified and tested 
funding sources, and a liquidity contingency plan. The FDIC 
issued supervisory guidance on liquidity risk in August of 
2008.

Q.6. Too-Big-To-Fail--Chairman Bair stated in her written 
testimony that ``the most important challenge is to find ways 
to impose greater market discipline on systemically important 
institutions. The solution must involve, first and foremost, a 
legal mechanism for the orderly resolution of those 
institutions similar to that which exists for FDIC-insured 
banks. In short we need to end too big to fail. I would agree 
that we need to address the too-big-to-fail issue, both for 
banks and other financial institutions.''
    Could each of you tell us whether putting a new resolution 
regime in place would address this issue?

A.6. There are three key elements to addressing the problem of 
systemic risk and too big to fail.
    First, financial firms that pose systemic risks should be 
subject to regulatory and economic incentives that require 
these institutions to hold larger capital and liquidity buffers 
to mirror the heightened risk they pose to the financial 
system. In addition, restrictions on leverage and the 
imposition of risk-based assessments on institutions and their 
activities would act as disincentives to the types of growth 
and complexity that raise systemic concerns.
    The second important element in addressing too big to fail 
is an enhanced structure for the supervision of systemically 
important institutions. This structure should include both the 
direct supervision of systemically significant financial firms 
and the oversight of developing risks that may pose risks to 
the overall U.S. financial system. Centralizing the 
responsibility for supervising these institutions in a single 
systemic risk regulator would bring clarity and accountability 
to the efforts needed to identify and mitigate the buildup of 
risk at individual institutions. In addition, a systemic risk 
council could be created to address issues that pose risks to 
the broader financial system by identifying cross-cutting 
practices, and products that create potential systemic risks.
    The third element to address systemic risk is the 
establishment of a legal mechanism for quick and orderly 
resolution of these institutions similar to what we use for 
FDIC insured banks. The purpose of the resolution authority 
should not be to prop up a failed entity indefinitely or to 
insure all liabilities, but to permit a timely and orderly 
resolution and the absorption of assets by the private sector 
as quickly as possible. Done correctly, the effect of the 
resolution authority will be to increase market discipline and 
protect taxpayers.

Q.7. How would we be able to convince the market that these 
systemically important institutions would not be protected by 
taxpayer resources as they had been in the past?

A.7. Given the long history of government bailouts for 
economically and systemically important firms, it will be 
extremely difficult to convince market participants that 
current practices have changed. Still, it is critical that we 
dispel the presumption that some institutions are ``too big to 
fail.''
    As outlined in my testimony, it is imperative that we 
undertake regulatory and legislative reforms that force TBTF 
institutions to internalize the social costs of bailouts and 
put shareholders, creditors, and managers at real risk of loss. 
Capital and other requirements should be put in place to 
provide disincentives for institutions to become too large or 
complex. This must be linked with a legal mechanism for the 
orderly resolution of systemically important nonbank financial 
firms--a mechanism similar to that which currently exists for 
FDIC-insured depository institutions.

Q.8. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank 
capital regulation. Some commentators have endorsed a concept 
requiring banks to hold more capital when good conditions 
prevail, and then allow banks to temporarily hold less capital 
in order not to restrict access to credit during a downturn. 
Advocates of this system believe that counter cyclical policies 
could reduce imbalances within financial markets and smooth the 
credit cycle itself.
    What do you see as the costs and benefits of adopting a 
more counter-cyclical system of regulation?

A.8. The FDIC would be supportive of a capital and accounting 
framework for insured depository institutions that avoids the 
unintended pro-cyclical outcomes we have experienced in the 
current crisis. Capital and other appropriate buffers should be 
built up during more benign parts of the economic cycle so that 
they are available during more stressed periods. The FDIC 
firmly believes that financial statements should present an 
accurate depiction of an institution's capital position, and we 
strongly advocate robust capital levels during both prosperous 
and adverse economic cycles. Some features of existing capital 
regimes, and certainly the Basel II Advanced Approaches, lead 
to reduced capital requirements during good times and increased 
capital requirements during more difficult economic periods. 
Some part of capital should be risk sensitive, but it must 
serve as a cushion throughout the economic cycle. We believe a 
minimum leverage capital ratio is a critical aspect of our 
regulatory process as it provides a buffer against unexpected 
losses and the vagaries of models-based approaches to assessing 
capital adequacy.
    Adoption of banking guidelines that mitigate the effects of 
pro-cyclicality could potentially lessen the government's 
financial risk arising from the various federal safety nets. In 
addition, they would help financial institutions remain 
sufficiently reserved against loan losses and adequately 
capitalized during good and bad times. In addition, some 
believe that counter-cyclical approaches would moderate the 
severity of swings in the economic cycle as banks would have to 
set aside more capital and reserves for lending, and thus take 
on less risk during economic expansions.

Q.9. Do you see any circumstances under which your agencies 
would take a position on the merits of counter-cyclical 
regulatory policy?

A.9. The FDIC would be supportive of a capital and accounting 
framework for insured depository institutions that avoids the 
unintended pro-cyclical outcomes we have experienced in the 
current crisis. Again, we are strongly supportive of robust 
capital standards for banks and thrifts as well as conservative 
accounting guidelines which accurately represent the financial 
position of insured institutions.

Q.10. G20 Summit and International Coordination--Many foreign 
officials and analysts have said that they believe the upcoming 
G20 summit will endorse a set of principles agreed to by both 
the Financial Stability Forum and the Basel Committee, in 
addition to other government entities. There have also been 
calls from some countries to heavily re-regulate the financial 
sector, pool national sovereignty in key economic areas, and 
create powerful supranational regulatory institutions. 
(Examples are national bank resolution regimes, bank capital 
levels, and deposit insurance.) Your agencies are active 
participants in these international efforts.
    What do you anticipate will be the result of the G20 
summit?

A.10. The G20 summit communique addressed a long list of 
principles and actions that were originally presented in the 
so-called Washington Action Plan. The communique provided a 
full progress report on each of the 47 actions in that plan. 
The major reforms included expansion and enhancement of the 
Financial Stability Board (formerly the Financial Stability 
Forum). The FSB will continue to assess the state of the 
financial system and promote coordination among the various 
financial authorities. To promote international cooperation, 
the G20 countries also agreed to establish supervisory colleges 
for significant cross-border firms, implement cross-border 
crisis management, and launch an Early Warning Exercise with 
the IMF. To strengthen prudent financial regulation, the G20 
endorsed a supplemental nonrisk based measure of capital 
adequacy to complement the risk-based capital measures, 
incentives for improving risk management of securitizations, 
stronger liquidity buffers, regulation and oversight of 
systemically important financial institutions, and a broad 
range of compensation, tax haven, and accounting provisions.

Q.11. Do you see any examples or areas where supranational 
regulation of financial services would be effective?

A.11. If we are to restore financial health across the globe 
and be better prepared for the next global financial situation, 
we must develop a sound basis of financial regulation both in 
the U.S. and internationally. This is particularly important in 
the area of cross-border resolutions of systemically important 
financial institutions. Fundamentally, the focus must be on 
reforms of national policies and laws in each country. Among 
the important requirements in many laws are on-site 
examinations, a leverage ratio as part of the capital regime, 
an early intervention system like prompt corrective action, 
more flexible resolution powers, and a process for dealing with 
troubled financial companies. This last reform also is needed 
in this country. However, we do not see any appetite for 
supranational financial regulation of financial services among 
the G20 countries at this time.

Q.12. How far do you see your agencies pushing for or against 
such supranational initiatives?

A.12. At this time and until the current financial situation is 
resolved, I believe the FDIC should focus its efforts on 
promoting an international leverage ratio, minimizing the pro-
cyclicality of the Basel II capital standards, cross-border 
resolutions, and other initiatives that the Basel Committee is 
undertaking. In the short run, achieving international 
cooperation on these issues will require our full attention.

Q.13. Regulatory Reform--Chairman Bair, Mr. Tarullo noted in 
his testimony the difficulty of crafting a workable resolution 
regime and developing an effective systemic risk regulation 
scheme.
    Are you concerned that there could be unintended 
consequences if we do not proceed with due care?

A.13. Once the government formally appoints a systemic risk 
regulator (SRR), market participants may assume that the 
likelihood of systemic events will be diminished going forward. 
By explicitly accepting the task of ensuring financial sector 
stability and appointing an agency responsible for discharging 
this duty, the government could create expectations that weaken 
market discipline. Private sector market participants may 
incorrectly discount the possibility of sector-wide 
disturbances. Market participants may avoid expending private 
resources to safeguard their capital positions or arrive at 
distorted valuations in part because they assume (correctly or 
incorrectly) that the SRR will reduce the probability of 
sector-wide losses or other extreme events. In short, the 
government may risk increasing moral hazard in the financial 
system unless an appropriate system of supervision and 
regulation is in place. Such a system must anticipate and 
mitigate private sector incentives to attempt to profit from 
this new form of government oversight and protection at the 
expense of taxpayers.
    When establishing a SRR, it is also important for the 
government to manage expectations. Few if any existing systemic 
risk monitors were successful in identifying financial sector 
risks prior to the current crisis. Central banks have, for some 
time now, acted as systemic risk monitors and few if any 
institutions anticipated the magnitude of the current crisis or 
the risk exposure concentrations that have been revealed. 
Regulators and central banks have mostly had to catch up with 
unfolding events with very little warning about impending firm 
and financial market failures.
    The need for and duties of a SRR can be reduced if we alter 
supervision and regulation in a manner that discourages firms 
from forming institutions that are systemically important or 
too-big-to fail. Instead of relying on a powerful SSR, we need 
instead to develop a ``fail-safe'' system where the failure of 
any one large institution will not cause the financial system 
to break down. In order to move in this direction, we need to 
create disincentives that limit the size and complexity of 
institutions whose failure would otherwise pose a systemic 
risk.
    In addition, the reform of the regulatory structure also 
should include the creation of a systemic risk council (SRC) to 
address issues that pose risks to the broader financial system. 
The SRC would be responsible for identifying institutions, 
practices, and markets that create potential systemic risks, 
implementing actions to address those risks, ensuring effective 
information flow, completing analyses and making 
recommendations on potential systemic risks, setting capital 
and other standards and ensuring that the key supervisors with 
responsibility for direct supervision apply those standards. 
The macro-prudential oversight of system-wide risks requires 
the integration of insights from a number of different 
regulatory perspectives--banks, securities firms, holding 
companies, and perhaps others. Only through these differing 
perspectives can there be a holistic view of developing risks 
to our system.
    It also is essential that these reforms be time to the 
establishment of a legal mechanism for quick and orderly 
resolution of these institutions similar to what we use for 
FDIC insured banks. The purpose of the resolution authority 
should not be to prop up a failed entity indefinitely or to 
insure all liabilities, but to permit a timely and orderly 
resolution and the absorption of assets by the private sector 
as quickly as possible. Done correctly, the effect of the 
resolution authority will be to increase market discipline and 
protect taxpayers.

Q.14. Credit Rating Agencies--Ms. Bair, you note the role of 
the regulatory framework, including capital requirements, in 
encouraging blind reliance on credit ratings. You recommend 
pre-conditioning ratings based capital requirements on wide 
availability of the underlying data.
    Wouldn't the most effective approach be to take ratings out 
of the regulatory framework entirely?

A.14. We need to consider a range of options for prospective 
capital requirements based on the lessons we are learning from 
the current crisis. Data from credit rating agencies can be a 
valuable component of a credit risk assessment process, but 
capital and risk management should not rely on credit ratings. 
This issue will need to be explored further as regulatory 
capital guidelines are considered.

Q.15. Systemic Regulator--Ms. Bair, you observed that many of 
the failures in this crisis were failures of regulators to use 
authority that they had.
    In light of this, do you believe layering a systemic risk 
regulator on top of the existing regime is the optimal way to 
proceed with regulatory restructuring?

A.15. A distinction should be drawn between the direct 
supervision of systemically significant financial firms and the 
macro-prudential oversight of developing risks that may pose 
systemic risks to the U.S. financial system. The former 
appropriately calls for a single regulator for the largest, 
most systemically significant firms, including large bank 
holding companies. The macro-prudential oversight of system-
wide risks requires the integration of insights from a number 
of different regulatory perspectives--banks, securities firms, 
holding companies, and perhaps others. Only through these 
differing perspectives can there be a holistic view of 
developing risks to our system. As a result, for this latter 
role, the FDIC would suggest creation of a systemic risk 
council (SRC) to provide analytical support, develop needed 
prudential policies, and have the power to mitigate developing 
risks.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                      FROM SHEILA C. BAIR

Q.1.a. It is clear that our current regulatory structure is in 
need of reform. At my subcommittee hearing on risk management, 
March 18, 2009, GAO pointed out that regulators often did not 
move swiftly enough to address problems they had identified in 
the risk management systems of large, complex financial 
institutions.
    Chair Bair's written testimony for today's hearing put it 
very well: `` . . . the success of any effort at reform will 
ultimately rely on the willingness of regulators to use their 
authorities more effectively and aggressively.''
    My questions may be difficult, but please answer the 
following:
    If this lack of action is a persistent problem among the 
regulators, to what extent will changing the structure of our 
regulatory system really get at the issue?

A.1.a. It is unclear whether a change in the U.S. regulatory 
structure would have made a difference in mitigating the 
outcomes of this crisis. Countries that rely on a single 
financial regulatory body are experiencing the same financial 
stress the U.S. is facing now. Therefore, it is not certain 
that a single powerful federal regulator would have acted 
aggressively to restrain risk taking during the years leading 
up to the crisis.
    For this reason, the reform of the regulatory structure 
also should include the creation of a systemic risk council 
(SRC) to address issues that pose risks to the broader 
financial system. The SRC would be responsible for identifying 
institutions, practices, and markets that create potential 
systemic risks, implementing actions to address those risks, 
ensuring effective information flow, completing analyses and 
making recommendations on potential systemic risks, setting 
capital and other standards and ensuring that the key 
supervisors with responsibility for direct supervision apply 
those standards. The macro-prudential oversight of system-wide 
risks requires the integration of insights from a number of 
different regulatory perspectives--banks, securities firms, 
holding companies, and perhaps others. Only through these 
differing perspectives can there be a holistic view of 
developing risks to our system.
    In the long run it is important to develop a ``fail-safe'' 
system where the failure of any one large institution will not 
cause the financial system to break down-that is, a system 
where firms are not systemically large and are not too-big-to 
fail. In order to move in this direction, we need to create 
incentives that limit the size and complexity of institutions 
whose failure would otherwise pose a systemic risk.
    Finally, a key element to address systemic risk is the 
establishment of a legal mechanism for quick and orderly 
resolution of these institutions similar to what we use for 
FDIC insured banks. The purpose of the resolution authority 
should not be to prop up a failed entity indefinitely or to 
insure all liabilities, but to permit a timely and orderly 
resolution and the absorption of assets by the private sector 
as quickly as possible. Done correctly, the effect of the 
resolution authority will be to increase market discipline and 
protect taxpayers.

Q.1.b. Along with changing the regulatory structure, how can 
Congress best ensure that regulators have clear 
responsibilities and authorities, and that they are accountable 
for exercising them ``effectively and aggressively''?

A.1.b. History shows that banking supervisors are reluctant to 
impose wholesale restrictions on bank behavior when banks are 
making substantial profits. Regulatory reactions to safety and 
soundness risks are often delayed until actual bank losses 
emerge from the practices at issue. While financial theory 
suggests that above average profits are a signal that banks 
have been taking above average risk, bankers often argue 
otherwise and regulators are all too often reluctant to 
prohibit profitable activities, especially if the activities 
are widespread in the banking system and do not have a history 
of generating losses. Supervision and regulation must become 
more proactive and supervisors must develop the capacity to 
intervene before significant losses are realized.
    In order to encourage proactive supervision, Congress could 
require semi-annual hearings in which the various regulatory 
agencies are required to: (1) report on the condition of their 
supervised institutions; (2) comment on the sustainability of 
the most profitable business lines of their regulated entities; 
(3) outline emerging issues that may engender safety and 
soundness concerns within the next three years; (4) discuss 
specific weaknesses or gaps in regulatory authorities that are 
a source of regulatory concern and, when appropriate, propose 
legislation to attenuate safety and soundness issues. This 
requirement for semi-annual testimony on the state of regulated 
financial institutions is similar in concept to the Humphrey-
Hawkins testimony requirement on Federal Reserve Board monetary 
policy.

Q.2.a. How do we overcome the problem that in the boom times no 
one wants to be the one stepping in to tell firms they have to 
limit their concentrations of risk or not trade certain risky 
products?
    What thought has been put into overcoming this problem for 
regulators overseeing the firms?

A.2.a. During good times and bad, regulators must strike a 
balance between encouraging prudent innovation and strong bank 
supervision. Without stifling innovation, we need to ensure 
that banks engage in new activities in a safe-and-sound manner 
and originate responsible loans using prudent underwriting 
standards and loan terms that borrowers can reasonably 
understand and have the capacity to repay.
    Going forward, the regulatory agencies should be more 
aggressive in good economic times to contain risk at 
institutions with high levels of credit concentrations, 
particularly in novel or untested loan products. Increased 
examination oversight of institutions exhibiting higher-risk 
characteristics is needed in an expanding economy, and 
regulators should have the staff expertise and resources to 
vigilantly conduct their work.

Q.2.b. Is this an issue that can be addressed through 
regulatory restructure efforts?

A.2.b. Reforming the existing regulatory structure will not 
directly solve the supervision of risk concentration issues 
going forward, but may play a role in focusing supervisory 
attention on areas of emerging risk. For example, a more 
focused regulatory approach that integrates the supervision of 
traditional banking operations with capital markets business 
lines supervised by a nonbanking regulatory agency will help to 
address risk across the entire banking company.

Q.3.a. As Mr. Tarullo and Mrs. Bair noted in their testimony, 
some financial institution failures emanated from institutions 
that were under federal regulation. While I agree that we need 
additional oversight over and information on unregulated 
financial institutions, I think we need to understand why so 
many regulated firms failed.
    Why is it the case that so many regulated entities failed, 
and many still remain struggling, if our regulators in fact 
stand as a safety net to rein in dangerous amounts of risk-
taking?

A.3.a. Since 2007, the failure of community banking 
institutions was caused in large part by deterioration in the 
real estate market which led to credit losses and a rapid 
decline in capital positions. The causes of such failures are 
consistent with our receivership experience in past crises, and 
some level of failures is not totally unexpected with the 
downturn in the economic cycle. We believe the regulatory 
environment in the U.S. and the implementation of federal 
financial stability programs has actually prevented more 
failures from occurring and will assist weakened banks in 
ultimately recovering from current conditions. Nevertheless, 
the bank regulatory agencies should have been more aggressive 
earlier in this decade in dealing with institutions with 
outsized real estate loan concentrations and exposures to 
certain financial products.
    For the larger institutions that failed, unprecedented 
changes in market liquidity had a significant negative effect 
on their ability to fund day-to-day operations as the 
securitization and inter-bank lending markets froze. The 
rapidity of these liquidity related failures was without 
precedent and will require a more robust regulatory focus on 
large bank liquidity going forward.

Q.3.b. While we know that certain hedge funds, for example, 
have failed, have any of them contributed to systemic risk?

A.3.b. Although hedge funds are not regulated by the FDIC, they 
can comprise large asset pools, are in many cases highly 
leveraged, and are not subject to registration or reporting 
requirements. The opacity of these entities can fuel market 
concern and uncertainty about their activities. In times of 
stress these entities are subject to heightened redemption 
requests, requiring them to sell assets into distressed markets 
and compounding downward pressure on asset values.

Q.3.c. Given that some of the federal banking regulators have 
examiners on-site at banks, how did they not identify some of 
these problems we are facing today?

A.3.c. As stated above, the bank regulatory agencies should 
have been more aggressive earlier in this decade in dealing 
with institutions with outsized real estate loan concentrations 
and exposures to certain financial products. Although the 
federal banking agencies identified concentrations of risk and 
a relaxation of underwriting standards through the supervisory 
process, we could have been more aggressive in our regulatory 
response to limiting banks' risk exposures.

Q.4.a. From your perspective, how dangerous is the ``too big to 
fail'' doctrine and how might it be addressed?
    Is it correct that deposit limits have been in place to 
avoid monopolies and limit risk concentration for banks?

A.4.a. While there is no formal ``too big to fail'' (TBTF) 
doctrine, some financial institutions have proven to be too 
large to be resolved within our traditional resolution 
framework. Many argued that creating very large financial 
institutions that could take advantage of modem risk management 
techniques and product and geographic diversification would 
generate high enough returns to assure the solvency of the 
firm, even in the face of large losses. The events of the past 
year have convincingly proven that this assumption was 
incorrect and is why the FDIC has recommended the establishment 
of resolution authority to handle the failure of large 
financial firms. There are three key elements to addressing the 
problem of systemic risk and too big to fail.
    First, financial firms that pose systemic risks should be 
subject to regulatory and economic incentives that require 
these institutions to hold larger capital and liquidity buffers 
to mirror the heightened risk they pose to the financial 
system. In addition, restrictions on leverage and the 
imposition of risk-based assessments on institutions and their 
activities would act as disincentives to the types of growth 
and complexity that raise systemic concerns.
    The second important element in addressing too big to fail 
is an enhanced structure for the supervision of systemically 
important institutions. This structure should include both the 
direct supervision of systemically significant financial firms 
and the oversight of developing risks that may pose risks to 
the overall U.S. financial system. Centralizing the 
responsibility for supervising these institutions in a single 
systemic risk regulator would bring clarity and accountability 
to the efforts needed to identify and mitigate the buildup of 
risk at individual institutions. In addition, a systemic risk 
council could be created to address issues that pose risks to 
the broader financial system by identifying cross-cutting 
practices, and products that create potential systemic risks.
    The third element to address systemic risk is the 
establishment of a legal mechanism for quick and orderly 
resolution of these institutions similar to what we use for 
FDIC insured banks. The purpose of the resolution authority 
should not be to prop up a failed entity indefinitely or to 
insure all liabilities, but to permit a timely and orderly 
resolution and the absorption of assets by the private sector 
as quickly as possible. Done correctly, the effect of the 
resolution authority will be to increase market discipline and 
protect taxpayers.
    With regard to statutory limits on deposits, there is a 10 
percent nationwide cap on domestic deposits imposed in the 
Riegle-Neal Interstate Banking and Branching Efficiency Act of 
1994. While this regulatory limitation has been somewhat 
effective in preventing concentration in the U.S. system, the 
Riegle-Neal constraints have some significant limitations. 
First, these limits only apply to interstate bank mergers. 
Also, deposits in savings and loan institutions generally are 
not counted against legal limits. In addition, the law 
restricts only domestic deposit concentration and is silent on 
asset concentration, risk concentration or product 
concentration. The four largest banking organizations have 
slightly less than 35 percent of the domestic deposit market, 
but have over 45 percent of total industry assets. As we have 
seen, even with these deposit limits, banking organizations 
have become so large and interconnected that the failure of 
even one can threaten the financial system.

Q.4.b. Might it be the case that for financial institutions 
that fund themselves less by deposits and more by capital 
markets activities that they should be subject to concentration 
limits in certain activities? Would this potentially address 
the problem of too big to fail?

A.4.b. A key element in addressing TBTF would be legislative 
and regulatory initiatives that are designed to force firms to 
internalize the costs of government safety-net benefits and 
other potential costs to society. Firms should face additional 
capital charges based on both size and complexity, higher 
deposit insurance related premiums or systemic risk surcharges, 
and be subject to tighter Prompt Corrective Action (PCA) limits 
under U.S. laws.
    In addition, we need to end investors' perception that TBTF 
continues to exist. This can only be accomplished by convincing 
the institutions (their management, their shareholders, and 
their creditors) that they are at risk of loss should the 
institution become insolvent. Although limiting concentrations 
of risky activities might lower the risk of insolvency, it 
would not change the presumption that a government bailout 
would be forthcoming to protect creditors from losses in a 
bankruptcy proceeding.
    An urgent priority in addressing the TBTF problem is the 
establishment of a special resolution regime for nonbank 
financial institutions and for financial and bank holding 
companies--with powers similar to those given to the FDIC for 
resolving insured depository institutions. The FDIC's authority 
to act as receiver and to set up a bridge bank to maintain key 
functions and sell assets as market conditions allow offers a 
good model for such a regime. A temporary bridge bank allows 
the government time to prevent a disorderly collapse by 
preserving systemically critical functions. It also enables 
losses to be imposed on market players who should appropriately 
bear the risk.

Q.5. It appears that there were major problems with these risk 
management systems, as I heard in GAO testimony at my 
subcommittee hearing on March 18, 2009, so what gave the Fed 
the impression that the models were ready enough to be the 
primary measure for bank capital?

A.5. Throughout the development and implementation of Basel II, 
large U.S. commercial and investment banks touted their 
sophisticated systems for measuring and managing risks, and 
urged regulators to align regulatory capital requirements with 
banks' own risk measurements. The FDIC consistently expressed 
concerns that the U.S. and international regulatory communities 
collectively were putting too much reliance on financial 
institutions' representations about the quality of their risk 
measurement and management systems.

Q.6. Moreover, how can the regulators know what ``adequately 
capitalized'' means if regulators rely on models that we now 
know had material problems?

A.6. The FDIC has had long-standing concerns with Basel II's 
reliance on model-based capital standards. If Basel II had been 
implemented prior to the recent financial crisis, we believe 
capital requirements at large institutions would have been far 
lower going into the crisis and our financial system would have 
been worse off as a result. Regulators are working 
internationally to address some weaknesses in the Basel II 
capital standards and the Basel Committee has announced its 
intention to develop a supplementary capital requirement to 
complement the risk based requirements.

Q.7. Can you tell us what main changes need to be made in the 
Basel II framework so that it effectively calculates risk? 
Should it be used in conjunction with a leverage ratio of some 
kind?

A.7. The Basel II framework provides a far too pro-cyclical 
capital approach. It is now clear that the risk mitigation 
benefits of modeling, diversification and risk management were 
overestimated when Basel II was designed to set minimum 
regulatory capital requirements for large, complex financial 
institutions. Capital must be a solid buffer against unexpected 
losses, while modeling by its very nature tends to reflect 
expectations of losses looking back over relatively recent 
experience.

    The risk-based approach to capital adequacy in the 
        Basel II framework should be supplemented with an 
        international leverage ratio. Regulators should judge 
        the capital adequacy of banks by applying a leverage 
        ratio that takes into account off-balance-sheet assets 
        and conduits as if these risks were on-balance-sheet.

    Institutions should be required to hold more 
        capital through the cycle and we should require better 
        quality capital. Risk-based capital requirements should 
        not fall so dramatically during economic expansions 
        only to increase rapidly during a downturn.

    The Basel Committee is working on both of these concepts as 
well as undertaking a number of initiatives to improve the 
quality and level of capital. That being said, however, the 
Committee and the U.S. banking agencies do not intend to 
increase capital requirements in the midst of the current 
crisis. The plan is to develop proposals and implement these 
when the time is right, so that the banking system will have a 
capital base that is more robust in future times of stress.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                      FROM SHEILA C. BAIR

Q.1. The convergence of financial services providers and 
financial products has increased over the past decade. 
Financial products and companies may have insurance, banking, 
securities, and futures components. One example of this 
convergence is AIG. Is the creation of a systemic risk 
regulator the best method to fill in the gaps and weaknesses 
that AIG has exposed, or does Congress need to reevaluate the 
weaknesses of federal and state functional regulation for 
large, interconnected, and large firms like AIG?

A.1. The activities that caused distress for AIG were primarily 
those related to its credit default swap (CDS) and securities 
lending businesses. The issue of lack of regulation of the 
credit derivatives market had been debated extensively in 
policy circles since the late 1990s. The recommendations 
contained in the 1999 study by the President's Working Group on 
Financial Markets, ``Over-the-Counter Derivatives Markets and 
the Commodity Exchange Act,'' were largely adopted in the 
Commodity Futures Modernization Act of 2000, where credit 
derivatives contracts were exempted from CFTC and SEC 
regulations other than those related to SEC antifraud 
provisions. As a consequence of the exclusions and environment 
created by these legislative changes, there were no major 
coordinated U.S. regulatory efforts undertaken to monitor CDS 
trading and exposure concentrations outside of the safety and 
soundness monitoring that was undertaken on an intuitional 
level by the primary or holding company supervisory 
authorities.
    AIG chartered AIG Federal Savings Bank in 1999, an OTS 
supervised institution. In order to meet European Union (EU) 
Directives that require all financial institutions operating in 
the EU to be subject to consolidated supervision, the OTS 
became AIG's consolidated supervisor and was recognized as such 
by the Bank of France on February 23, 2007 (the Bank of France 
is the EU supervisor with oversight responsibility for AIG's EU 
operations). In its capacity as consolidated supervisor of AIG, 
the OTS had the authority and responsibility to evaluate AIG's 
CDS and securities lending businesses. Even though the OTS had 
supervisory responsibility for AIG's consolidated operations, 
the OTS was not organized or staffed in a manner that provided 
the resources necessary to evaluate the risks underwritten by 
AIG.
    The supervision of AIG demonstrates that reliance solely on 
the supervision of these institutions is not enough. We also 
need a ``fail-safe'' system where if any one large institution 
fails, the system carries on without breaking down. Financial 
firms that pose systemic risks should be subject to regulatory 
and economic incentives that require these institutions to hold 
larger capital and liquidity buffers to mirror the heightened 
risk they pose to the financial system. In addition, 
restrictions on leverage and the imposition of risk-based 
premiums on institutions and their activities would act as 
disincentives to growth and complexity that raise systemic 
concerns.
    In addition to establishing disincentives to unchecked 
growth and increased complexity of institutions, two additional 
fundamental approaches could reduce the likelihood that an 
institution will be too big to fail. One action is to create or 
designate a supervisory framework for regulating systemic risk. 
Another critical aspect to ending too big to fail is to 
establish a comprehensive resolution authority for systemically 
significant financial companies that makes the failure of any 
systemically important institution both credible and feasible.

Q.2. Recently there have been several proposals to consider for 
financial services conglomerates. One approach would be to move 
away from functional regulation to some type of single 
consolidated regulator like the Financial Services Authority 
model. Another approach is to follow the Group of 30 Report 
which attempts to modernize functional regulation and limit 
activities to address gaps and weaknesses. An in-between 
approach would be to move to an objectives-based regulation 
system suggested in the Treasury Blueprint. What are some of 
the pluses and minuses of these three approaches?

A.2. Financial firms that pose systemic risks should be subject 
to regulatory and economic incentives that require these 
institutions to hold larger capital and liquidity buffers to 
mirror the heightened risk they pose to the financial system. 
In addition, the supervisory structure should include both the 
direct supervision of systemically significant financial firms 
and the oversight of developing risks that may pose risks to 
the overall U.S. financial system. Effective institution 
specific supervision is needed by functional regulators focused 
on safety and soundness as well as consumer protection. 
Finally, there should be a legal mechanism for quick and 
orderly resolution of these institutions similar to what we use 
for FDIC insured banks.
    Whatever the approach to regulation and supervision, any 
system must be designed to facilitate coordination and 
communication among supervisory agencies and the relevant 
safety-net participants.
    In response to your question:
    Single Consolidated Regulator. This approach regulates and 
supervises a total financial organization. It designates a 
single supervisor to examine all of an organization's 
operations. Ideally, it must appreciate how the integrated 
organization works and bring a unified regulatory focus to the 
financial organization. The supervisor can evaluate risk across 
product lines and assess the adequacy of capital and 
operational systems that support the organization as a whole. 
Integrated supervisory and enforcement actions can be taken, 
which will allow supervisors to address problems affecting 
several different product lines. If there is a single 
consolidated regulator, the potential for overlap and 
duplication of supervision and regulation is reduced with fewer 
burdens for the organization and less opportunity for 
regulatory arbitrage. By centralizing supervisory authority 
over all subsidiaries and affiliates that comprise a financial 
organization, the single consolidated regulator model should 
increase regulatory and supervisory efficiency (for example 
through economies of scale) and accountability.
    With regard to disadvantages, a financial system 
characterized by a handful of giant institutions with global 
reach and a single regulator is making a huge bet that those 
few banks and their regulator over a long period of time will 
always make the right decisions at the right time. Another 
disadvantage is the potential for an unwieldy structure and a 
very cumbersome and bureaucratic organization. It may work best 
in financial systems with few financial organizations. 
Especially in larger systems, it may create the risk of a 
single point of regulatory failure.
    The U.S. has consolidated supervision, but individual 
components of financial conglomerates are supervised by more 
than one supervisor. For example, the Federal Reserve functions 
as the consolidated supervisor for bank holding companies, but 
in most cases it does not supervise the activities of the 
primary depository institutions. Similarly, the Securities and 
Exchange was the consolidated supervisor for many 
internationally active investment banking groups, but these 
institutions often included depository institutions that were 
regulated by a banking supervisor.
    Functional Regulation. Functional regulation and 
supervision applies a common set of rules to a line of business 
or product irrespective of the type of institution involved. It 
is designed to level the playing field among financial firms by 
eliminating the problem of having different regulators govern 
equivalent products and services. It may, however, artificially 
divide a firm's operations into departments by type of 
financial activity or product. By separating the regulation of 
the products and services and assigning different regulators to 
supervise them, absent a consolidated supervisor, no functional 
supervisor has an overall picture of the firm's operations and 
how those operations may affect the safety and soundness of the 
individual pieces. To be successful, this approach requires 
close coordination among the relevant supervisors. Even then, 
it is unclear how these alternative functional supervisors can 
be organized to efficiently focus on the overall safety and 
soundness of the enterprise.
    Functional regulation may be the most effective means of 
supervising highly sophisticated and emerging aspects of 
finance that are best reviewed by teams of examiners 
specializing in such technical areas
    Objectives-Based Regulation. This approach attempts to 
gamer the benefits of the single consolidated regulator 
approach, but with a realization that the efficacy of safety-
and-soundness regulation and supervision may benefit if it is 
separated from consumer protection supervision and regulation. 
This regulatory model maintains a system of multiple 
supervisors, each specializing in the regulation of a 
particular objective-typically safety and soundness and 
consumer protection (there can be other objectives as well). 
The model is designed to bring uniform regulation to firms 
engaged in the same activities by regulating the entire entity. 
Arguments have been put forth that this model may be more 
adaptable to innovation and technological advance than 
functional regulation because it does not focus on a particular 
product or service. It also may not be as unwieldy as the 
consolidated regulator model in large financial systems. It 
may, however, produce a certain amount of duplication and 
overlap or could lead to regulatory voids since multiple 
regulators are involved.
    Another approach to organize a system-wide regulatory 
monitoring effort is through the creation of a systemic risk 
council (SRC) to address issues that pose risks to the broader 
financial system. Based on the key roles that they currently 
play in determining and addressing systemic risk, positions on 
this council should be held by the U.S. Treasury, the FDIC, the 
Federal Reserve Board, and the Securities and Exchange 
Commission. It may be appropriate to add other prudential 
supervisors as well.
    The SRC would be responsible for identifying institutions, 
practices, and markets that create potential systemic risks, 
implementing actions to address those risks, ensuring effective 
information flow, completing analyses and making 
recommendations on potential systemic risks, setting capital 
and other standards, and ensuring that the key supervisors with 
responsibility for direct supervision apply those standards. 
The standards would be designed to provide incentives to reduce 
or eliminate potential systemic risks created by the size or 
complexity of individual entities, concentrations of risk or 
market practices, and other interconnections between entities 
and markets.
    The SRC could take a more macro perspective and have the 
authority to overrule or force actions on behalf of other 
regulatory entities. In order to monitor risk in the financial 
system, the SRC also should have the authority to demand better 
information from systemically important entities and to ensure 
that information is shared more readily.
    The creation of comprehensive systemic risk regulatory 
regime will not be a panacea. Regulation can only accomplish so 
much. Once the government formally establishes a systemic risk 
regulatory regime, market participants may assume that the 
likelihood of systemic events will be diminished. Market 
participants may incorrectly discount the possibility of 
sector-wide disturbances and avoid expending private resources 
to safeguard their capital positions. They also may arrive at 
distorted valuations in part because they assume (correctly or 
incorrectly) that the regulatory regime will reduce the 
probability of sector-wide losses or other extreme events.
    To truly address the risks posed by systemically important 
institutions, it will be necessary to utilize mechanisms that 
once again impose market discipline on these institutions and 
their activities. For this reason, improvements in the 
supervision of systemically important entities must be coupled 
with disincentives for growth and complexity, as well as a 
credible and efficient structure that permits the resolutions 
of these entities if they fail while protecting taxpayers from 
exposure.

Q.3. If there are institutions that are too big to fail, how do 
we identify that? How do we define the circumstance where a 
single company is so systemically significant to the rest of 
our financial circumstances and our economy that we must not 
allow it to fail?

A.3. At present, the federal banking regulatory agencies likely 
have the best information regarding which large, complex, 
financial organizations (LCFO) would be ``systemically 
significant'' institutions if they were in danger of failing. 
Whether an institution is systemically important, however, 
would depend on a number of factors, including economic 
conditions. For example, if markets are functioning normally, a 
large institution could fail without systemic repercussions. 
Alternatively, in times of severe financial sector distress, 
much smaller institutions might well be judged to be systemic. 
Ultimately, identification of what is systemic will have to be 
decided within the structure created for systemic risk 
regulation.
    Even if we could identify the ``too big to fail'' (TBTF) 
institutions, it is unclear that it would be prudent to 
publicly identify the institutions or fully disclose the 
characteristics that identify an institution as systemic. 
Designating a specific firm as TBTF would have a number of 
undesirable consequences: market discipline would be fully 
suppressed and the firm would have a competitive advantage in 
raising capital and funds. Absent some form of regulatory cost 
associated with systemic status, the advantages conveyed by 
such status create incentives for other firms to seek TBTF 
status--a result that would be counterproductive.
    Identifying TBTF institutions, therefore, must be 
accompanied by legislative and regulatory initiatives that are 
designed to force TBTF firms to internalize the costs of 
government safety-net benefits and other potential costs to 
society. TBTF firms should face additional capital charges 
based on both size and complexity, higher deposit insurance 
related premiums or systemic risk surcharges, and be subject to 
tighter Prompt Corrective Action (PCA) limits under U.S. laws.

Q.4. We need to have a better idea of what this notion of too 
big to fail is--what it means in different aspects of our 
industry and what our proper response to it should be. How 
should the federal government approach large, multinational and 
systemically significant companies?

A.4. ``Too-Big-To-Fail'' implies that an organization is of 
such importance to the financial system that its failure will 
impose widespread costs on the economy and the financial system 
either by causing the failure of other linked financial 
institutions or by seriously disrupting intermediation in 
banking and financial markets. In such cases, the failure of 
the organization has potential spillover effects that could 
lead to widespread depositor runs, impair public confidence in 
the broader financial system, or cause serious disruptions in 
domestic and international payment and settlement systems that 
would in turn have negative and long lasting implications for 
economic growth.
    Although TBTF is generally associated with the absolute 
size of an organization, it is not just a function of size, but 
also of the complexity of the organization and its position in 
national and international markets (market share). Systemic 
risk may also arise when organizations pose a significant 
amount of counterparty risk (for example, through derivative 
market exposures of direct guarantees) or when there is risk of 
important contagion effects when the failure of one institution 
is interpreted as a negative signal to the market about the 
condition of many other institutions.
    As described above, a financial system characterized by a 
handful of giant institutions with global reach and a single 
regulator is making a huge bet that those few banks and their 
regulator over a long period of time will always make the right 
decisions at the right time. There are three key elements to 
addressing the problem of too big to fail.
    First, financial firms that pose systemic risks should be 
subject to regulatory and economic incentives that require 
these institutions to hold larger capital and liquidity buffers 
to mirror the heightened risk they pose to the financial 
system. In addition, restrictions on leverage and the 
imposition of risk-based assessments on institutions and their 
activities would act as disincentives to the types of growth 
and complexity that raise systemic concerns.
    The second important element in addressing too big to fail 
is an enhanced structure for the supervision of systemically 
important institutions. This structure should include both the 
direct supervision of systemically significant financial firms 
and the oversight of developing risks that may pose risks to 
the overall U.S. financial system. Centralizing the 
responsibility for supervising these institutions in a single 
systemic risk regulator would bring clarity and accountability 
to the efforts needed to identify and mitigate the buildup of 
risk at individual institutions. In addition, a systemic risk 
council could be created to address issues that pose risks to 
the broader financial system by identifying cross-cutting 
practices, and products that create potential systemic risks.
    The third element to address systemic risk is the 
establishment of a legal mechanism for quick and orderly 
resolution of these institutions similar to what we use for 
FDIC insured banks. The purpose of the resolution authority 
should not be to prop up a failed entity indefinitely or to 
insure all liabilities, but to permit a timely and orderly 
resolution and the absorption of assets by the private sector 
as quickly as possible. Done correctly, the effect of the 
resolution authority will be to increase market discipline and 
protect taxpayers.

Q.5. What does ``fail'' mean? In the context of AIG, we are 
talking about whether we should have allowed an orderly Chapter 
11 bankruptcy proceeding to proceed. Is that failure?

A.5. A firm fails when it becomes insolvent; the value of its 
assets is less than the value of its liabilities or when its 
regulatory capital falls below required regulatory minimum 
values. Alternatively, a firm can fail when it has insufficient 
liquidity to meet its payment obligations which may include 
required payments on liabilities or required transfers of cash-
equivalent instruments to meet collateral obligations.
    According to the above definition, AIG's initial liquidity 
crisis qualifies it as a failure. AIG's need for cash arose as 
a result of increases in required collateral obligations 
triggered by a ratings downgrade, increases in the market value 
of the CDS protection AIG sold, and by mass redemptions by 
counterparties in securities lending agreements where borrowers 
returned securities and demand their cash collateral. At the 
same time, AIG was unable to raise capital or renew commercial 
paper financing to meet increased need for cash.
    Subsequent events suggest that AIG's problems extended 
beyond a liquidity crisis to insolvency. Large losses AIG has 
experienced depleted much of its capital. For instance, AIG 
reported a net loss in the fourth quarter 2008 of $61.7 billion 
bringing its net loss for the full year (2008) to $99.3 
billion. Without government support, which is in excess of $180 
billion, AIG would be insolvent and a bankruptcy filing would 
have been unavoidable.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
                      FROM SHEILA C. BAIR

Q.1. Two approaches to systemic risk seem to be identified, (1) 
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to 
fail'' or ``too systemically important to fail'' or (2) impose 
an additional regulator and additional rules and market 
discipline on institutions that are considered systemically 
important.
    Which approach do you endorse? If you support approach one 
how you would limit institution size and how would you identify 
new areas creating systemic importance?
    If you support approach two how would you identify 
systemically important institutions and what new regulations 
and market discipline would you recommend?

A.1. There are three key elements to addressing the problem of 
systemic risk and too big to fail.
    First, financial firms that pose systemic risks should be 
subject to regulatory and economic incentives that require 
these institutions to hold larger capital and liquidity buffers 
to mirror the heightened risk they pose to the financial 
system. In addition, restrictions on leverage and the 
imposition of risk-based assessments on institutions and their 
activities would act as disincentives to the types of growth 
and complexity that raise systemic concerns.
    The second important element in addressing too big to fail 
is an enhanced structure for the supervision of systemically 
important institutions. This structure should include both the 
direct supervision of systemically significant financial firms 
and the oversight of developing risks that may pose risks to 
the overall U.S. financial system. Centralizing the 
responsibility for supervising these institutions in a single 
systemic risk regulator would bring clarity and accountability 
to the efforts needed to identify and mitigate the buildup of 
risk at individual institutions. In addition, a systemic risk 
council could be created to address issues that pose risks to 
the broader financial system by identifying cross-cutting 
practices, and products that create potential systemic risks. 
Based on the key roles that they currently play in determining 
and addressing systemic risk, positions on this council should 
be held by the U.S. Treasury, the FDIC, the Federal Reserve 
Board, and the Securities and Exchange Commission. It may be 
appropriate to add other prudential supervisors as well.
    The creation of comprehensive systemic risk regulatory 
regime will not be a panacea. Regulation can only accomplish so 
much. Once the government formally establishes a systemic risk 
regulatory regime, market participants may assume that the 
likelihood of systemic events will be diminished. Market 
participants may incorrectly discount the possibility of 
sector-wide disturbances and avoid expending private resources 
to safeguard their capital positions. They also may arrive at 
distorted valuations in part because they assume (correctly or 
incorrectly) that the regulatory regime will reduce the 
probability of sector-wide losses or other extreme events.
    To truly address the risks posed by systemically important 
institutions, it will be necessary to utilize mechanisms that 
once again impose market discipline on these institutions and 
their activities. This leads to the third element to address 
systemic risk--the establishment of a legal mechanism for quick 
and orderly resolution of these institutions similar to what we 
use for FDIC insured banks. The purpose of the resolution 
authority should not be to prop up a failed entity indefinitely 
or to insure all liabilities, but to permit a timely and 
orderly resolution and the absorption of assets by the private 
sector as quickly as possible. Done correctly, the effect of 
the resolution authority will be to increase market discipline 
and protect taxpayers.

Q.2. Please identify all regulatory or legal barriers to the 
comprehensive sharing of information among regulators including 
insurance regulators, banking regulators, and investment 
banking regulators. Please share the steps that you are taking 
to improve the flow of communication among regulators within 
the current legislative environment.

A.2. Through the Federal Financial Institutions Examination 
Council (FFIEC), the federal and state bank regulatory agencies 
have adopted a number of information-sharing protocols and 
joint operational work streams to promote consistent 
information flow and reasonable access to supervisory 
activities among the agencies. The FFIEC's coordination efforts 
and joint examination process (when necessary) is an efficient 
means to conduct joint federal and state supervision efforts at 
banking organizations with multiple lines of business. The 
FFIEC initiates projects regularly to enhance our supervision 
processes, examination policies and procedures, examiner 
training, and outreach to the industry.
    The FFIEC collaboration process for bank supervision works 
well. However, for the larger and more complex institutions, 
the layering of insurance and securities/capital markets units 
on a traditional banking organization increases the complexity 
of the overall federal supervisory process. This complexity is 
most pronounced within the small universe of systemically 
important institutions which represent a concentration of risk 
to the FDIC's Deposit Insurance Fund. The banking regulators 
generally do not have jurisdiction over securities and 
insurance activities which are vested in the U.S. Securities 
and Exchange Commission (SEC) and the U.S. Commodity Futures 
Trading Commission (CFTC) for securities activities, and state 
insurance regulators for insurance operations.
    In some cases, large banking organizations have significant 
involvement in securities and capital markets-related 
activities supervised by the SEC. The FFIEC agencies do have 
information sharing protocols with the securities regulators 
and rely significantly on the SEC's examination findings when 
evaluating a company's overall financial condition. In fact, 
the FDIC has signed information-sharing agreements with the SEC 
as well as the state securities and insurance commissioners. 
Prospectively, it may be appropriate to integrate the 
securities regulators' activities more closely with the FFIEC's 
processes to enhance information sharing and joint supervisory 
analyses.
    Finally, as mentioned in the previous question, an 
additional way to improve information sharing would be through 
the creation of a systemic risk council (SRC) to address issues 
that pose risks to the broader financial system. The SRC would 
be responsible for identifying institutions, practices, and 
markets that create potential systemic risks, implementing 
actions to address those risks, ensuring effective information 
flow, completing analyses and making recommendations on 
potential systemic risks, setting capital and other standards 
and ensuring that the key supervisors with responsibility for 
direct supervision apply those standards. In order to monitor 
risk in the financial system, the SRC also should have the 
authority to demand better information from systemically 
important entities and to ensure that information is shared 
among regulators more readily.

Q.3. If Congress charged the FDIC with the responsibility for 
the ``special resolution regime'' that you discuss in your 
written testimony, what additional regulatory authorities would 
you need and what additional resources would you need to be 
successful? Can you describe the difference in treatment for 
the shareholders of Bear Sterns under the current situation 
verses the situation if the ``special resolution regime'' was 
already in place?

A.3. Additional Regulatory Authorities--Resolution authority 
for both (1) systemically significant financial companies and 
(2) nonsystemically significant depository institution holding 
companies, including:

    Powers and authorities similar to those provided in 
        the Federal Deposit Insurance Act for resolving failed 
        insured depository institutions;

    Funding mechanisms, including potential borrowing 
        from and repayment to the Treasury;

    Separation from bankruptcy proceedings for all 
        holding company affiliates, including those directly 
        controlling the IDI, when necessary to address the 
        interdependent enterprise carried out by the insured 
        depository institution and the remainder of the 
        organization; and

    Powers and authorities similar to those provided in 
        the Federal Deposit Insurance Act for assistance to 
        open entities in the case of systemically important 
        entities, conservatorships, bridge institutions, and 
        receiverships.

    Additional Resources--The FDIC seeks to rely on in-house 
expertise to the extent possible. Thus, for example, the FDIC's 
staff has experts in capital markets, including 
securitizations. When pertinent expertise is not readily 
available in-house, the FDIC contracts out to complement its 
resources. If the FDIC identifies a longer-term need for such 
expertise, it will bring the necessary expertise in-house.
    Difference in the Treatment for the Shareholders of Bear 
Stearns--With the variety of liquidation options now proposed, 
the FDIC would have had a number of tools at its disposal that 
would have enhanced its ability to effect an orderly resolution 
of Bear Stearns. In particular, the appointment of the FDIC as 
receiver would have essentially terminated the rights of the 
shareholders. Any recovery on their equity interests would be 
limited to whatever net proceeds of asset liquidations remained 
after the payment in full of all creditors. This prioritization 
of recovery can assist to establish greater market discipline.

Q.4. Your testimony recommends that ``any new plan ensure that 
consumer protection activities are aligned with other bank 
supervisory information, resources, and expertise, and that 
enforcement of consumer protection rules be left to bank 
regulators.''
    Can you please explain how the agency currently takes into 
account consumer complaints and how the agency reflects those 
complaints when investigating the safety and soundness of an 
institution? Do you feel that the FDIC has adequate information 
sharing between the consumer protection examiners and safety 
and soundness examiners? If not, what are your suggestions to 
increase the flow of information between the different types of 
examiners?

A.4. Consumer complaints can indicate potential safety-and-
soundness or consumer protection issues. Close cooperation 
among FDIC Consumer Affairs, compliance examination, and 
safety-and-soundness examination staff in the Field Office, 
Regional Office, and Washington Office is essential to 
addressing issues raised by consumer complaints and determining 
the appropriate course of action.
    Consumer complaints are received by the FDIC and financial 
institutions. Complaints against non FDIC-supervised 
institutions are forwarded to the appropriate primary 
regulator. The FDIC's Consumer Affairs staff receives the 
complaints directed to the FDIC and responds to and maintains 
files on these complaints. Consumer Affairs may request that 
examiners assist with a complaint investigation if an on-site 
review at a financial institution is deemed necessary.
    Consumer complaints received by the FDIC, as well as the 
complaints received by a financial institution (or by third 
party service providers), are reviewed by compliance examiners 
during the pre-examination planning phase of a compliance 
examination. In addition, information obtained from the 
financial institution pertaining to consumer-related 
litigation, investigations by other government entities, and 
any institution management reports on the type, frequency, and 
distribution of consumer complaints are also reviewed. 
Compliance examiners consider this information, along with 
other types of information about the institution's operations, 
when establishing the scope of a compliance examination, 
including issues to be investigated and regulatory areas to be 
assessed during the examination. During the on-site compliance 
examination, examiners review the institution's complaint 
response processes as part of a comprehensive evaluation of the 
institution's compliance management system.
    During risk management examinations, examiners will review 
information about consumer complaints and determine the 
potential for safety-and-soundness concerns. This, along with 
other types of information about the institution's operations, 
is used to determine the scope of a safety-and-soundness 
examination. Examples of complaints that may raise such 
concerns include allegations that the bank is extending poorly 
underwritten loans, a customer's account is being fraudulently 
manipulated, or insiders are receiving benefits not available 
to other bank customers. Where feasible, safety-and-soundness 
and compliance examinations may be conducted concurrently. At 
times, joint examination teams have been formed to evaluate and 
address risks at institutions offering complex products or 
services that prompted an elevated level of supervisory 
concern.
    Apart from examination-related activity, the Consumer 
Affairs staff forwards to regional management all consumer 
complaints that appear to raise safety-and-soundness concerns 
as quickly as possible. Regional management will confirm that a 
consumer complaint raises safety-and-soundness issues and 
determine the appropriate course of action to investigate the 
complaint under existing procedures and guidance. If the 
situation demonstrates safety-and-soundness issues, a Case 
Manager will assume responsibility for coordinating the 
investigation and, in certain situations, may prepare the 
FDIC's response to the complaint or advise the Consumer Affairs 
staff in their efforts to respond to the complaint. The Case 
Manager determines whether the complaint could be an indicator 
of a larger, more serious issue within the institution.
    Quarterly, the Consumer Affairs staff prepares a consumer 
complaint summary report from its Specialized Tracking and 
Reporting System for institutions identified on a regional 
office's listing of institutions that may generate a higher 
number of complaints. These types of institutions may include, 
but are not limited to, banks with composite ratings of ``4'' 
and ``5,'' subprime lenders, high loan-to-value lenders, 
consumer lenders, and credit card specialty institutions. This 
report provides summary data on the number and nature of 
consumer complaints received during the previous quarter. The 
Case Manager reviews the consumer complaint information for 
trends that may indicate a safety-and-soundness issue and 
documents the results of the review.
    We believe FDIC examination staff effectively communicates, 
coordinates, and collaborates. Safety-and-soundness and 
compliance examiners work in the same field offices, and 
therefore, the regular sharing of information is commonplace. 
To ensure that pertinent examination or other relevant 
information is shared between the two groups of examiners, 
field territories hold quarterly meetings where consumer 
protection/compliance and risk management issues are discussed. 
In addition, Relationship Managers, Case Managers, and Review 
Examiners in every region monitor institutions and facilitate 
communication about compliance and risk management issues and 
develop cohesive supervisory plans. Both compliance examination 
and risk management examination staff share the same senior 
management. Effective information sharing ensures the FDIC is 
consistent in its examination approach, and compliance and risk 
management staffs are working hand in hand.
    Although some suggest that an advantage of a separate 
agency for consumer protection would be its single-focus 
mission, this position may not acknowledge the reality of the 
interconnectedness of safety-and-soundness and consumer 
protection concerns, as well as the value of using existing 
expertise and examination infrastructure, noted above. Thus, 
even if such an agency only were tasked with rule-writing 
responsibilities, it would not be in a position to fully 
consider the safety-and-soundness dimensions of consumer 
protection issues. Moreover, if the agency also were charged 
with enforcing those rules, replicating the uniquely 
comprehensive examination and supervisory presence to which 
federally regulated financial institutions are currently 
subject would involve creating an extremely large new federal 
bureaucracy. Just providing enforcement authority, without 
examination or supervision, would simply duplicate the Federal 
Trade Commission.
    Placing consumer compliance examination activities in a 
separate organization, apart from other supervisory 
responsibilities, ultimately will limit the effectiveness of 
both programs. Over time, staff at both agencies would lose the 
expertise and understanding of how consumer protection and the 
safe and sound conduct of a financial institution's business 
operations interrelate.

Q.5. In your written testimony you state that ``failure to 
ensure that financial products were appropriate and sustainable 
for consumers has caused significant problems, not only for 
those consumers, but for the safety and soundness of financial 
institutions.'' Do you believe that there should be a 
suitability standard placed on lending institutions?

A.5. Certainly, as a variety of nontraditional mortgage 
products became widely available, a growing number of consumers 
began to receive mortgage loans that were unlikely to be 
affordable in the long term. This was a major precipitating 
factor in the current financial crisis.
    With regard to mortgage lending, lenders should apply an 
affordability standard to ensure that a borrower has the 
ability to repay the debt according to the terms of the 
contract. Loans should be affordable and sustainable over the 
long-term and should be underwritten to the fully indexed rate. 
Such a standard would also be valuable if applied across all 
credit products, including credit cards, and should help 
eliminate practices that do not provide financial benefits to 
consumers.
    However, an affordability standard will serve its intended 
purpose only if it is applied to all originators of home loans, 
including financial institutions, mortgage brokers, and other 
third parties.

Q.6. Deposit Insurance Question--Recently, the FDIC has asked 
Congress to increase their borrowing authority from the 
Treasury up to $100 billion, citing that this would be 
necessary in order avoid imposing significant increases in 
assessments on insured financial institutions. Currently, the 
FDIC provides rebates to depository financial institutions when 
the DIF reaches 1.5 percent. Given the increase in bank 
closings over the past 12 months, do you believe the rebate 
policy should be reviewed or eliminated? What do you think is 
an appropriate level for the insurance fund in order to protect 
depositors at the increased amount of $250,000?

A.6. While the Federal Deposit Insurance Reform Act of 2005 
provided the FDIC with greater flexibility to base insured 
institutions' assessments on risk, it restricted the growth of 
the DIF. Under the Reform Act, when the DIF reserve ratio is 
above 1.35 percent, the FDIC is required to dividend half of 
the amount in excess of the amount required to maintain the 
reserve ratio at 1.35 percent. In addition, when the DIF 
reserve ratio is above 1.50 percent, the FDIC is required to 
dividend all amounts above the amount required to maintain the 
reserve ratio at 1.5 percent. The result of these mandatory 
dividends is to effectively cap the size of the DIF and to 
limit the ability of the fund to grow in good times.
    A deposit insurance system should be structured with a 
counter-cyclical bias-that is, funds should be allowed to 
accumulate during strong economic conditions when deposit 
insurance losses may be low, as a cushion against future needs 
when economic circumstances may be less favorable and losses 
higher. However, the current restrictions on the size of the 
DIF limit the ability of the FDIC to rebuild the fund to levels 
that can offset the pro-cyclical effect of assessment increases 
during times of economic stress. Limits on the size of the DIF 
of this nature inevitably mean that the FDIC will have to 
charge higher premiums when economic conditions cause 
significant numbers of bank failures. As part of the 
consideration of broader regulatory restructuring, Congress may 
want to consider the impact of the mandatory rebate requirement 
or the possibility of providing for greater flexibility to 
permit the DIF to grow to levels in good times that will 
establish a sufficient cushion against losses in the event of 
an economic downturn.
    Although the process of weighing options against the 
backdrop of the current crisis is only starting, taking a look 
at what might have occurred had the DIF reserve ratio been 
higher at its onset may be instructive.
    The reserve ratio of the DIF declined from 1.22 percent as 
of December 31, 2007, to 0.36 percent as of December 31, 2008, 
a decrease of 86 basis points. If at the start of the current 
economic downturn the reserve ratio of the DIF had been 2.0 
percent, allowing for a similar 86 basis point decrease, the 
reserve ratio would have been 1.14 percent at the end of the 
first quarter of 2009. At that level, given the current 
economic climate and the desire to structure the deposit 
insurance system in a counter-cyclical manner, it is debatable 
whether the FDIC would have found either the special assessment 
or an immediate increase in deposit insurance premiums 
necessary.
    An increase in the deposit insurance level will increase 
total insured deposits. While increasing the coverage level to 
$250,000 will decrease the actual DIF reserve ratio (which is 
the ratio of the fund to estimated insured deposits), it will 
not necessarily change the appropriate reserve ratio. As noted 
in the response to the previous question, building reserve 
ratios to higher levels during good times may obviate the need 
for higher assessments during downturns.
                                ------                                


       RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
                      FROM SHEILA C. BAIR

Q.1. I have concerns about the recent decision by the Federal 
Deposit Insurance Corporation (FDIC) Board of Directors to 
impose a special assessment on insured institutions of 20 basis 
points, with the possibility of assessing an additional 10 
basis points at any time as may be determined by the Board.
    Since this decision was announced, I have heard from many 
Texas community bankers, who have advised me of the potential 
earnings and capital impact on their financial institutions, 
and more importantly, the resulting loss of funds necessary to 
lend to small business customers and consumers in Texas 
communities. It is estimated that assessments on Texas banks, 
if implemented as proposed, will remove nearly one billion 
dollars from available capital. When leveraged, this results in 
nearly eight to twelve billion dollars that will no longer be 
available for lending activity throughout Texas. At a time when 
responsible lending is critical to pulling our nation out of 
recession, this sort of reduction in local lending has the 
potential to extend our economic downturn.
    I understand you believe that any assessments on the 
banking industry may be reduced by roughly half, or 10 basis 
points, should Congress provide the FDIC an increase in its 
line of credit at the Department of Treasury from $30 billion 
to $100 billion. That is why I have signed on as a cosponsor of 
The Depositor Protection Act of 2009, which accomplishes that 
goal.
    However, my banking community informs me that even this 
modest proposed reduction in the special assessments will still 
disproportionately penalize community banks, the vast majority 
of which neither participated nor contributed to the 
irresponsible lending tactics that have led to the erosion of 
the FDIC deposit insurance fund (DIF).
    I understand that there are various alternatives to ensure 
the fiscal stability of the DIF without adversely affecting the 
community banking industry, such as imposing a systemic risk 
premium, basing assessments on assets with an adjustment for 
capital rather than total insured deposits, or allowing banks 
to amortize the expenses over several years.
    I respectfully request the following:

    Could you outline several proposals to improve the 
        soundness of the DIF while mitigating the negative 
        effects on the community banking industry?

    Could you outline whether the FDIC has the 
        authority to implement these policy proposals, or 
        whether the FDIC would need additional authorities?

    If additional authority is needed, from which 
        entity (i.e., Congress? Treasury?) Would the FDIC need 
        those additional authorities?

A.1. The FDIC realizes that assessments are a significant 
expense for the banking industry. For that reason, we continue 
to consider alternative ways to alleviate the pressure on the 
DIF. In the proposed rule on the special assessment (adopted in 
final on May 22, 2009), we specifically sought comment on 
whether the base for the special assessment should be total 
assets or some other measure that would impose a greater share 
of the special assessment on larger institutions. The Board 
also requested comment on whether the special assessment should 
take into account the assistance that has been provided to 
systemically important institutions. The final rule reduced the 
proposed special assessment to five basis points on each 
insured depository institutions assets, minus its Tier 1 
capital, as of June 30, 2009. The assessment is capped at 10 
basis points of an institution's domestic deposits so that no 
institution will pay an amount greater than they would have 
paid under the proposed interim rule.
    The FDIC has taken several other actions under its existing 
authority in an effort to alleviate the burden of the special 
assessment. On February 27, 2009, the Board of Directors 
finalized new risk-based rules to ensure that riskier 
institutions bear a greater share of the assessment burden. We 
also imposed a surcharge on guaranteed bank debt under the 
Temporary Liquidity Guarantee Program (TLGP) and will use the 
money raised by the surcharge to reduce the proposed special 
assessment.
    Several other steps to improve the soundness of the DIF 
would require congressional action. One such step would be for 
Congress to establish a statutory structure giving the FDIC the 
authority to resolve a failing or failed depository institution 
holding company (a bank holding company supervised by the 
Federal Reserve Board or a savings and loan holding company, 
including a mutual holding company, supervised by the Office of 
Thrift Supervision) with one or more subsidiary insured 
depository institutions that are failing or have failed.
    As the corporate structures of bank holding companies, 
their insured depository and other affiliates continue to 
become more complex, an insured depository institution is 
likely to be dependent on affiliates that are subsidiaries of 
its holding company for critical services, such as loan and 
deposit processing and loan servicing. Moreover, there are many 
cases in which the affiliates are dependent for their continued 
viability on the insured depository institution. Failure and 
the subsequent resolution of an insured depository institution 
whose key services are provided by affiliates present 
significant legal and operational challenges. The insured 
depository institutions' failure may force its holding company 
into bankruptcy and destabilize its subsidiaries that provide 
indispensable services to the insured depository institution. 
This phenomenon makes it extremely difficult for the FDIC to 
effectuate a resolution strategy that preserves the franchise 
value of the failed insured depository institution and protects 
the DIF. Bankruptcy proceedings, involving the parent or 
affiliate of an insured depository institution, are time-
consuming, unwieldy, and expensive. The threat of bankruptcy by 
the bank holding company or its affiliates is such that the 
Corporation may be forced to expend considerable sums propping 
up the bank holding company or entering into disadvantageous 
transactions with the bank holding company or its subsidiaries 
in order to proceed with an insured depository institution's 
resolution. The difficulties are particularly extreme where the 
Corporation has established a bridge depository institution to 
preserve franchise value, protect creditors (including 
uninsured depositors), and facilitate disposition of the failed 
institution's assets and liabilities.
    Certainty regarding the resolution of large, complex 
financial institutions would also help to build confidence in 
the strength of the DIF. Unlike the clearly defined and proven 
statutory powers that exist for resolving insured depository 
institutions, the current bankruptcy framework available to 
resolve large complex nonbank financial entities and financial 
holding companies was not designed to protect the stability of 
the financial system. Without a system that provides for the 
orderly resolution of activities outside of the depository 
institution, the failure of a systemically important holding 
company or nonbank financial entity will create additional 
instability. This problem could be ameliorated or cured if 
Congress provided the necessary authority to resolve a large, 
complex financial institution and to charge systemically 
important firms fees and assessments necessary to fund such a 
systemic resolution system.
    In addition, financial firms that pose systemic risks 
should be subject to regulatory and economic incentives that 
require these institutions to hold larger capital and liquidity 
buffers to mirror the heightened risk they pose to the 
financial system. Restrictions on leverage and the imposition 
of risk-based assessments on institutions and their activities 
also would act as disincentives to the types of growth and 
complexity that raise systemic concerns.

Q.2. I commend you for your tireless efforts in helping our 
banking system survive this difficult environment, and I look 
forward to working closely with you to arrive at solutions to 
support the community banking industry while ensuring the long-
term stability of the DIF to protect insured depositors against 
loss.
    Will each of you commit to do everything within your power 
to prevent performing loans from being called by lenders? 
Please outline the actions you plan to take.

A.2. The FDIC understands the tight credit conditions in the 
market and is engaged in a number of efforts to improve the 
current situation. Over the past year, we have issued guidance 
to the institutions we regulate to encourage banks to maintain 
the availability of credit. Moreover, our examiners have 
received specific instructions on properly applying this 
guidance to FDIC supervised institutions.
    On November 12, 2008, we joined the other federal banking 
agencies in issuing the Interagency Statement on Meeting the 
Needs of Creditworthy Borrowers (FDIC FIL-128-2008). This 
statement reinforces the FDIC's view that the continued 
origination and refinancing of loans to creditworthy borrowers 
is essential to the vitality of our domestic economy. The 
statement encourages banks to continue making loans in their 
markets, work with borrowers who may be encountering difficulty 
during this challenging period, and pursue initiatives such as 
loan modifications to prevent unnecessary foreclosures.
    In light of the present challenges facing banks and their 
customers, the FDIC hosted in March a roundtable discussion 
focusing on how regulators and financial institutions can work 
together to improve credit availability. Representatives from 
the banking industry were invited to share their concerns and 
insights with the federal bank regulators and representatives 
from state banking agencies. The attendees agreed that open, 
two-way communication between the regulators and the industry 
was vital to ensuring that safety and soundness considerations 
are well balanced with the critical need of providing credit to 
businesses and consumers.
    One of the important points that came out of the session 
was the need for ongoing dialog between bankers and their 
regulators as they work jointly toward a solution to the 
current financial crisis. Toward this end, the FDIC created a 
new senior level position to expand community bank outreach. In 
conjunction with this office, the FDIC plans to establish an 
advisory committee to address the unique concerns of this 
segment of the banking community.
    As part of our ongoing supervisory evaluation of banks that 
participate in federal financial stability programs, the FDIC 
also is taking into account how available capital is deployed 
to make responsible loans. It is necessary and prudent for 
banking organizations to track the use of the funds made 
available through federal programs and provide appropriate 
information about the use of these funds. On January 12, 2009, 
the FDIC issued a Financial Institution Letter titled 
Monitoring the Use of Funding from Federal Financial Stability 
and Guarantee Programs (FDIC FIL-1-2009), advising insured 
institutions that they should track their use of capital 
injections, liquidity support, and/or financing guarantees 
obtained through recent financial stability programs as part of 
a process for determining how these federal programs have 
improved the stability of the institution and contributed to 
lending to the community. Equally important to this process is 
providing this information to investors and the public. This 
Financial Institution Letter advises insured institutions to 
include information about their use of the funds in public 
reports, such as shareholder reports and financial statements.
    Internally at the FDIC, we have issued guidance to our bank 
examiners for evaluating participating banks' use of funds 
received through the TARP Capital Purchase Program and the 
Temporary Liquidity Guarantee Program, as well as the 
associated executive compensation restrictions mandated by the 
Emergency Economic Stabilization Act. Examination guidelines 
for the new Public-Private Investment Fund will be forthcoming. 
During examinations, our supervisory staff will be reviewing 
banks' efforts in these areas and will make comments as 
appropriate to bank management. We will review banks' internal 
metrics on the loan origination activity, as well as more broad 
data on loan balances in specific loan categories as reported 
in Call Reports and other published financial data. Our 
examiners also will be considering these issues when they 
assign CAMELS composite and component ratings. The FDIC will 
measure and assess participating institutions' success in 
deploying TARP capital and other financial support from various 
federal initiatives to ensure that funds are used in a manner 
consistent with the intent of Congress, namely to support 
lending to U.S. businesses and households.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                     FROM MICHAEL E. FRYZEL

Q.1. Consumer Protection Regulation--Some have advocated that 
consumer protection and prudential supervision should be 
divorced, and that a separate consumer protection regulation 
regime should be created. They state that one source of the 
financial crisis emanated from the lack of consumer protection 
in the underwriting of loans in the originate-to-distribute 
space.
    What are the merits of maintaining it in the same agency? 
Alternatively, what is the best argument each of you can make 
for a new consumer protection agency?

A.1. Credit unions occupy a very small space within the 
originate-to-distribute landscape. Less than 8 percent of the 
$250 billion in loans originated by credit unions in 2008 were 
sold in whole to another party. While selling loans has grown 
within the credit union industry, it remains a small portion of 
business, with most credit unions choosing to hold their loans 
in portfolio when possible. Additionally, the abuses of 
consumers seen in some areas have not manifested themselves 
within the credit union community.
    The originate-to-distribute model would seem to create an 
environment where the loan originator is less concerned about 
consumer protection and more concerned with volume and fee 
generation. The lender using this model may focus less on what 
is best for the borrower, as they will not be the entity 
retaining the liability should the borrower later default.
    Maintaining consumer protection with the same regulator who 
is responsible for prudential supervision adds economies of 
scale and improves efficiencies for completing the supervision 
of the institutions. This approach allows one regulator to 
possess all information and authority regarding the supervision 
of individual institutions. In the past, NCUA has performed 
consumer compliance examinations separate from safety and 
soundness examinations. However, in order to maximize economies 
of scales and allow examiners to possess all information 
regarding the institution, the separation of consumer 
compliance and safety and soundness examinations was 
discontinued. Some federal and state agencies currently perform 
those functions as two separate types of examination under one 
regulator.
    The oversight of consumer protection could be given to a 
separate regulatory agency. The agency would likely have broad 
authority over all financial institutions and affiliated 
parties. In theory, creating such an agency would allow safety 
and soundness examiners to focus on those particular risks. For 
those agencies without consumer compliance examiners, it would 
create an agency of subject matter experts to help ensure 
consumer protection laws are adhered to.

Q.2. Regulatory Gaps or Omissions--During a recent hearing, the 
Committee has heard about massive regulatory gaps in the 
system. These gaps allowed unscrupulous actors like AIG to 
exploit the lack of regulatory oversight. Some of the 
counterparties that AIG did business with were institutions 
under your supervision.
    Why didn't your risk management oversight of the AIG 
counterparties trigger further regulatory scrutiny? Was there a 
flawed assumption that AIG was adequately regulated, and 
therefore no further scrutiny was necessary?
    Was there dialogue between the banking regulators and the 
state insurance regulators? What about the SEC?
    If the credit default swap contracts at the heart of this 
problem had been traded on an exchange or cleared through a 
clearinghouse, with requirement for collateral and margin 
payments, what additional information would have been 
available? How would you have used it?

A.2. NCUA does not directly or indirectly regulate or oversee 
the operation of AIG. Therefore, we defer to the other 
regulatory bodies. Chartering and regulatory restrictions 
prevent federally chartered credit unions from investing in 
companies such as AIG. Federally chartered credit unions are 
generally limited to investing in government issued or 
guaranteed securities and cannot invest in the diverse range of 
higher yielding products, including commercial paper and 
corporate debt securities.

Q.3. Liquidity Management--A problem confronting many financial 
institutions currently experiencing distress is the need to 
roll-over short-term sources of funding. Essentially these 
banks are facing a shortage of liquidity. I believe this 
difficulty is inherent in any system that funds long-term 
assets, such as mortgages, with short-term funds. Basically the 
harm from a decline in liquidity is amplified by a bank's level 
of ``maturity-mismatch.''
    I would like to ask each of the witnesses, should 
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to 
do so?

A.3. Funding long-term, fixed-rate loans with short-term funds 
is a significant concern. The inherent risk in such balance 
sheet structuring is magnified with the increased probability 
that the United States may soon enter a period of inflation and 
rising rates on short-term funding sources. The effects of a 
rising interest rate environment when most funding sources have 
no maturity or a maturity of less than one year creates the 
potential for substantial narrowing of net interest margins 
moving forward.
    NCUA recently analyzed how credit union balance sheets have 
transformed over the last 10 years, especially in the larger 
institutions. Letter to Credit Unions 08-CU-20, Evaluating 
Current Risks to Credit Unions, examines the changing balance 
sheet risk profile. The Letter provides the industry words of 
caution as well as direction on addressing current risks. NCUA 
has also issued several other Letters to Credit Unions over the 
past several years regarding this very issue and has developed 
additional examiner tools for evaluating liquidity and interest 
rate risk.
    While there are various tools the industry uses for 
measuring interest rate and liquidity risk, the tools involve 
making many assumptions. The assumptions become more involved 
as balance sheets become more complex. Each significant 
assumption needs to be evaluated for reasonableness, with the 
underlying assumption not necessarily having been tested over 
time or over all foreseeable scenarios. The grey area in such 
analysis is significant. In our proposed regulatory changes for 
corporate credit unions, better matching of maturities of 
assets and liabilities will be regulated with concentration and 
sector limits as well as other controls.

Q.4. Too-Big-To-Fail--Chairman Bair stated in her written 
testimony that ``the most important challenge is to find ways 
to impose greater market discipline on systemically important 
institutions. The solution must involve, first and foremost, a 
legal mechanism for the orderly resolution of those 
institutions similar to that which exists for FDIC-insured 
banks. In short we need to end too big to fail. I would agree 
that we need to address the too-big-to-fail issue, both for 
banks and other financial institutions.''
    Could each of you tell us whether putting a new resolution 
regime in place would address this issue?

A.4. While the NCUA continues to recommend maintaining multiple 
financial regulators and charter options to enable the 
continued checks and balances such a structure produces, the 
agency also agrees with the need for establishing a regulatory 
oversight entity to help mitigate risk to the nation's 
financial system. Extending the reach of this entity beyond the 
federally regulated financial institutions may help impose 
market discipline on systemically important institutions. Care 
needs to be taken in deciding how to address the too-big-to-
fail issue. Overreaching could stifle financial innovation and 
actually cause more harm than good. At the same time, under 
reaching could provide inadequate resolution when it is needed 
most.
    The statutory construct of federal credit unions limits 
growth with membership restrictions, so no new initiatives are 
deemed necessary to address the ``too big to faily7is sue for 
credit unions. Federally insured credit unions hold $8 13.44 
billion in assets, while financial institutions insured by the 
FDIC hold $13.85 trillion in assets. Federally insured credit 
unions make up only 5.56 percent of all federally insured 
assets. \1\ Therefore, the credit union industry as a whole 
does not pose a systemic risk to the financial industry. 
However, federally insured credit unions serve a unique role in 
the financial industry by providing basic and affordable 
financial services to their members. In order to preserve this 
role, federally insured credit unions must maintain their 
independent regulator and insurer.
---------------------------------------------------------------------------
     \1\ Based on December 31, 2008, financial data.

Q.5. How would we be able to convince the market that these 
systemically important institutions would not be protected by 
---------------------------------------------------------------------------
taxpayer resources as they had been in the past?

A.5. It will be difficult to convince a market accustomed to 
seeing taxpayer bailouts of systemically important institutions 
that those institutions will no longer be protected by taxpayer 
resources. A regulatory oversight entity empowered to resolve 
institutions deemed systemically important would help impose 
greater market discipline. Given the recent and historical 
government intercession, consumers and the marketplace have 
become accustomed to and grown to expect financial assistance 
from the government. The greater the expectation for government 
to use taxpayer resources to resolve institutions the greater 
the moral hazard becomes. This could cause institutions to take 
greater levels of risk knowing they will not have to face the 
consequences.

Q.6. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank 
capital regulation. Some commentators have endorsed a concept 
requiring banks to hold more capital when good conditions 
prevail, and then allow banks to temporarily hold less capital 
in order not to restrict access to credit during a downturn. 
Advocates of this system believe that counter cyclical policies 
could reduce imbalances within financial markets and smooth the 
credit cycle itself.
    What do you see as the costs and benefits of adopting a 
more counter-cyclical system of regulation?

A.6. In managing the National Credit Union Share Insurance Fund 
(NCUSIF), the NCUA Board's Normal Operating Level policy 
considers the counter-cyclical impact when managing the Fund's 
equity level. During otherwise stable or prosperous economic 
periods, the Board may assess a premium, up to the statutory 
limits, to increase the Fund equity level, in order to avoid 
the need to charge premiums at the trough of the business 
cycle. In order to improve this system, NCUA would need the 
ability to charge premiums, during good times, above the 
current threshold (an equity level of 1.30).
    A more robust and flexible risk-based capital requirement 
for credit unions would improve counter-cyclical impact. 
Currently, NCUA does not have authority to allow overall 
capital levels to vary based on swings in the business cycle. 
Prompt Corrective Action (12 U.S.C. 1790d) establishes 
statutory minimum levels of capital which are not flexible.

Q.7. Do you see any circumstances under which your agencies 
would take a position on the merits of counter-cyclical 
regulatory policy?

A.7. NCUA will support efforts to improve counter-cyclical 
regulatory policy. Greater flexibility in the management of the 
NCUSIF's equity level and improvements in the measurement and 
retention of capital for credit unions are good starting 
points.

Q.8. G20 Summit and International Coordination--Many foreign 
officials and analysts have said that they believe the upcoming 
G20 summit will endorse a set of principles agreed to by both 
the Financial Stability Forum and the Basel Committee, in 
addition to other government entities. There have also been 
calls from some countries to heavily re-regulate the financial 
sector, pool national sovereignty in key economic areas, and 
create powerful supranational regulatory institutions. 
(Examples are national bank resolution regimes, bank capital 
levels, and deposit insurance.) Your agencies are active 
participants in these international efforts.
    What do you anticipate will be the result of the G20 
summit?
    Do you see any examples or areas where supranational 
regulation of financial services would be effective?
    How far do you see your agencies pushing for or against 
such supranational initiatives?

A.8. Many news accounts characterize the recent G20 summit as a 
forum for international cooperation to discuss the condition of 
the international financial system and to promote international 
financial stability. NCUA supports these efforts to share 
information and ideas and to marshal international support for 
a concerted effort to stabilize the global economy.
    In comparison to banks, federally insured credit unions are 
relatively small institutions. Additionally, because of the 
limited nature of a credit union's field of membership (those 
individuals a credit union is authorized to serve), U.S. credit 
unions are almost exclusively domestic institutions with 
virtually no, or highly limited, international presence. 
Accordingly, NCUA believes that a supranational regulatory 
institution would not be an effective tool for credit union 
regulation. Because of credit unions' small size and unique 
structure, NCUA believes credit unions need the customized 
supervisory approach that can only be provided by an agency 
dedicated to the exclusive regulation of credit unions, and 
which understands the unique nature of credit union operations. 
In the broader financial regulatory context, NCUA is hesitant 
to endorse the creation of powerful supranational regulatory 
institutions without knowing more about the extent of authority 
and jurisdiction those regulatory entities would have over U.S. 
financial institutions. While NCUA supports international 
cooperation, NCUA believes it is vital to economic and national 
security to maintain complete U.S. sovereignty over U.S. 
financial institutions.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                     FROM MICHAEL E. FRYZEL

Q.1. It is clear that our current regulatory structure is in 
need of reform. At my subcommittee hearing on risk management, 
March 18, 2009, GAO pointed out that regulators often did not 
move swiftly enough to address problems they had identified in 
the risk management systems of large, complex financial 
institutions.
    Chair Bair's written testimony for today's hearing put it 
very well: `` . . . the success of any effort at reform will 
ultimately rely on the willingness of regulators to use their 
authorities more effectively and aggressively.''
    My questions may be difficult, but please answer the 
following:
    If this lack of action is a persistent problem among the 
regulators, to what extent will changing the structure of our 
regulatory system really get at the issue?

A.1. For the most part, the credit unions have not become 
large, complex financial institutions. By virtue of their 
enabling legislation along with regulations established by the 
NCUA, federal credit unions are more restricted in their 
operation than other financial institutions. For example, 
investment options for federal credit unions are largely 
limited to U.S. debt obligations, federal government agency 
instruments, and insured deposits. Federal credit unions cannot 
invest in a diverse range of higher yielding products, 
including commercial paper and corporate debt securities. 
Another example of restrictions in the credit union industry 
includes the affiliation limitations. Federal credit unions are 
much more limited than other financial institutions in the 
types of businesses in which they engage and in the kinds of 
affiliates with which they deal. Federal credit unions cannot 
invest in the shares of an insurance company or control another 
financial depository institution. Limitations such as these 
have helped the credit union industry weather the current 
economic downturn. These limitations among the other unique 
characteristics of credit unions make credit unions 
fundamentally different from other forms of financial 
institutions and demonstrate the need to ensure their charter 
is preserved in order to continue to meet their members' 
financial needs.
    Restructuring the regulatory system to include a systemic 
regulator would add a level of checks and balances to the 
system to address the issue of regulators using their 
authorities more effectively and aggressively. The systemic 
regulator should be responsible for establishing general safety 
and soundness guidelines for financial institutions and then 
monitoring the financial regulators to ensure these guidelines 
are implemented. This extra layer of monitoring would help 
ensure financial regulators effectively and aggressively 
address problems at hand.

Q.2. Along with changing the regulatory structure, how can 
Congress best ensure that regulators have clear 
responsibilities and authorities, and that they are accountable 
for exercising them ``effectively and aggressively''?

A.2. If a systemic regulator is established, one of its 
responsibilities should include monitoring the implementation 
of the established safety and soundness guidelines. This 
monitoring will help ensure financial regulators effectively 
and aggressively enforce the established guidelines. The 
oversight entity's main functions should be to establish broad 
safety and soundness principles and then monitor the individual 
financial regulators to ensure the established principles are 
implemented. This structure also allows the oversight entity to 
set objective-based standards in a more proactive manner, and 
would help alleviate competitive conflict detracting from the 
resolution of economic downturns. This type of structure would 
also promote uniformity in the supervision of financial 
institutions while affording the preservation of the different 
segments of the financial industry, including the credit union 
industry.
    Financial regulators should be encouraged to aggressively 
address areas of increased risk as they are discovered. Rather 
than financial institution management alone determining risk 
limits, financial regulators must take administrative action 
when the need arises. Early recognition of problems and 
implementing resolutions will help ensure necessary actions are 
taken earlier rather than later. In addition, financial 
regulators should more effectively use off-site monitoring to 
identify and then increase supervision in areas of greater risk 
within the financial institutions.

Q.3. How do we overcome the problem that in the boom times no 
one wants to be the one stepping in to tell firms they have to 
limit their concentrations of risk or not trade certain risky 
products?
    What thought has been put into overcoming this problem for 
regulators overseeing the firms?

A.3. There is a need to establish concentration limits on risky 
products. NCUA already has limitations in place that have 
helped the credit union industry avoid some of the issues 
currently faced by other institutions. For example:

    Federal credit unions' investments are largely 
        limited to United States debt obligations, federal 
        government agency instruments, and insured deposits. 
        \2\ Federal credit unions cannot invest in a diverse 
        range of higher yielding products, including commercial 
        paper and corporate debt securities. Also, federal 
        credit unions have limited authority for broker-dealer 
        relationships. \3\
---------------------------------------------------------------------------
     \2\ NCUA Rules and Regulations Part 703.
     \3\ NCUA Rules and Regulations Part 703.

    Federal credit unions are much more limited than 
        other financial institutions in the types of businesses 
        in which they engage and in the kinds of affiliates 
        with which they deal. Federal credit unions cannot 
        invest in the shares of an insurance company or control 
        another financial depository institution. Also, they 
        cannot be part of a financial services holding company 
        and become affiliates of other depository institutions 
---------------------------------------------------------------------------
        or insurance companies.

    Unlike other financial institutions, federal credit 
        unions cannot issue stock to raise additional capital. 
        \4\ Also, federal credit unions have borrowing 
        authority limited to 50 percent of paid-in and 
        unimpaired capital and surplus. \5\
---------------------------------------------------------------------------
     \4\ 12 U.S.C. 1790d(b)(1)(B)(i).
     \5\ 12 U.S.C. 1757(9).

    Sound decision making should always take precedence over 
following the current trend. The addition of a systemic 
regulator would provide the overall monitoring for systemic 
risk that should be limited. The systemic regulator would then 
establish principles-based regulations for the financial 
regulators to implement. This would provide checks and balances 
to ensure regulators were addressing the issues identified. The 
systemic regulator should be charged with monitoring and 
implementing guidelines for the systemic risks to the industry, 
while the financial regulators would supervise the financial 
institutions and implement the guidelines established by the 
systemic regulator. Since the systemic regulator only has 
oversight over the financial regulators, they would not have 
direct supervision of the financial institutions. This buffer 
would help overcome the issue of when limits should be 
---------------------------------------------------------------------------
implemented.

Q.4. Is this an issue that can be addressed through regulatory 
restructure efforts?

A.4. As stated above, the addition of a systemic regulator 
would help address these issues by providing a buffer between 
the systemic regulator establishing principles-based 
regulations and the financial regulators implementing the 
regulations. The addition of the systemic regulator could 
change the approach of when and how regulators address areas of 
risk.
    The monitoring performed by the systemic regulator would 
help ensure the financial regulators were taking a more 
proactive approach to supervising the institutions for which 
they are responsible.

Q.5. As Mr. Tarullo and Mrs. Bair noted in their testimony, 
some financial institution failures emanated from institutions 
that were under federal regulation. While I agree that we need 
additional oversight over and information on unregulated 
financial institutions, I think we need to understand why so 
many regulated firms failed.
    Why is it the case that so many regulated entities failed, 
and many still remain struggling, if our regulators in fact 
stand as a safety net to rein in dangerous amounts of risk-
taking?

A.5. While regulators are a safety net to guard against 
dangerous amounts of risk taking, the confluence of events that 
led to the current level of failures and troubled institutions 
may have been beyond the control of individual regulators. 
While many saw the risk in lower mortgage loan standards and 
the growth of alternative mortgage products, the combination of 
these and the worst recessionary conditions and job losses in 
decades ended with devastating results to the financial 
industry. Exacerbating this combination was the layering of 
excess leverage that built over time, not only in businesses 
and the financial industry, but also in individual households.
    In regards to the credit union industry's record in the 
current economic environment, 82 federally insured credit 
unions have failed in the past 5 years (based on the number of 
credit unions causing a loss to the National Credit Union Share 
Insurance Fund). Overall, federally insured credit unions 
maintained reasonable financial performance in 2008. As of 
December 31, 2008, federally insured credit unions maintained a 
strong level of capital with an aggregate net worth ratio of 
10.92 percent. While earnings decreased from prior levels due 
to the economic downturn, federally insured credit unions were 
able to post a 0.30 percent return on average assets in 2008. 
Delinquency was reported at 1.37 percent, while net charge-offs 
was 0.84 percent. Shares in federally insured credit unions 
grew at 7.71 percent, with membership growing at 2.01 percent, 
and loans growing at 7.08 percent. \6\
---------------------------------------------------------------------------
     \6\ Based on December 31, 2008, Call Report (NCUA Form 5300) data.

Q.6. While we know that certain hedge funds, for example, have 
---------------------------------------------------------------------------
failed, have any of them contributed to systemic risk?

A.6. As the NCUA does not regulate or oversee hedge funds, it 
is not within our scope to be able to comment on the impact of 
failed hedge funds and whether or not those failures 
contributed to systemic risk.

Q.7. Given that some of the federal banking regulators have 
examiners on-site at banks, how did they not identify some of 
these problems we are facing today?

A.7. NCUA does not have on-site examiners in natural person 
credit unions. However, as a result of the current economy, 
NCUA has shortened the examination cycle to 12 months versus 
the prior 18 months schedule. NCUA also performs quarterly 
reviews of the financial data submitted to the agency by the 
credit union.
    NCUA does have on-site examiners in some corporate credit 
unions. Natural person credit unions serve members of the 
public, whereas corporate credit unions serve the natural 
person credit unions. On March 20,2009, NCUA placed two 
corporate credit unions into conservatorship, due mainly to the 
decline in value of mortgage backed securities held on their 
balance sheets. Conventional evaluation techniques did not 
sufficiently identify the risks of these newer structured 
securities or the insufficiency of the credit enhancements that 
supposedly protected the securities from losses. NCUA's 
evaluation techniques did not fully keep pace with the speed of 
change in the structure and risk of these securities. 
Additionally, much of the information obtained by on-site 
examiners is provided by the regulated institutions. These 
institutions may become less than forthcoming in providing 
negative information when trends are declining. NCUA is 
currently evaluating the structure of the corporate credit 
union program to determine what changes are necessary. NCUA is 
also reviewing the corporate credit union regulations and will 
be making changes to strengthen these entities.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                     FROM MICHAEL E. FRYZEL

Q.1. The convergence of financial services providers and 
financial products has increased over the past decade. 
Financial products and companies may have insurance, banking, 
securities, and futures components. One example of this 
convergence is AIG. Is the creation of a systemic risk 
regulator the best method to fill in the gaps and weaknesses 
that AIG has exposed, or does Congress need to reevaluate the 
weaknesses of federal and state functional regulation for 
large, interconnected, and large firms like AIG?

A.1. NCUA has previously expressed its support for establishing 
a systemic risk regulator to monitor financial institution 
regulators, issue principles-based regulations and guidance, 
and establish general safety and soundness guidance for 
financial regulators under its control. This oversight entity 
would monitor systemic risk across institution types. \7\ This 
broad oversight would complement NCUA's more in-depth and 
customized approach to regulating federally insured credit 
unions.
---------------------------------------------------------------------------
     \7\ For purposes of this response, financial institutions include 
commercial banks and other insured depository institutions, insurers, 
companies engaged in securities and futures transactions, finance 
companies, and specialized companies established by the government as 
defined by the Treasury Blueprint. Individual financial regulators 
would implement and enforce the established guidelines for the 
institutions they regulate.
---------------------------------------------------------------------------
    Credit unions are unique, cooperative, not-for-profit 
entities with a statutory mandate to serve people of modest 
means. NCUA believes the combination of federal functional 
regulators performing front-line examinations and oversight by 
a systemic risk regulator would be a good method to fill 
weaknesses exposed by AIG. Additionally, because of the small 
size of most credit unions and the limitations placed on their 
charters, credit unions generally do not become part of a large 
conglomerate of business entities.

Q.2. Recently there have been several proposals to consider for 
financial services conglomerates. One approach would be to move 
away from functional regulation to some type of single 
consolidated regulator like the Financial Services Authority 
model. Another approach is to follow the Group of 30 Report 
which attempts to modernize functional regulation and limit 
activities to address gaps and weaknesses. An in-between 
approach would be to move to an objectives-based regulation 
system suggested in the Treasury Blueprint. What are some of 
the pluses and minuses of these three approaches?

A.2. Credit unions have not become financial service 
conglomerates due to limitations within the laws impacting 
credit unions including restricted fields of membership and 
limited potential activity. Therefore, the functional 
regulatory approach currently in place has worked in the credit 
union industry. While there is no perfect regulatory model to 
adopt and follow that addresses all of the current issues in 
the financial services industry, we can take portions from 
different plans to create a regulatory system that meets the 
needs of the current economy.
    A modernized functional regulatory system would divide the 
financial services industry into at least five categories: 
credit unions, banks, insurance, securities, and futures. This 
approach would allow the functional regulators to operate with 
expertise within their segment of the financial institutions. A 
functional regulator provides regulation for the specific 
issues facing their financial sector. This approach also allows 
a single regulator to possess the information and authority 
necessary to completely oversee the regulated entities within 
their segment of the industry while eliminating inefficiencies 
made with multiple overseers of the same entity. One drawback 
of this system is the possibility of regulators addressing the 
same issue with different approaches. One way to address this 
issue is the addition of a systemic oversight agency to the 
financial services industry. A systemic oversight agency could 
issue principles-based regulations and guidance, promoting 
uniformity in the supervision of the industry, while allowing 
the functional regulators to implement the regulations and 
guidance in a manner most appropriate for their financial 
segment. This type of structure would help preserve the 
different segments of the industry and maintain the checks and 
balances afforded by the different segments within the 
industry.
    With the single consolidated regulator approach, authority 
over all aspects of regulated institutions would be established 
under one regulator. This approach would allow the regulator to 
possess all information and authority regarding individual 
institutions, which would eliminate inefficiencies of multiple 
overseers for the same institution. This approach would also 
ensure the financial services industry operated under a 
consistent regulatory approach. However, this approach could 
result in the loss of specialized attention and focus on the 
various distinct segments of the financial institutions. An 
agency responsible for all institutions might focus on the 
larger institutions where the systemic risk predominates, 
potentially to the detriment of smaller institutions. For 
example, as federally insured credit unions are generally the 
smaller, less complex institutions in a consolidated financial 
regulator arrangement, the unique character of credit unions 
would quickly be lost, absorbed by the for-profit model and 
culture of other financial institutions. Loss of credit unions 
as a type of financial institution would limit access to the 
affordable services for persons of modest means that are 
offered by credit unions.
    An objectives-based regulatory approach as outlined in the 
Treasury Blueprint (market stability, prudential, and business 
conduct regulators) would ensure all financial institutions 
operated under a consistent regulatory approach. However, like 
the single consolidated regulator, this approach could also 
result in the loss of specialized attention and focus on the 
distinct segments of financial institutions, thus harming the 
credit union charter. Again, each regulator might focus on the 
larger financial institutions where the systemic risk 
predominates, while not addressing the different types of risks 
found in the smaller institutions. This approach also would 
result in multiple regulators for the same institution, where 
no single regulator possessed all of the information and 
authority necessary to monitor the overall systemic risk of the 
institution. In addition, disputes between the regulators 
regarding jurisdiction over the different objectives would 
arise. Inefficiencies would be created with multiple regulators 
supervising the same institution. Again, the focus on the 
objective rather than the charter could potentially harm the 
credit union industry where credit unions only comprise a small 
part of the financial institution community.
    In closing, the approach selected to regulate the financial 
services providers must protect the unique regulatory needs of 
the various components of the financial sectors, including the 
credit union industry.

Q.3. If there are institutions that are too big to fail, how do 
we identify that? How do we define the circumstance where a 
single company is so systemically significant to the rest of 
our financial circumstances and our economy that we must not 
allow it to fail?

A.3. If the definition of ``too big to fail'' encompasses only 
those institutions that are systemically significant enough 
where their failure would have an adverse impact on financial 
markets and the economy, then credit unions would not be 
considered too big to fail.
    Within the credit union system there are regulatory 
safeguards in place to reduce the potential for ``too big to 
fail'' entities. The field of membership restrictions that 
govern membership of the credit union limit the potential for 
any systemic risk. The impact of a failure of a large natural 
person credit union would be limited to any cost of the 
failure, which would be passed on to all other federally 
insured credit unions via the assessment of a premium should 
the equity level of the NCUSIF fall below the required level.

Q.4. We need to have a better idea of what this notion of too 
big to fail is--what it means in different aspects of our 
industry and what our proper response to it should be. How 
should the federal government approach large, multinational and 
systemically significant companies?

A.4. In large, multinational and systemically significant 
institutions, federal regulators should take an aggressive 
approach to examining and monitoring. As issues are discovered, 
the regulator must quickly and firmly take the appropriate 
action before the issue escalates.
    Very few federally insured credit unions have a 
multinational presence. Due to field of membership limitations, 
only credit unions where a portion of their members are located 
in foreign counties, such as a Department of Defense related 
credit union, would have multinational exposure. \8\ In those 
cases, there is limited multinational significance to the 
credit union business model.
---------------------------------------------------------------------------
     \8\ Credit unions are chartered to serve a field of membership 
that shares a common bond such as the employees of a company, members 
of an association, or a local community. Therefore, credit unions may 
not serve the general public like other financial institutions and the 
credit unions' activities are largely limited to domestic activities, 
which has minimized the impact of globalization in the credit union 
industry.

Q.5. What does ``fail'' mean? In the context of AIG, we are 
talking about whether we should have allowed an orderly Chapter 
---------------------------------------------------------------------------
11 bankruptcy proceeding to proceed. Is that failure?

A.5. NCUA regulates federally insured credit unions, which do 
not file Chapter 11 bankruptcies. However, federally insured 
credit unions can become insolvent and be liquidated. No member 
of a federally insured credit union has ever lost a penny of 
insured shares. In order to preserve confidence in the credit 
union industry, NCUA usually pays out members within three days 
from the time a federally insured credit union fails. NCUA has 
an Asset Management and Assistance Center that is available to 
quickly handle credit union liquidations and perform management 
and asset recovery.
    Based on the requirements set forth in 12 U.S.C. 1790d of 
the Federal Credit Union Act, NCUA considers a credit union in 
danger of closing (a potential failure) when the credit union:

    Is subject to mandatory conservatorship, 
        liquidation or ``other corrective action'' for not 
        maintaining required levels of capital;

    Is subject to discretionary conservatorship or 
        liquidation or is required to merge for not maintaining 
        required levels of capital;

    Is subject to a high probability of sustaining an 
        identifiable loss (e.g., fraud, unexpected and sudden 
        outflow of funds, operational failure, natural 
        disaster, etc.) and could not maintain required levels 
        of capital, so that it would be subject to 
        conservatorship or liquidation.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
                     FROM MICHAEL E. FRYZEL

Q.1. Two approaches to systemic risk seem to be identified, (1) 
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to 
fail'' or ``too systemically important to fail'' or (2) impose 
an additional regulator and additional rules and market 
discipline on institutions that are considered systemically 
important.
    Which approach do you endorse? If you support approach one 
how you would limit institution size and how would you identify 
new areas creating systemic importance?
    If you support approach two how would you identify 
systemically important institutions and what new regulations 
and market discipline would you recommend?

A.1. Federally insured credit unions hold $8 13.44 billion in 
assets, while financial institutions insured by the FDIC hold 
$13.85 trillion in assets. Federally insured credit unions make 
up only 5.56 percent of all federally insured asset. \9\ 
Therefore, the credit union industry as a whole does not pose a 
systemic risk to the financial industry. However, federally 
insured credit unions serve a unique role in the financial 
industry by providing basic and affordable financial services 
to their members. The credit union system of regulation has 
produced natural limits on size. Though under stress, the 
credit union system has continued their long history of 
financial stability and quality service. So, implementing some 
limits on size may be prudent given the success of the credit 
union regulatory model.
---------------------------------------------------------------------------
     \9\ Based on December 31, 2008, financial data.

Q.2. Please identify all regulatory or legal barriers to the 
comprehensive sharing of information among regulators including 
insurance regulators, banking regulators, and investment 
banking regulators. Please share the steps that you are taking 
to improve the flow of communication among regulators within 
---------------------------------------------------------------------------
the current legislative environment.

A.2. NCUA does not believe there are any significant regulatory 
or legal barriers to prevent it from information sharing with 
other agency regulators. NCUA currently shares information with 
state credit union supervisors on a regular basis, trains and 
provides computer equipment to state examiners, and often 
conducts joint supervisory examinations with state agencies. 
NCUA regional management meets with state credit union 
supervisors in order to discuss such things as problem areas, 
problem institutions, and economic issues. In addition, NCUA 
executive management meets with the National Association of 
State Credit Union Supervisors (NASCUS) at least semi-annually 
to discuss current issues.
    NCUA also participates in Federal Financial Institutions 
Examination Council (FFIEC) \10\ where information is shared 
and resources are pooled together to develop regulations, 
policies, training materials, etc. Working groups within the 
FFIEC also include representatives from other federal agencies 
outside of the financial regulatory agencies as needed.
---------------------------------------------------------------------------
     \10\ The FFIEC includes the Board of Governors of the Federal 
Reserve (FRB), the Federal Deposit Insurance Corporation (FDIC), the 
NCUA, the Office of the Comptroller of the Currency (OCC), the Office 
of Thrift Supervision (OTS), and the State Liaison Committee (SLC).
---------------------------------------------------------------------------
    NCUA believes information sharing can be a valuable tool to 
ensure safe and sound operations for various kinds of financial 
institutions. Of course, appropriate parameters must be 
established to clarify what information is to be shared and for 
what purposes and to ensure the confidential treatment of 
sensitive information.
                                ------                                


       RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
                     FROM MICHAEL E. FRYZEL

Q.1. Will each of you commit to do everything within your power 
to prevent performing loans from being called by lenders? 
Please outline the actions you plan to take.

A.1. NCUA has strongly encouraged federally insured credit 
unions to work with borrowers under financial stress. While 
credit unions must be prudent in their approach, there are 
avenues they need to explore in working through these 
situations that can result in positive outcomes for both 
parties. In April of 2007, NCUA issued Letter to Credit Unions 
07-CU-06 titled ``Working with Residential Mortgage 
Borrowers,'' which included an FFIEC initiative to encourage 
institutions to consider all loan workout arrangements. NCUA 
subsequently issued Letter to Credit Unions 08-CU-05 in March 
of 2008 supporting the Hope NOW alliance, which focuses on 
modifying qualified loans. More recently, NCUA Letter to Credit 
Unions 09-CU-04, issued in March 2009, encourages credit union 
participation in the Making Home Affordable loan modification 
program. NCUA is currently in the process of developing a 
Letter to Credit Unions that will further address loan 
modifications. NCUA has been, and will remain, supportive of 
all prudent efforts to avoid calling loans and taking 
foreclosure actions.
    While NCUA remains supportive of workout arrangements in 
general, the data available does not suggest performing loans 
are being called at a significant level within the credit union 
industry. What is more likely to occur is the curtailing of 
existing lines of credit for both residential and construction 
and development lending. It is conceivable that underlying 
collateral values supporting such loans have deteriorated and 
no longer support lines of credit outstanding or unused 
commitments. In those instances, a business decision must be 
made regarding whether to curtail the line of credit. There 
likely will be credit union board established credit risk 
parameters that need to be considered as well as regulatory 
considerations, especially as it relates to construction and 
development lending.
    Credit union business lending is restricted by statute to 
the lesser of 1.75 times the credit union's net worth or 12.25 
percent of assets (some exceptions apply). There are further 
statutory thresholds on the level of construction and 
development lending, borrower equity requirements for such 
lending, limits on unsecured business lending, and maximum loan 
to value limitations (generally 80 percent without insurance or 
up to 95 percent with insurance). While business lending 
continues to grow within credit unions, the level of such 
lending as of December 31, 2008, is 3.71 percent of total 
credit union assets and 5.32 percent of total credit union 
loans. Only 6.15 percent of outstanding credit union business 
loans, or $1.95 billion, are for construction and development, 
which is a very small piece of the overall construction and 
development loan market.
    Credit union loan portfolios grew at a rate of over 7 
percent in 2008. The level of total unfunded loan commitments 
continues to grow, which suggests there is not a pervasive 
calling of lines of credit. Credit unions need to continue to 
act independently in regard to credit decisions. Each loan will 
involve unique circumstances including varying levels of risk. 
Some markets have been much more severely impacted by the 
change in market conditions, creating specific risk 
considerations for affected loans. Additionally, there are 
significant differences between loans to the average 
residential home owner who is current on their loan even though 
their loan to value ratio is now 110 percent, versus the 
developer who has a line of credit to fund his commercial use 
or residential construction project. Continued funding for the 
developer may be justified or may be imprudent. Continued 
funding may place the institution at additional risk or beyond 
established risk thresholds, depending on the circumstances.
    The agency continues to support the thoughtful evaluation 
by credit union management of each performing loan rather than 
a blanket approach to curtailing the calling of performing 
loans.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                     FROM DANIEL K. TARULLO

Q.1. Consumer Protection Regulation--Some have advocated that 
consumer protection and prudential supervision should be 
divorced, and that a separate consumer protection regulation 
regime should be created. They state that one source of the 
financial crisis emanated from the lack of consumer protection 
in the underwriting of loans in the originate-to-distribute 
space.
    What are the merits of maintaining it in the same agency? 
Alternatively, what is the best argument each of you can make 
for a new consumer protection agency?

A.1. The best argument for maintaining supervision of consumer 
protection in the same agency that provides safety and 
soundness and supervision is that the two are linked both 
substantiveIy and practically. Thus there are substantial 
efficiency and information advantages from having the two 
functions housed in the same agency. For example, risk 
assessments related to an institution's management of consumer 
compliance functions are closely linked with other safety and 
soundness risks, and factor in to assessments of bank 
management and financial, legal, and reputation risks. 
Likewise, evaluations of management or controls in lending 
processes in safety and soundness examinations factor in to 
assessments of compliance risk management. Supervisory 
assessments for both safety and soundness and consumer 
protection, as well as enforcement actions or supervisory 
follow up, are best made with the benefit of the broader 
context of the entire organization's risks and capacity. 
Furthermore, determinations that certain products or practices 
are ``unfair and deceptive'' in some cases require an 
understanding of how products are priced, offered, and marketed 
in an individual institution. This information is best obtained 
through supervisory monitoring and examinations.
    A related point is that responsibility for prudential and 
consumer compliance examinations and enforcement benefits 
consumer protection rulewriting responsibilities. Examiners are 
often the first government officials to see problems with the 
application and implementation of rules in consumer 
transactions. Examiners are an important source of expertise in 
banking operations and lending activities, and they are trained 
to understand the interplay of all the risks facing individual 
banking organizations.
    The best argument for an independent consumer agency within 
the financial regulatory structure is that it will focus 
single-mindedly on consumer protection as its primary mission. 
The argument is that the leadership of an agency with multiple 
functions may trade one off against the other one, at times, be 
distracted by responsibilities in one area and less attentive 
to problems in the other. A corollary of this basic point is 
that the agency would be more inclined to act to deter use of 
harmful financial products and, if properly structured and 
funded, may be less susceptible to the sway of powerful 
industry influences. Proponents of a separate agency also argue 
that a single consumer regulator responsible for monitoring and 
enforcing compliance would end the competition among regulatory 
agencies that they believe promotes a ``competition in laxity'' 
for fear that supervised entities will engage in charter 
shopping.
    Apart from the relative merits of the foregoing arguments, 
two points of context are probably worth making: First, any 
agency assigned rulewriting authority will be effective only if 
it has considerable expertise in consumer credit markets, 
retail payments, banking operations, and economic analysis. 
Successful rulewriting requires an understanding of the likely 
effects of protections to prevent abuses on the availability of 
responsible and affordable credit. Second, the policies and 
performance of both an ``integrated'' agency and a free-
standing consumer protection agency will depend importantly on 
the leadership appointed to head those entities.

Q.2. Regulatory Gaps or Omissions--During a recent hearing, the 
Committee has heard about massive regulatory gaps in the 
system. These gaps allowed unscrupulous actors like AIG to 
exploit the lack of regulatory oversight. Some of the 
counterparties that AIG did business with were institutions 
under your supervision.
    Why didn't your risk management oversight of the AIG 
counterparties trigger further regulatory scrutiny? Was there a 
flawed assumption that AIG was adequately regulated, and 
therefore no further scrutiny was necessary?
    Was there dialogue between the banking regulators and the 
state insurance regulators? What about the SEC?
    If the credit default swap contracts at the heart of this 
problem had been traded on an exchange or cleared through a 
clearinghouse, with requirement for collateral and margin 
payments, what additional information would have been 
available? How would you have used it?

A.2. The problems created by AIG provide perhaps the best case 
study in showing the need for regulatory reform, enhanced 
consolidated supervision of institutions and business lines 
that perform the same function, and an explicit regulatory 
emphasis on systemic risk. Importantly, some of the largest 
counterparties to AIG were foreign institutions and investments 
banks not directly supervised by the Federal Reserve. Even 
then, however, established industry practices prior to the 
crisis among financial institution counterparties with high 
credit ratings called for little exchange of initial margins on 
OTC derivative contracts. Such practices and AIG's high credit 
rating thus inhibited the checks and balances initial margins 
would have placed on AIG's positions. Federal Reserve 
supervisory reviews of counterparty credit risk exposures at 
individual firms prior to the crisis did not flag AIG as posing 
significant counterparty credit risk since AIG was regularly 
able to post its variation margins on OTC derivative contracts 
thus reducing its exposure. Moreover, AIG spread its exposures 
across a number of different counterparties and instruments.
    The over-reliance on credit ratings in a number of areas 
leading up to the current crisis, as well as the need for 
better information on market-wide exposures in the OTC 
derivatives market, have motivated supervisory efforts to move 
the industry to the use of central clearing parties and the 
implementation of a data warehouse on OTC derivative 
transactions. This effort, reinforced with appropriate 
statutory authority, is a critical part of a systemic risk 
agenda.
    The Federal Reserve actively participates on an insurance 
working group, which includes other federal banking and thrift 
agencies and the National Association of Insurance 
Commissioners (NAIC). The working group meets quarterly to 
discuss developments in the insurance and banking sectors, 
legislative developments, and other topics of particular 
significant. In addition, to the working group, the Federal 
Reserve communicates regularly with the NAIC and insurance 
regulators on specific matters. With respect to the SEC, the 
Federal Reserve has information sharing arrangements in place 
for companies under our supervision. Since the Federal Reserve 
had no supervisory responsibility for AIG, we did not discuss 
the company or its operations with either the state insurance 
regulators or the SEC until the time of our initial discount 
window loan in September 2008.
    Credit default swap contracts may be centrally cleared 
(whether they are traded over the counter or listed on an 
exchange) only if they are sufficiently standardized. 
Presently, sufficiently standardized CDS contracts comprise 
those written on CDS indices, on tranches of CDS indices, and 
on some corporate single-name entities. The CDS contracts at 
the heart of the AIG collapse were written mainly on tranches 
of ABS CDOs, which are generally individually tailored (e.g., 
bespoke transactions) in nature and therefore not feasible 
either for exchange trading or central clearing. For such 
nonstandard transactions we are strongly advocating the use of 
centralized trade repositories, which would maintain official 
records of all noncentrally-cleared CDS deals. It is important 
to note that the availability of information on complex deals 
in a central repository or otherwise is necessary but not 
sufficient for fully understanding the risks of these 
positions. Even if additional information on AIG's positions 
had been available from trade repositories and other sources, 
the positions would have been as difficult to value and monitor 
for risk without considerable additional analysis.
    Most critically, both trade repositories and clearinghouses 
provide information on open CDS contracts. Of most value and 
interest to regulators are the open interest in CDS written on 
specific underliers and the open positions of a given entity 
vis-a-vis its counterparties. Both could provide regulators 
with information on aggregate and participant exposures in near 
real time. A clearinghouse could in addition provide 
information on collateral against these exposures and the CCP's 
valuation of the contracts cleared. An exchange on top of a 
clearinghouse would be able to provide real-time information on 
trading interest in terms of prices and volumes, which could be 
used by regulators to monitor market activity.

Q.3. Systemic Risk Regulation--The Federal Reserve and the OTS 
currently have consolidated supervisory authority over bank and 
thrift holding companies respectively. This authority grants 
the regulators broad powers to regulate some of our Nation's 
largest, most complex firms, yet some of these firms have 
failed or are deeply troubled.
    Mr. Tarullo, do you believe there were failures of the 
Federal Reserve's holding company supervision regime and, if 
so, what would be different under a new systemic risk 
regulatory scheme?

A.3. I expect that when the history of the financial crisis is 
finally written, culpability will be shared by essentially 
every part of the government responsible for constructing and 
implementing financial regulation, including the Federal 
Reserve. Since just about all financial institutions have been 
adversely affected by the financial crisis--not just those that 
have failed--all supervisors have lessons to learn from this 
crisis.
    As to what will be different going forward, I would suggest 
the following:
    First, the Federal Reserve is already implementing a number 
of changes, such as enhancing risk identification processes to 
more quickly detect emerging risks. The Board is also improving 
the processes to issue supervisory guidance and policies to 
make them more timely and effective. In 2008 the Board issued 
supervisory guidance on consolidated supervision to clarify the 
Federal Reserve's role as consolidated supervisor and to assist 
the examination staff as they carry out supervision of banking 
institutions, particularly large, complex firms with multiple 
legal entities.
    Second, I would hope that both statutory provisions and 
administrative practices would change so as to facilitate a 
truly comprehensive approach to consolidated supervision. This 
would include, among other things, amending the Gramm-Leach-
Bliley Act, whose emphasis on ``functional regulation'' for 
prudential purposes is at odds with the comprehensive approach 
that is needed to supervise large, complex institutions 
effectively for safety and soundness and systemic risks. For 
example, the Act places certain limits on the Federal Reserve's 
ability to examine or obtain reports from functionally 
regulated subsidiaries of a bank holding company.
    Third, our increasing focus on risks that are created 
across institutions and in interactions among institutions 
should improve identification of incipient risks within 
specific institutions that may not be so evident based on 
examination of a single firm. In this regard, the Federal 
Reserve is expanding and refining the use of horizontal 
supervisory reviews. An authority charged with systemic risk 
regulatory tasks would presumably build on this kind of 
approach, but it is also important in more conventional, 
institution-specific consolidated supervision.
    Fourth, I believe it is fair to say that there is a 
different orientation towards regulation and supervision within 
the current Board than may have been the case at times in the 
past.

Q.4. Liquidity Management--A problem confronting many financial 
institutions currently experiencing distress is the need to 
roll-over short-term sources of funding. Essentially these 
banks are facing a shortage of liquidity. I believe this 
difficulty is inherent in any system that funds long-term 
assets, such as mortgages, with short-term funds. Basically the 
harm from a decline in liquidity is amplified by a bank's level 
of ``maturity-mismatch.''
    I would like to ask each of the witnesses, should 
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to 
do so?

A.4. The current crisis has proven correct those who have 
maintained in recent years that liquidity risk management 
needed considerably more attention from banks, holding 
companies, and supervisors. As will be described below, a 
number of steps are already being taken to address this need, 
but additional analysis will clearly be needed. At the outset, 
though, it is worth emphasizing that maturity transformation 
through adequately controlled maturity mismatches is an 
important economic function that banks provide in promoting 
overall economic growth. Indeed, the current problems did not 
arise solely from balance sheet maturity mismatches that banks 
carried into the current crisis. For almost 2 years, many 
financial institutions have been unable to roll over short-term 
and maturing intermediate-term funding or have incurred 
maturity mismatches primarily because of their inability to 
obtain longer-term funds as a result of solvency concerns in 
the market. This has been exacerbated by some institutions 
having to take onto their balance sheets assets that were 
previously considered off-balance sheet.
    To elaborate this point, it is important to note that most 
of the serious mismatches that led to significant ``tail'' 
liquidity risks occurred in instruments and activities outside 
of traditional bank lending and borrowing businesses. The most 
serious mismatches encountered were engineered into various 
types of financial products and securitization vehicles such as 
structured investment vehicles (SIVs), variable rate demand 
notes (VRDNs) and other products sold to institutional and 
retail customers. In addition, a number of managed stable value 
investment products such as registered money market mutual 
funds and unregistered stable value investment accounts and 
hedge funds undertook significant mismatches that compromised 
their integrity. Many of these mismatches were transferred to 
banking organizations during the crisis through contractual 
commitments to extend liquidity to such vehicles and products. 
Where no such contractual commitments existed, assets came onto 
banks' balance sheets as a result of their decisions to support 
sponsored securitization vehicles, customer funding products, 
and investment management funds in the interest of mitigating 
the banks' brand reputation risks.
    However, such occurrences do not minimize the significant 
mismatches that occurred through financial institutions', and 
their hedge fund customers', significant use of short-term 
repurchase agreements and reverse repurchase agreements to 
finance significant potions off their dealer inventories and 
trading positions. Such systemic reliance on short-term funding 
placed significant pressures on the triparty repo market.
    The task for regulators and policy makers is to ensure that 
any mismatches taken by banking organizations are appropriately 
managed and controlled. The tools used by supervisors to 
achieve this goal include the clear articulation of supervisory 
expectations surrounding sound practices for liquidity risk 
management and effective on-site assessment as to whether 
institutions are complying with those expectations. In an 
effort to strengthen these tools, supervisors have taken a 
number of steps. In September 2008 the Basel Committee on Bank 
Supervision (BCBS) issued a revised set of international 
principles on liquidity risk management. The U.S. bank 
regulatory agencies plan to issue joint interagency guidance 
endorsing those principles and providing a single set of U.S. 
supervisory expectations that aggregates well-established 
guidance issued by each agency in the past. Both the 
international and U.S. guidance, which highlight the need for 
banks to assess the liquidity risk embedded in off-balance 
sheet exposures, should re-enforce both banks' efforts to 
enhance their liquidity risk management processes and 
supervisory actions to improve oversight of these processes. In 
addition, the BCBS currently has efforts underway to establish 
international standards on liquidity risk exposures that is 
expected to be issued for comment in the second half of 2009. 
Such standards have the potential for setting the potential 
limits on maturity mismatches and requirements for more stable 
funding of dealer operations, while acknowledging the important 
role maturity mismatches play in promoting economic growth.

Q.5. What Is Really Off-Balance Sheet--Chairman Bair noted that 
structured investment vehicles (SIVs) played an important role 
in funding credit risk that are at the core of our current 
crisis. While the banks used the SIVs to get assets of their 
balance sheet and avoid capital requirements, they ultimately 
wound up reabsorbing assets from these SIVs.
    Why did the institutions bring these assets back on their 
balance sheet? Was there a discussion between the OCC and those 
with these off-balance sheet assets about forcing the investor 
to take the loss?
    How much of these assets are now being supported by the 
Treasury and the FDIC?
    Based on this experience, would you recommend a different 
regulatory treatment for similar transactions in the future? 
What about accounting treatment?

A.5. Companies that sponsored SIVs generally acted as 
investment managers for the SIVs and funded holdings of longer-
term assets with short-term commercial paper and medium-term 
notes. As the asset holdings began to experience market value 
declines and the liquidity for commercial paper offerings 
deteriorated, SIVs faced ratings pressure on outstanding debt. 
In addition, SIV sponsors faced legal and reputational risk as 
losses began accruing to third-party holders of equity 
interests in the SIVs. Market events caused some SIV sponsors 
to reconsider their interests in the vehicles they sponsored 
and to conclude that they were the primary beneficiary as 
defined in FASB Interpretation No. 46(R), which required them 
to consolidate the related SIVs. In addition, market events 
caused some SIV sponsors to commit formally to support SIVs 
through credit or liquidity facilities with the intention of 
maintaining credit ratings on outstanding senior debt. Those 
additional commitments caused the sponsors to conclude that 
they were the primary beneficiary of the related vehicles and, 
therefore, to consolidate.
    Very few U.S. banks consolidated SIV assets in 2007 and 
2008. Citigroup disclosed in their 2008 Annual Report that $6.4 
billion in SIV assets were part of an agreed asset pool covered 
in the U.S. government loss sharing arrangement announced 
November 23, 2008. We are not aware of other material direct 
support of SIV assets through the Treasury Department or the 
FDIC.
    Recent events have demonstrated the need for supervisors 
and banks to better assess risks associated with off-balance 
sheet exposures. The Federal Reserve participated in the 
development of proposed guidance published by the BCBS in 
January 2009, to strengthen supervisory expectations for 
capturing firm-wide risk concentrations arising from both on- 
and off-balance-sheet exposures. These include both contractual 
exposures, as well as the potential impact on overall risk, 
capital, and liquidity of noncontractual exposures such as 
reputational risk exposure to off-balance-sheet vehicles and 
asset management activities. Exercises to evaluate possible 
additional supervisory and regulatory changes to the 
requirements for off-balance-sheet exposures are ongoing and 
include the BCBS efforts to develop international standards 
surrounding banks' liquidity risk profiles.
    The Federal Reserve supports recent efforts by the 
Financial Accounting Standards Board to amend and clarify the 
accounting treatment for off-balance-sheet vehicles such as 
SIVs, securitization trusts, and structured finance conduits. 
We applauded the FASB for requiring additional disclosure of 
such entities in public company financials starting with year-
end 2008 reports, as well. We are hopeful that the amended 
accounting guidance for consolidation of special purpose 
entities like SIVs will result in consistent application in 
practice and enhanced transparency. That outcome would permit 
financial statement users, including regulators, to assess 
potential future risks facing financial institutions by virtue 
of the securitization and structured finance activities in 
which it engages.

Q.6. Regulatory Conflict of Interest--Federal Reserve Banks 
which conduct bank supervision are run by bank presidents that 
are chosen in part by bankers that they regulate.
    Mr. Tarullo, do you see the potential for any conflicts of 
interest in the structural characteristics of the Fed's bank 
supervisory authorities?

A.6. The Board of Governors has the statutory responsibility 
for supervising bank holding companies, state member banks, and 
the other banking organizations for which the Federal Reserve 
System has supervisory authority under the Bank Holding Company 
Act, the Federal Reserve Act, and other federal laws. See, 
e.g., 12 U.S.C. 248(a) (state member banks), 1844 (bank 
holding companies), and 3106(c) (U.S. branches and agencies of 
foreign banks). Although the Board has delegated authority to 
the Reserve Banks to conduct many of the Board's supervisory 
functions with respect to banking organizations, applicable 
regulations and policies are adopted by the Board alone. The 
Reserve Banks conduct supervisory activities subject to 
oversight and monitoring by the Board. It is my expectation 
that the Board will exercise this oversight vigorously.
    The recently completed Supervisory Capital Assessment 
Program (SCAP) provides an excellent example of how this 
oversight and interaction can operate effectively in practice. 
The SCAP process was a critically important part of the 
government's efforts to promote financial stability and ensure 
that the largest banking organizations have sufficient capital 
to continue providing credit to households and businesses even 
under adverse economic conditions. The Board played a lead and 
active role in the design of the SCAP, the coordination and 
implementation of program policies, and the assessment of 
results across all Federal Reserve districts. These efforts 
were instrumental in ensuring that the SCAP was rigorous, 
comprehensive, transparent, effective, and uniformly applied. 
The Board is considering ways to apply the lessons learned from 
the SCAP to the Federal Reserve's regular supervisory 
activities to make them stronger, more effective, and more 
consistent across districts.

Q.7. Too-Big-To-Fail--Chairman Bair stated in her written 
testimony that ``the most important challenge is to find ways 
to impose greater market discipline on systemically important 
institutions. The solution must involve, first and foremost, a 
legal mechanism for the orderly resolution of those 
institutions similar to that which exists for FDIC-insured 
banks. In short we need to end too big to fail.'' I would agree 
that we need to address the too-big-to-fail issue, both for 
banks and other financial institutions.
    Could each of you tell us whether putting a new resolution 
regime in place would address this issue?
    How would we be able to convince the market that these 
systemically important institutions would not be protected by 
taxpayer resources as they had been in the past?

A.7. As we have seen in the current financial crisis, large, 
complex, interconnected financial firms pose significant 
challenges to supervisors. Policymakers have strong incentives 
to prevent the failure of such firms because of the risks such 
a failure would pose to the financial system and the broader 
economy. However, the belief of market participants that a 
particular firm will receive special government assistance if 
it becomes troubled has many undesirable effects. For instance, 
it reduces market discipline and encourages excessive risk-
taking by the firm. It also provides an artificial incentive 
for firms to grow in size and complexity, in order to be 
perceived as too big to fail. And it creates an unlevel playing 
field with smaller firms, which may not be regarded as having 
implicit government support. Moreover, of course, the 
government rescues of such firms are potentially very costly to 
taxpayers.
    Improved resolution procedures for systemically important 
financial firms would help reduce the too-big-to-fail problem 
in two ways. First, such procedures would visibly provide the 
authorities with the legal tools needed to manage the failure 
of a systemically important firm while still ensuring that 
creditors and counterparties suffer appropriate losses in the 
event of the firm's failure. As a result, creditors and 
counterparties should have greater incentives to impose market 
discipline on financial firms. Second, by giving the government 
options other than general support to keep a distressed firm 
operating, resolution procedures should give the managers of 
systemically important firms somewhat better incentives to 
limit risk taking and avoid failure.
    While resolution authority of this sort is an important 
piece of an agenda to control systemic risk, it is no panacea. 
In the first place, resolving a large, complex financial 
institution is a completely different task from resolving a 
small or medium-sized bank. No part of the U.S. Government has 
experience in this task. Although one or more agencies could 
acquire relevant expertise as needed, we cannot be certain how 
this resolution mechanism would operate in practice. Second, 
precisely because of the uncertainties that will, at least for 
a time, surround a statutory mechanism of this sort, there must 
also be effective supervision and regulation of these 
institutions that is targeted more directly at their systemic 
importance.

Q.8. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank 
capital regulation. Some commentators have endorsed a concept 
requiring banks to hold more capital when good conditions 
prevail, and then allow banks to temporarily hold less capital 
in order not to restrict access to credit during a downturn. 
Advocates of this system believe that counter-cyclical policies 
could reduce imbalances within financial markets and smooth the 
credit cycle itself.
    What do you see as the costs and benefits of adopting a 
more counter-cyclical system of regulation?
    Do you see any circumstances under which your agencies 
would take a position on the merits of counter-cyclical 
regulatory policy?

A.8. There is a good bit of evidence that current capital 
standards, accounting rules, certain other regulations, and 
even deposit insurance premiums have made the financial sector 
excessively pro-cyclical--that is, they lead financial 
institutions to ease credit in booms and tighten credit in 
downturns more than is justified by changes in the 
creditworthiness of borrowers, thereby intensifying cyclical 
changes.
    For example, capital regulations require that banks' 
capital ratios meet or exceed fixed minimum standards in order 
for the bank to be considered safe and sound by regulators. 
Because banks typically find raising capital to be difficult in 
economic downturns or periods of financial stress, their best 
means of boosting their regulatory capital ratios during 
difficult periods may be to reduce new lending, perhaps more so 
than is justified by the credit environment.
    As I noted in my testimony, the Federal Reserve is working 
with other U.S. and foreign supervisors to strengthen the 
existing capital rules to achieve a higher level and quality of 
required capital. As one part of this overall effort, we have 
been assessing various proposals for mitigating the pro-
cyclical effects of existing capital rules, including dynamic 
provisioning or a requirement that financial institutions 
establish strong capital buffers above current regulatory 
minimums in good times, so that they can weather financial 
market stress and continue to meet customer credit needs. This 
is but one of a number of important ways in which the current 
pro-cyclical features of financial regulation could be 
modified, with the aim of counteracting rather than 
exacerbating the effects of financial stress.

Q.9. G20 Summit and International Coordination--Many foreign 
officials and analysts have said that they believe the upcoming 
G20 summit will endorse a set of principles agreed to by both 
the Financial Stability Forum and the Basel Committee, in 
addition to other government entities. There have also been 
calls from some countries to heavily re-regulate the financial 
sector, pool national sovereignty in key economic areas, and 
create powerful supranational regulatory institutions. 
(Examples are national bank resolution regimes, bank capital 
levels, and deposit insurance.) Your agencies are active 
participants in these international efforts.
    What do you anticipate will be the result of the G20 
summit?
    Do you see any examples or areas where supranational 
regulation of financial services would be effective?
    How far do you see your agencies pushing for or against 
such supranational initiatives?

A.9. As you point out, the Federal Reserve has for many years 
worked with international organizations such as the Basel 
Committee on Banking Supervision, the Financial Stability Forum 
(now the Financial Stability Board), the Joint Forum and others 
on matters of mutual interest. Our participation reflects our 
long-held belief, reinforced by the current financial crisis, 
that the international dimensions of financial supervision and 
regulation and financial stability are critical to the health 
and stability of the U.S. financial system and economy, as well 
as to the competitiveness of our financial firms. Thus, it is 
very much in the self-interest of the United States to play an 
active role in international forums. Our approach in these 
groups has not been on the development of supranational 
authorities. Rather, it has been on the voluntary collection 
and sharing of information, the open discussion of views, the 
development of international contacts and knowledge, the 
transfer of technical expertise, cooperation in supervising 
globally active financial firms, and agreements an basic 
substantive rules such as capital requirements. As evidenced in 
the activities of the G20 and the earlier-mentioned 
international fora, the extraordinary harm worked by the 
current financial crisis on an international scale suggests the 
need for continued evolution of these approaches to ensure the 
stability of major financial firms and systems around the 
world.

Q.10. Consolidated Supervised Entities--Mr. Tarullo, in your 
testimony you noted that ``the SEC was forced to rely on a 
voluntary regime'' because it lacked the statutory authority to 
act as a consolidated supervisor.
    Who forced the SEC to set up the voluntary regime? Was it 
the firm that wanted to avoid being subject to a more rigorous 
consolidated supervision regime?

A.10. Under the Securities Exchange Act of 1934 (15 U.S.C. 
78a, et seq.), the Securities and Exchange Commission (SEC) 
has broad supervisory authority over SEC-registered broker-
dealers, but only limited authority with respect to a company 
that controls a registered broker-dealer. See 15 U.S.C. 78o 
and 78q(h). In 2002, the European Union (EU) adopted a 
directive that required banking groups and financial 
conglomerates based outside the EU to receive, by August 2004, 
a determination that the financial group was subject to 
consolidated supervision by its home country authorities in a 
manner equivalent to that required by the EU for EU-based 
financial groups. If a financial group could not obtain such a 
determination, the directive permitted EU authorities to take a 
range of actions with respect to the non-EU financial group, 
including requiring additional reports from the group or, 
potentially, requiring the group to reorganize all its EU 
operations into a single EU holding company that would be 
subject to consolidated supervision by a national regulator 
within the EU. See Directive 2002/87/EC of the European 
Parliament and of the Council of 16 (Dec. 2002). After this 
directive was adopted, several of the large U.S. investment 
banks that were not affiliated at the time with a bank holding 
company expressed concern that, if they were unable to obtain 
an equivalency determination from the EU, the firms' 
significant European operations could be subject to potentially 
costly or disruptive EU-imposed requirements under the 
directive.
    In light of these facts, and to improve its own ability to 
monitor and address the risks at the large U.S. investment 
banks that might present risks to their subsidiary broker-
dealers, the SEC in 2004 adopted rules establishing a voluntary 
consolidated supervision regime for those investment banking 
firms that controlled U.S. broker-dealers with at least $1 
billion in tentative net capital, and at least $500 million of 
net capital, under the SEC's broker-dealer capital rules. The 
Goldman Sachs Group, Inc. (Goldman Sachs), Morgan Stanley, 
Merrill Lynch & Co., Inc. (Merrill Lynch), Lehman Brothers 
Holdings, Inc. (Lehman), and The Bear Stearns Companies, Inc., 
each applied and received approval to become consolidated 
supervised entities (CSEs) under the SEC's rules. These rules 
were not the same as would have applied to these entities had 
they became bank holding companies. While operating as CSEs, 
Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman also 
controlled FDIC-insured state banks under a loophole in current 
law that allows any type of company to acquire an FDIC-insured 
industrial loan company (LC) chartered in certain states 
without becoming subject to the prudential supervisory and 
regulatory framework established under the Bank Holding Company 
Act of 1956 (BHC Act). \1\ As I noted in my testimony, the 
Board continues to believe that this loophole in current law 
should be closed.
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     \1\ The ownership of such ILCs also disqualified such firms from 
potential participation in the alternative, voluntary consolidated 
supervisory regime that Congress authorized the SEC to establish for 
``investment bank holding companies'' as part of the Gramm-Leach-Bliley 
Act of 1999. See 15 U.S.C. 78q(i)(1)(A)(i).

Q.11. Credit Default Swaps--Mr. Tarullo, the Federal Reserve 
Bank of New York has been actively promoting the central 
clearing of credit default swaps.
    How will you encourage market participants, some of whom 
benefit from an opaque market, to clear their trades?
    Is it your intent to see the establishment of one 
clearinghouse or are you willing to allow multiple central 
clearing facilities to exist and compete with one another?
    Is the Fed working with European regulators to coordinate 
efforts to promote clearing of CDS transactions?
    How will the Fed encourage market participants, some of 
whom benefit from an opaque market, to clear their credit 
default swap transactions?
    Is it the Fed's expectation that there will be only one 
credit default swap clearinghouse or do you envision multiple 
central clearing counterparties existing in the long run?
    How is the Fed working with European regulators to 
coordinate efforts to promote clearing of credit default swap 
transactions?
    What other classes of OTC derivatives are good candidates 
for central clearing and what steps is the Fed taking to 
encourage the development and use of central clearing 
counterparties?

A.11. The Federal Reserve can employ supervisory tool to 
encourage derivatives dealers that are banks or part of a bank 
holding company to centrally clear CDS. These include the use 
of capital charges to provide incentives, as well as direct 
supervisory guidance for firms to ensure that any product to 
which such a dealer is a party will, if possible, be submitted 
to and cleared by a CCP.
    The Federal Reserve is also encouraging greater 
transparency in the CDS market. Through the Federal Reserve 
Bank of New York's (FRBW) ongoing initiatives with market 
participants, the major dealers have been providing regulators 
with data on the volumes of CDS trades that are recorded in the 
trade repository and will soon begin reporting data around the 
volume of CDS trades cleared through a CCP.
    There are multiple existing or proposed CCPs for CDS. The 
Federal Reserve has not endorsed any one CCP proposal. Our top 
priority is that any CDS CCP be well-regulated and prudently 
managed. We believe that market forces in a competitive 
environment should determine which and how many CDS CCPs exist 
in the long run.
    The FRBNY has hosted a series of meetings with U.S. and 
foreign regulators to discuss possible information sharing 
arrangements and other methods of cooperation within the 
regulatory community. Most recently, the FRBNY hosted a 
workshop on April 17, attended by 28 financial regulators 
including those with direct regulatory authority over a CCP, as 
well as other interested regulators and governmental 
authorities that are currently considering CDS market matters. 
Workshop participants included European regulators with broad 
coverage such as the European Commission, the European Central 
Bank and the Committee of European Securities Regulators. \2\ 
Participants discussed CDS CCP regulatory interests and 
information needs of other authorities and the market more 
broadly and agreed to a framework to facilitate information 
sharing and cooperation.
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     \2\ Regulators and other interested authorities that attended the 
April 17 Workshop included: Belgian Banking, Finance and Insurance 
Commission (CBFA), National Bank of Belgium, Committee of European 
Securities Regulators (CESR), European Central Bank, European 
Commission, Bank of France, Commission Bancaire, French Financial 
Markets Authority (AMF), Deutsche Bundesbank, German Financial 
Supervisory Authority (BaFin), Committee on Payment and Settlement 
Systems (CPSS) Bank of Italy, Bank of Japan, Japan Financial Services 
Agency , Netherlands Authority for the Financial Markets (AFM), 
Netherlands Bank , Bank of Spain, Spanish National Securities Market 
Commission (CNMV), Swiss Financial Market Supervisory Authority 
(FINMA). Swiss National Bank, Bank of England, UK Financial Services 
Authority, Commodity Futures Trading Commission, Federal Deposit 
Insurance Corporation, Federal Reserve Bank of New York, Federal 
Reserve Board, New York State Banking Department, Office of the 
Comptroller of the Currency, and the Securities and Exchange 
Commission.
---------------------------------------------------------------------------
    The FRBNY will continue to coordinate with other regulators 
in the U.S. and Europe to establish a coherent approach for 
communicating supervisory expectations, to encourage consistent 
treatment of CCPs across jurisdictions, and to ensure that 
regulators have adequate access to the information necessary to 
carry out their respective objectives.
    Additionally, since 2005 the FRBNY has been coordinating 
with foreign regulators \3\ in its ongoing work with major 
dealers and large buy-side firms to strengthen the operational 
infrastructure of the OTC derivatives market more broadly. The 
regulatory community holds monthly calls to discuss, these 
efforts, which include central clearing for CDS.
---------------------------------------------------------------------------
     \3\ Foreign regulators engaged in this effort include the UK 
Financial Services Authority, the German Federal Financial Supervisory 
Authority, the French Commission Bancaire, and the Swiss Financial 
Market Supervisory Authority.
---------------------------------------------------------------------------
    The degree of risk reduction and enhanced operational 
efficiency that might be obtained from the use of a CCP may 
vary across asset classes. However, a CCP for any OTC 
derivatives asset class must be well designed with effective 
risk management controls that meet, at a minimum, international 
standards for central counterparties.
    A number of CCPs are already in use for other OTC 
derivatives asset classes including LCH.Clearnet's SwapClear 
for interest rates and CME/NYMEX's ClearPort for energy and 
other OTC commodities. The FRBNY is working with the market 
participants to ensure that clearing members utilize more fully 
available clearing services and to encourage CCPs to support 
additional products and include a wider range of participants. 
The industry will provide further details to regulators and the 
public at the end of May addressing many of these issues for 
the various derivative asset classes.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                     FROM DANIEL K. TARULLO

Q.1. It is clear that our current regulatory structure is in 
need of reform. At my subcommittee hearing on risk management, 
March 18, 2009, GAO pointed out that regulators often did not 
move swiftly enough to address problems they had identified in 
the risk management systems of large, complex financial 
institutions.
    Chair Bair's written testimony for today's hearing put it 
very well: `` . . . the success of any effort at reform will 
ultimately rely on the willingness of regulators to use their 
authorities more effectively and aggressively.''
    My questions may be difficult, but please answer the 
following:

    If this lack of action is a persistent problem 
        among the regulators, to what extent will changing the 
        structure of our regulatory system really get at the 
        issue?

    Along with changing the regulatory structure, how 
        can Congress best ensure that regulators have clear 
        responsibilities and authorities, and that they are 
        accountable for exercising them ``effectively and 
        aggressively''?

A.1. Changing regulatory structures and--for that matter--
augmenting existing regulatory authorities are necessary, but 
not sufficient, steps to engender strong and effective 
financial regulation. The regulatory orientation of agency 
leadership and staff are also central to achieving this end. 
While staff capacities and expertise will generally not 
deteriorate (or improve) rapidly, leadership can sometimes 
change extensively and quickly.
    While this fact poses a challenge in organizing regulatory 
systems, there are some things that can be done. Perhaps most 
important is that responsibilities and authorities be both 
clearly defined and well-aligned, so that accountability is 
clear. Thus, for example, assigning a particular type of 
rulemaking and rule implementation to a specific agency makes 
very clear who deserves either blame or credit for outcomes. 
Where a rulemaking or rule enforcement process is collective, 
on the other hand, the apparent shared responsibility may mean 
in practice that no one is responsible: Procedural delays and 
substantive outcomes can also be attributed to someone else's 
demands or preferences.
    When responsibility is assigned to an agency, the agency 
should be given adequate authority to execute that 
responsibility effectively. In this regard, Congress may wish 
to review the Gramm-Leach-Bliley Act and other statutes to 
ensure that authorities and responsibilities are clearly 
defined for both primary and consolidated supervisors of 
financial firms and their affiliates. Some measure of 
regulatory overlap may be useful in some circumstances--a kind 
of constructive redundancy--so long as both supervisors have 
adequate incentives for balancing various policy objectives. 
But if, for example, access to information is restricted or one 
supervisor must rely on the judgments of the other, the risk of 
misaligned responsibility and authority recurs.

Q.2. How do we overcome the problem that in the boom times no 
one wants to be the one stepping in to tell firms they have to 
limit their concentrations of risk or not trade certain risky 
products?
    What thought has been put into overcoming this problem for 
regulators overseeing the firms?
    Is this an issue that can be addressed through regulatory 
restructure efforts?

A.2. Your questions highlight a very real and important issue--
how best to ensure that financial supervisors exercise the 
tools at their disposal to address identified risk management 
weaknesses at an institution or within an industry even when 
the firm, the industry, and the economy are experiencing growth 
and appear in sound condition. In such circumstances, there is 
a danger that complacency or a belief that a ``rising tide will 
lift all boats'' may weaken supervisory resolve to forcefully 
address issues. In addition, the supervisor may well face 
pressure from external sources--including the supervised 
institutions, industry or consumer groups, or elected 
officials--to act cautiously so as not to change conditions 
perceived as supporting growth. For example, in 2006, the 
Federal Reserve, working in conjunction with the other federal 
banking agencies, developed guidance highlighting the risks 
presented by concentrations in commercial real estate. This 
guidance drew criticism from many quarters, but is particularly 
relevant today given the substantial declines in many regional 
and local commercial real estate markets.
    Although these dangers and pressures are to some degree 
inherent in any regulatory framework, there are ways these 
forces can be mitigated. For example, sound and effective 
leadership at any supervisory agency is critical to the 
consistent achievement of that agency's mission. Moreover, 
supervisory agencies should be structured and funded in a 
manner that provides the agency appropriate independence. Any 
financial supervisory agency also should have the resources, 
including the ability to attract and retain skilled staff, 
necessary to properly monitor, analyze and--when necessary--
challenge the models, assumptions and other risk management 
practices and internal controls of the firms it supervises, 
regardless of how large or complex they may be.
    Ultimately, however, supervisors must show greater resolve 
in demanding that institutions remain in sound financial 
condition, with strong capital and liquidity buffers, and that 
they have strong risk management. While these may sound like 
obvious statements in the current environment, supervisors will 
be challenged when good times return to the banking industry 
and bankers claim that they have learned their lessons. At 
precisely those times, when bankers and other financial market 
actors are particularly confident, when the industry and others 
are especially vocal about the costs of regulatory burden and 
international competitiveness, and when supervisors cannot yet 
cite recognized losses or writedowns, regulators must be firm 
in insisting upon prudent risk management.
    Once again, regulatory restructuring can he helpful, but 
will not be a panacea. Financial regulators should speak with 
one, strong voice in demanding that institutions maintain good 
risk management practices and sound financial condition. We 
must be particularly attentive to cases where different 
agencies could be sending conflicting messages. Improvements to 
the U.S. regulatory structure could provide added benefit by 
ensuring that there are no regulatory gaps in the U.S. 
financial system, and that entities cannot migrate to a 
different regulator or, in some cases, beyond the boundary of 
any regulation, so as to place additional pressure on those 
supervisors who try to maintain firm safety and soundness 
policies.

Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, 
some financial institution failures emanated from institutions 
that were under federal regulation. While I agree that we need 
additional oversight over and information on unregulated 
financial institutions, I think we need to understand why so 
many regulated firms failed.
    Why is it the case that so many regulated entities failed, 
and many still remain struggling, if our regulators in fact 
stand as a safety net to rein in dangerous amounts of risk-
taking?
    While we know that certain hedge funds, for example, have 
failed, have any of them contributed to systemic risk?
    Given that some of the federal banking regulators have 
examiners on-site at banks, how did they not identify some of 
these problems we are facing today?

A.3. My expectation is that, when the history of this financial 
crisis and its origins is ultimately written, culpability will 
be shared by essentially every part of the government 
responsible for constructing and implementing financial 
regulation, as well as many financial institutions themselves. 
Since just about all financial institutions have been adversely 
affected by the financial crisis, all supervisors have lessons 
to learn from this crisis. The Federal Reserve is already 
implementing a number of changes, such as enhancing risk 
identification processes to more quickly detect emerging risks, 
not just at individual institutions but across the banking 
system. This latter point is particularly important, related as 
it is to the emerging consensus that more attention must be 
paid to risks created across institutions. The Board is also 
improving the processes to issue supervisory guidance and 
policies to make them more timely and effective. In 2008 the 
Board issued supervisory guidance on consolidated supervision 
to clarify the Federal Reserve's role as consolidated 
supervisor and to assist examination staff as they carry out 
supervision of banking institutions, particularly large, 
complex firms with multiple legal entities.
    With respect to hedge funds, although their performance was 
particularly poor in 2008, and several large hedge funds have 
failed over the past 2 years, to date none has been a 
meaningful source of systemic risk or resulted in significant 
losses to their dealer bank counterparties. Indirectly, the 
failure of two hedge funds in 2007 operated by Bear Stearns 
might be viewed as contributing to the ultimate demise of that 
investment bank 9 months later, given the poor quality of 
assets the firm had to absorb when it decided to support the 
funds. However, these failures in and of themselves were not 
the sole cause of Bear Stearns' problems. Of course, the 
experience with Long Term Capital Management in 1998 stands as 
a reminder that systemic risk can be associated with the 
activities of large, highly leveraged hedge funds.
    On-site examiners of the federal banking regulators did 
identify a number of issues prior to the current crisis, and in 
some cases developed policies and guidance for emerging risks 
and issues that warranted the industry's attention--such as in 
the areas of nontraditional mortgages, home equity lending, and 
complex structured financial transactions. But it is clear that 
examiners should have been more forceful in demanding that 
bankers adhere to policies and guidance, especially to improve 
their own risk management capacities. Going forward, changes 
have been made in internal procedures to ensure appropriate 
supervisory follow-through on issues that examiners do 
identify, particularly during good times when responsiveness to 
supervisory policies and guidance may be lower.

Q.4. While I think having a systemic risk regulator is 
important, I have concerns with handing additional authorities 
to the Federal Reserve after hearing GAO's testimony yesterday 
at my subcommittee hearing.
    Some of the Fed's supervision authority currently looks a 
lot like what it might conduct as a systemic risk regulator, 
and the record there is not strong from what I have seen.
    If the Federal Reserve were to be the new systemic risk 
regulator, has there been any discussion of forming a board, 
similar to the Federal Open Market Committee, that might 
include other regulators and meet quarterly to discuss and 
publicly report on systemic risks?
    If the Federal Reserve were the systemic risk regulator, 
would it conduct horizontal reviews that it conducts as the 
supervisor for bank holding companies, in which it looks at 
specific risks across a number of institutions?
    If so, and given what we heard March 18, 2009, at my 
subcommittee hearing from GAO about the weaknesses with some of 
the Fed's follow-up on reviews, what confidence can we have 
that the Federal Reserve would do a better job than it has so 
far?

A.4. In thinking about reforming financial regulation, it may 
be useful to begin by identifying the desirable components of 
an agenda to contain systemic risk, rather than with the 
concept of a specific systemic risk regulator. In my testimony 
I suggested several such components--consolidated supervision 
of all systemically important financial institutions, analysis 
and monitoring of potential sources of systemic risk, special 
capital and other rules directed at systemic risk, and 
authority to resolve nonbank, systemically important financial 
institutions in an orderly fashion. As a matter of sound 
administrative structure and practice, there is no reason why 
all four of these tasks need be assigned to the same agency. 
Indeed, there may be good reasons to separate some of these 
functions--for example, conflicts may arise if the same agency 
were to be both a supervisor of an institution and the 
resolution authority for that institution if it should fail.
    Similarly, there is no inherent reason why an agency 
charged with enacting and enforcing special rules addressed to 
systemic risk would have to be the consolidated supervisor of 
all systemically important institutions. If another agency had 
requisite expertise and experience to conduct prudential 
supervision of such institutions, and so long as the systemic 
risk regulator would have necessary access to information 
through examination and other processes and appropriate 
authority to address potential systemic risks, the roles could 
be separated. For example, were Congress to create a federal 
insurance regulator with a safety and soundness mission, that 
regulator might be the most appropriate consolidated supervisor 
for nonbank holding company firms whose major activities are in 
the insurance area.
    With respect to analysis and monitoring, it would seem 
useful to incorporate an interagency process into the framework 
for systemic risk regulation. Identification of inchoate or 
incipient systemic risks will in some respects be a difficult 
exercise, with a premium on identifying risk correlations among 
firms and markets. Accordingly, the best way to incorporate 
more expertise and perspectives into the process is through a 
collective process, perhaps a designated sub-group of the 
President's Working Group on Financial Markets. Because the 
aim, of this exercise would be analytic, rather than 
regulatory, there would be no problem in having both executive 
departments and independent agencies cooperating. Moreover, as 
suggested in your question, it may be useful to formalize this 
process by having it produce periodic public reports. An 
additional benefit of such a process would be that to allow 
nongovernmental analysts to assess and, where appropriate, 
critique these reports. As to potential rule-making, on the 
other hand, experience suggests that a single agency should 
have both authority and responsibility. While it may be helpful 
for a rule-maker to consult with other agencies, having a 
collective process would seem a prescription for delay and for 
obscuring accountability.
    Regardless of whether the Federal Reserve is given 
additional responsibilities, we will continue to conduct 
horizontal reviews. Horizontal reviews of risks, risk 
management practices and other issues across multiple financial 
firms are very effective vehicles for identifying both common 
trends and institution-specific weaknesses. The recently 
completed Supervisory Capital Assessment Program (SCAP) 
demonstrates the effectiveness of such reviews and marked an 
important evolutionary step in the ability of such reviews to 
enhance consolidated supervision. This exercise was 
significantly more comprehensive and complex than horizontal 
supervisory reviews conducted in the past. Through these 
reviews, the Federal Reserve obtained critical perspective on 
the capital adequacy and risk management capabilities of the 19 
largest U.S. bank holding companies in light of the financial 
turmoil of the last year.
    While the SCAP process was an unprecedented supervisory 
exercise in an unprecedented situation, it does hold important 
lessons for more routine supervisory practice. The review 
covered a wide range of potential risk exposures and available 
firm resources. Prior supervisory reviews have tended to focus 
on fewer firms, specific risks and/or individual business 
lines, which likely resulted in more, ``siloed'' supervisory 
views. A particularly innovative and effective element of the 
SCAP review was the assessment of individual institutions using 
a uniform set of supervisory devised stress parameters, 
enabling better supervisory targeting of institution-specific 
strengths and weaknesses. Follow-up from these assessments was 
rapid, and detailed capital plans for the institutions will 
follow shortly.
    As already noted, we expect to incorporate lessons from 
this exercise into our consolidated supervision of bank holding 
companies. In addition, though, the SCAP process suggests some 
starting points for using horizontal reviews in systemic risk 
assessment.
    Regarding your concerns about the Federal Reserve's 
performance in the run-up to the financial crisis, we are in 
the midst of a comprehensive review of all aspects of our 
supervisory practices. Since last year, Vice Chairman Kohn has 
led an effort to develop recommendations for improvements in 
our conduct of both prudential supervision and consumer 
protection. We are including advice from the Government 
Accountability Office, the Congress, the Treasury, and others 
as we look to improve our own supervisory practices. Among 
other things, our analysis reaffirms that capital adequacy, 
effective liquidity planning, and strong risk management are 
essential for safe and sound banking; the crisis revealed 
serious deficiencies on the part of some financial institutions 
in one or more of the areas. The crisis has likewise 
underscored the need for more coordinated, simultaneous 
evaluations of the exposures and practices of financial 
institutions, particularly large, complex firms.

Q.5. Mr. Tarullo, the Federal Reserve has been at the forefront 
of encouraging countries to adopt Basel II risk-based capital 
requirements. This model requires, under Pillar I of Basel II, 
that risk-based models calculate required minimum capital.
    It appears that there were major problems with these risk 
management systems, as I heard in GAO testimony at my 
subcommittee hearing on March l8th, 2009, so what gave the Fed 
the impression that the models were ready enough to be the 
primary measure for bank capital?
    Moreover, how can the regulators know what ``adequately 
capitalized'' means if regulators rely on models that we now 
know had material problems?

A.5. The current status of Basel II implementation is defined 
by the November 2007 rule that was jointly issued by the Office 
of the Comptroller of the Currency, Federal Deposit Insurance 
Corporation, Office of Thrift Supervision, and Federal Reserve 
Board. Banks will not be permitted to operate under the 
advanced approaches until supervisors are confident the 
underlying models are functioning in a manner that supports 
using them as basis for determining inputs to the risk-based 
capital calculation. The rule imposes specific model 
validation, stress testing, and internal control requirements 
that a bank must meet in order to use the Basel II advanced 
approaches. In addition, a bank must demonstrate that its 
internal processes meet all of the relevant qualification 
requirements for a period of at least 1 year (the parallel run) 
before it may be permitted by its supervisor to begin using 
those processes to provide inputs for its risk-based capital 
requirements. During the first 3 years of applying Basel II, a 
bank's regulatory capital requirement would not be permitted to 
fall below floors established by reference to current capital 
rules. Moreover, banks will not be allowed to exit this 
transitional period if supervisors conclude that there are 
material deficiencies in the operation of the Basel II approach 
during these transitional years. Finally, supervisors have the 
continued authority to require capital beyond the minimum 
requirements, commensurate with a bank's credit, market, 
operational, or other risks.
    Quite apart from these safeguards that U.S. regulators will 
apply to our financial institutions, the Basel Committee has 
undertaken initiatives to strengthen capital requirements--both 
those directly related to Basel II and other areas such as the 
quality of capital and the treatment of market risk. Staff of 
the Federal Reserve and other U.S. regulatory agencies are 
participating fully in these reviews. Furthermore, we have 
initiated an internal review on the pace and nature of Basel II 
implementation, with particular attention to how the long-
standing debate over the merits and limitations of Basel II has 
been reshaped by experience in the current financial crisis. 
While Basel II was not the operative capital requirement for 
U.S. banks in the prelude to the crisis, or during the crisis 
itself, regulators must understand how it would have made 
things better or worse before permitting firms to use it as the 
basis for regulatory capital requirements.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                     FROM DANIEL K. TARULLO

Q.1. The convergence of financial services providers and 
financial products has increased over the past decade. 
Financial products and companies may have insurance, banking, 
securities, and futures components. One example of this 
convergence is AIG. Is the creation of a systemic risk 
regulator the best method to fill in the gaps and weaknesses 
that AIG has exposed, or does Congress need to reevaluate the 
weaknesses of federal and state functional regulation for 
large, interconnected, and large firms like AIG?

A.1. The approaches of establishing systemic risk regulation 
and reassessing current statutory patterns of functional 
regulation need not be mutually exclusive, and Congress may 
want to consider both. Empowering a governmental authority to 
monitor, assess and, if necessary, curtail systemic risks 
across the entire U.S. financial system is one way to help 
protect the financial system from risks that may arise within 
or across financial industries or markets that may be 
supervised or regulated by different financial supervisors or 
that may be outside the jurisdiction of any financial 
supervisor. AIG is certainly an example of a firm whose 
connections with other financial entities constituted a 
distinct source of systemic risk.
    At the same time, strong and effective consolidated 
supervision provides the institution-specific focus necessary 
to help ensure that large, diversified organizations operate in 
a safe and sound manner, regardless of where in the 
organization its various activities are conducted. Indeed as I 
indicated in my testimony, systemic risk regulatory authority 
should complement, not displace, consolidated supervision. 
While all holding companies that own a bank are subject to 
group-wide consolidated supervision under the Bank Holding 
Company Act (12 U.S.C. 184141 et seq.) other systemically 
significant companies may currently escape such supervision. In 
addition, as suggested by your question, Congress may wish to 
consider whether a broader and more robust application of the 
principle of consolidated supervision would help reduce the 
potential for the build up of risk-taking in different parts of 
a financial organization or the financial sector more broadly. 
This could entail, among other things, revising the provisions 
of Gramm-Leach-Bliley Act that currently limit the ability of 
consolidated supervisors to monitor and address risks at 
functionally regulated subsidiaries within a financial 
organization and specifying that consolidated supervisors of 
financial firms have clear authority to monitor and address 
safety and soundness concerns in all parts of an organization.

Q.2. Recently there have been several proposals to consider for 
financial services conglomerates. One approach would be to move 
away from functional regulation to some type of single 
consolidated regulator like the Financial Services Authority 
model. Another approach is to follow the Group of 30 Report 
which attempts to modernize functional regulation and limit 
activities to address gaps and weaknesses. An in-between 
approach would be to move to an objectives-based regulation 
system suggested in the Treasury Blueprint. What are some of 
the pluses and minuses of these three approaches?

A.2. There are two separate, but related, questions to answer 
in thinking about regulation of large, complex financial 
institutions. The first pertains to the substantive regulatory 
approaches to be adopted, the second to how those regulatory 
tasks will be allocated to specific regulatory agencies. As to 
the former question, in considering possible changes to current 
arrangements, Congress should be guided by a few basic 
principles that should help shape a legislative program.
    First, recent experience has shown that it is critical that 
all systemically important firms be subject to effective 
consolidated supervision. The lack of consolidated supervision 
can leave gaps in coverage that allow large financial firms to 
take actions that put themselves, other firms, and the entire 
financial sector at risk. To be fully effective, consolidated 
supervisors must have clear authority to monitor and address 
safety and soundness concerns in all parts of an organization. 
Accordingly, specific consideration should be given to 
modifying the limits currently placed on the ability of 
consolidated supervisors to monitor and address risks at an 
organization's functionally regulated subsidiaries.
    Second, it is important to have a resolution regime that 
facilitates managing the failure of a systemically important 
financial firm in an orderly manner, including a mechanism to 
cover the costs of the resolution. In most cases, federal 
bankruptcy laws provide an appropriate framework for the 
resolution of nonbank financial institutions. However, this 
framework does not sufficiently protect the public's interest 
in ensuring the orderly resolution of nonbank financial 
institutions when a failure would pose substantial systemic 
risks.
    With respect to the allocation of regulatory missions among 
agencies, one can imagine a range of institutional arrangements 
that could provide for the effective supervision of financial 
services firms. While models adopted in other countries can be 
useful in suggesting options, the breadth and complexity of the 
financial services industry in the United States suggests that 
the most workable arrangements will take account of the 
specific characteristics of our industry. As previously 
indicated, we suggest that Congress consider charging an agency 
with an explicit financial stability mission, including such 
tasks as assessing and, if necessary, curtailing systemic risks 
across the U.S. financial system. While establishment of such 
an authority would not be a panacea, this mission could 
usefully complement the focus of safety and soundness 
supervisors of individual firms.

Q.3. If there are institutions that are too big to fail, how do 
we identify that? How do we define the circumstance where a 
single company is so systemically significant to the rest of 
our financial circumstances and our economy that we must not 
allow it to fail?

A.3. Identifying whether a given institution's failure is 
likely to impose systemic risks on the U.S. financial system 
and our overall economy depends on specific economic and market 
conditions, and requires substantial judgment by policymakers. 
That said, several key principles should guide policymaking in 
this area.
    No firm should be considered too big to fail in the sense 
that existing stockholders cannot lose their entire investment, 
existing senior management and boards of directors cannot be 
replaced, and over time the organization cannot be wound down 
or sold in whole or in part. In addition, from the point of 
view of maintaining financial stability, it is critical that 
such a wind down occur in an orderly manner, the reason for our 
recommendation for improved resolution procedures for 
systemically financial firms. Still, even without improved 
procedures, it is important to try to resolve the firm in an 
orderly manner without guaranteeing the longer-term existence 
of any individual firm.
    The core concern of policymakers should be whether the 
failure of the firm would likely have contagion, or knock-on, 
effects on other key financial institutions and markets, and 
ultimately on the real economy. Such interdependencies can be 
direct, such as through deposit and loan relationships, or 
indirect, such as through concentrations in similar types of 
assets. Interdependencies can extend to broader financial 
markets and can also be transmitted through payment and 
settlement systems. The failure of the firm and other 
interconnected firms might affect the real economy through a 
sharp reduction in the supply of credit, or rapid declines in 
the prices of key financial and nonfinancial assets. Of course, 
contagion effects are typically more likely in the case of a 
very large institution than with a smaller institution. 
However, size is not the only criterion for determining whether 
a firm is potentially systemic. A firm may have systemic 
importance if it is critical to the functioning of key markets 
or critical payment and settlement systems.

Q.4. We need to have a better idea of what this notion of too 
big to fail is--what it means in different aspects of our 
industry and what our proper response to it should be. How 
should the federal government approach large, multinational, 
and systemically significant companies?

A.4. As we have seen in the current financial crisis, large, 
complex, interconnected financial firms pose significant 
challenges to supervisors. Policymakers have strong incentives 
to prevent the failure of such firms, particularly in a crisis, 
because of the risks that a failure would pose to the financial 
system and the broader economy. However, the belief of market 
participants that a particular firm will receive special 
government assistance if it becomes troubled has many 
undesirable effects. It reduces market discipline and 
encourages excessive risk-taking by the firm. It also provides 
an incentive for firms to grow in size and complexity, in order 
to be perceived as too big to fail. And it creates an unlevel 
playing field with smaller firms, which may not be regarded as 
having implicit government support. Moreover, government 
rescues of such firms can involve the commitment of substantial 
public resources, as we have seen recently, with the potential 
for taxpayer losses.
    In the midst of this crisis, given the highly fragile state 
of financial markets and the global economy, government 
assistance to avoid the failures of major financial 
institutions was deemed necessary to avoid a further serious 
destabilization of the financial system, with adverse 
consequences for the broader economy. Looking to the future, 
however, it is imperative that policymakers address this issue 
by better supervising systemically critical firms to prevent 
excessive risk-taking and by strengthening the resilience of 
the financial system to minimize the consequences when a large 
firm must be unwound.
    Achieving more effective supervision of large and complex 
financial firms will require, at a minimum, the following 
actions. First, supervisors need to move vigorously to address 
the capital, liquidity, and risk management weaknesses at major 
financial institutions that have been revealed by the crisis. 
Second, the government must ensure a robust framework--both in 
law and practice--for consolidated supervision of all 
systemically important financial firms. Third, the Congress 
should put in place improved tools to allow the authorities to 
resolve systemically important nonbank financial firms in an 
orderly manner, including a mechanism to cover the costs of the 
resolution. Improved resolution procedures for these firms 
would help reduce the too-big-to-fail problem by narrowing the 
range of circumstances that might be expected to prompt 
government intervention to keep a firm operating.

Q.5. What does ``fail'' mean? In the context of AIG, we are 
talking about whether we should have allowed an orderly Chapter 
11 bankruptcy proceeding to proceed. Is that failure?

A.5. As a general matter, a company is considered to have 
``failed'' if it no longer has the capacity to fund itself and 
meet its obligations, is insolvent (that is its obligations to 
others exceed its assets), or other conditions exist that 
permit a governmental authority, a court or stakeholders of the 
company to put the firm into liquidation or place the company 
into a conservatorship, receivership, or similar custodial 
arrangement. Under the Federal Deposit Insurance Act (FDIA), 
for example, a conservator or receiver may be appointed for an 
insured depository institution if any of a number of grounds 
exist. See 12 U.S.C. 1821(c)(5). Such grounds include that the 
institution is in an unsafe or unsound condition to transact 
business, or the institution has incurred or is likely to incur 
losses that deplete all or substantially all of its capital and 
there is no reasonable prospect for the institution to become 
adequately capitalized without federal assistance.
    In the fall of 2008, American International Group, Inc. 
(AIG) faced severe liquidity pressures that threatened to force 
it imminently into bankruptcy. As Chairman Bernanke has 
testified, the Federal Reserve and the Treasury determined that 
AIG's bankruptcy under the conditions then prevailing would 
have posed unacceptable risks to the global financial system 
and to the economy. Such an event could have resulted in the 
seizure of its insurance subsidiaries by their regulators--
leaving policyholders facing considerable uncertainty about the 
status of their claims--and resulted in substantial losses by 
the many banks, investment banks, state and local government 
entities, and workers that had exposures to AIG. The Federal 
Reserve and Treasury also believed that the risks posed to the 
financial system as a whole far outstripped the direct effects 
of a default by AIG on its obligations. For example, the 
resulting losses on AIG commercial paper would have exacerbated 
the problems then facing money market mutual funds. The failure 
of the firm in the middle of a financial crisis also likely 
would have substantially increased the pressures on large 
commercial and investment banks and could have caused 
policyholders and creditors to pull back from the insurance 
industry more broadly.
    The AIG case provides strong support for a broad policy 
agenda that would address both systemic risk and the problems 
caused by firms that may be viewed as being too big, or too 
interconnected, to fail, particularly in times of more 
generalized financial stress. A key aspect of such an agenda 
includes development of appropriate resolution procedures for 
potentially systemic financial firms that would allow the 
government to resolve such a firm in an orderly manner and in a 
way that mitigates the potential for systemic shocks. As 
discussed in my testimony, other important measures that would 
help address the current too-big-to-fail problem include 
ensuring that all systemically important financial firms are 
subject to an effective regime for consolidated prudential 
supervision and vesting a government authority with more direct 
responsibility for monitoring and regulation of potential 
systemic risks in the financial system.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
                     FROM DANIEL K. TARULLO

Q.1. Two approaches to systemic risk seem to be identified: (1) 
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to 
fail'' or ``too systemically important to fail'' or (2) impose 
an additional regulator and additional rules and market 
discipline on institutions that are considered systemically 
important.
    Which approach do you endorse? If you support approach one 
how you would limit institution size and how would you identify 
new areas creating systemic importance?
    If you support approach two how would you identify 
systemically important institutions and what new regulations 
and market discipline would you recommend?

A.1. As we have seen in the current financial crisis, large, 
complex, interconnected financial firms pose significant 
challenges to supervisors. In the current environment, market 
participants recognize that policymakers have strong incentives 
to prevent the failure of such firms because of the risks such 
a failure would pose to the financial system and the broader 
economy. A number of undesirable consequences can ensue: a 
reduction in market discipline, the encouragement of excessive 
risk-taking by the firm, an artificial incentive for firms to 
grow in size and complexity in order to be perceived as too big 
to fail, and an unlevel playing field with smaller firms that 
are not regarded as having implicit government support. 
Moreover, of course, government rescues of such firms can be 
very costly to taxpayers.
    The nature and scope of this problem suggests that multiple 
policy instruments may be necessary to contain it. Firms whose 
failure would pose a systemic risk should be subject to 
especially close supervisory oversight of their risk-taking, 
risk management, and financial condition, and should be held to 
high capital and liquidity standards. As I emphasized in my 
testimony, the government must ensure a robust framework--both 
in law and practice--for consolidated supervision of all 
systemically important financial firms. In addition, it is 
important to provide a mechanism for resolving systemically 
important nonbank financial firm in an orderly manner.
    A systemic risk authority that would be charged with 
assessing and, if necessary, curtailing systemic risks across 
the entire U.S. financial system could complement firm-specific 
consolidated supervision. Such an authority would focus 
particularly on the systemic connections and potential risks of 
systemically important financial institutions.
    Whatever the nature of reforms that are eventually adopted, 
it may well be necessary at some point to identify those firms 
and other market participants whose failure would be likely to 
impose systemic effects. Identifying such firms is a very 
complex task that would inevitably depend on the specific 
circumstances of a given situation and requires substantial 
judgment by policymakers. That being said, several key 
principles should guide policymaking in this area.
    No firm should be considered too big to fail in the sense 
that existing stockholders cannot lose their entire investment, 
existing senior management and boards of directors cannot be 
replaced, and over time the organization cannot be wound down 
or sold in an orderly way either in whole or in part, which is 
why we have recommended that Congress create an orderly 
resolution procedure for systemically important financial 
firms. The core concern of policymakers should be whether the 
failure of the firm would be likely to have contagion, or 
knock-on, effects on other key financial institutions and 
markets and ultimately on the real economy. Of course, 
contagion effects are typically more likely in the case of a 
very large institution than with a smaller institution. 
However, size is not the only criterion for determining whether 
a firm is potentially systemic. A firm may have systemic 
importance if it is critical to the functioning of key markets 
or critical payment and settlement systems.

Q.2. Please identify all regulatory or legal barriers to the 
comprehensive sharing of information among regulators including 
insurance regulators, banking regulators, and investment 
banking regulators. Please share the steps that you are taking 
to improve the flow of communication among regulators within 
the current legislative environment.

A.2. In general, there are few formal regulatory or legal 
barriers to sharing bank supervisory information among 
regulators, and such sharing is done routinely. Like other 
federal banking regulators, the Board's regulations generally 
prohibit the disclosure of confidential supervisory information 
(such as examination reports and ratings, and other supervisory 
correspondence) and other confidential information relating to 
supervised financial institutions without the Board's consent. 
See 12 C.F.R. 261, Subpart C. These regulations, however, 
expressly permit designated Board and Reserve Bank staff to 
make this information available to other Federal banking 
supervisors on request. 12 C.F.R. 261.20(c).. As a practical 
matter, federal banking regulators have access to a database 
that contains examination reports for regulated institutions, 
including commercial banks, bank holding companies, branches of 
foreign banks, and other entities, and can view examination 
material relevant to their supervisory responsibility. State 
banking supervisors also have access to this database for 
entities they regulate. State banking supervisors may also 
obtain other information on request if they have direct 
supervisory authority over the institution or if they have 
entered into an information sharing agreement with their 
regional Federal Reserve Bank and the information concerns an 
institution that has acquired or applied to acquire a financial 
institution subject to the state regulator's jurisdiction. Id. 
at 261.20(d).
    The Board has entered into specific sharing agreements with 
a number of state and federal regulators, including most state 
insurance regulators, the Securities and Exchange Commission, 
the Commodity Futures Trading Commission, the Office of Foreign 
Asset Control (OFAC), and the Financial Crimes Enforcement 
Network (FinCEN), authorizing sharing of information of common 
regulatory and supervisory interest. We frequently review these 
agreements to see whether it would be appropriate to broaden 
the scope of these agreements to permit the release of 
additional information without compromising the examination 
process.
    Other supervisory or regulatory bodies may request access 
to the Board's confidential information about a financial 
institution by directing a request to the Board's general 
counsel. Financial supervisors also may use this process to 
request access to information that is not covered by one of the 
regulatory provisions or agreements discussed above. Normally 
such requests are granted subject to agreement on the part of 
the regulatory body to maintain the confidentiality of the 
information, so long as the requester bas identified a 
legitimate basis for its interest in the information.
    Because the Federal Reserve is responsible for the 
supervision of all bank holding companies and financial holding 
companies on a consolidated basis, it is critical that the 
Federal Reserve also have timely access to the confidential 
supervisory information of other bank supervisors or functional 
regulators relating to the bank, securities, or insurance 
subsidiaries of such holding companies. Indeed, the Gramm-
Leach-Bliley Act (GLBA) provides that the Federal Reserve must 
rely to the fullest extent possible on the reports of 
examinations prepared by the Office of the Comptroller of the 
Currency, the Federal Deposit Insurance Corporation, the SEC, 
and the state insurance authorities for the national bank, 
state nonmember bank, broker-dealer, and insurance company 
subsidiaries of a bank holding company. The GLBA also places 
certain limits on the Federal Reserve's ability to examine or 
obtain reports from functionally regulated subsidiaries of a 
bank holding company.
    Consistent with these provisions, the Federal Reserve has 
worked with other regulators to ensure the proper flow of 
information to the Federal Reserve through information sharing 
arrangements and other mechanisms similar to those described 
above. However, the restrictions in current law still can 
present challenges to timely and effective consolidated 
supervision in light of, among other things, differences in 
supervisory models--for example, between those favored by bank 
supervisors and those used by regulators of insurance and 
securities subsidiaries--and differences in supervisory 
timetables, resources, and priorities. In its review of the 
U.S. financial architecture, we hope that the Congress will 
consider revising the provisions of Gramm-Leach-Bliley Act to 
help ensure that consolidated supervisors have the necessary 
tools and authorities to monitor and address safety and 
soundness concerns in all parts of an organization.

Q.3. What delayed the issuance of regulations under the Home 
Ownership Equity Protection Act for more than 10 years? Was the 
Federal Reserve receiving outside pressure not to write these 
rules? Is it necessary for Congress to implement target 
timelines for agencies to draft and implement rules and 
regulations as they pertain to consumer protections?

A.3. In responding, I will briefly report the history of the 
Federal Reserve's rulemakings under the Home Ownership and 
Equity Protection Act (HOEPA). Although I did not join the 
Board until January 2009, I support the action taken by 
Chairman Bernanke and the Board in 2007 to propose stronger 
HOEPA rules to address practices in the subprime mortgage 
market. I should note, however, that in my private academic 
capacity I believed that the Board should have acted well 
before it did.
    HOEPA, which defines a class of high-cost mortgage loans 
that are subject to restrictions and special disclosures, was 
enacted in 1994 as an amendment to the Truth in Lending Act. In 
March 1995, the Federal Reserve published rules to implement 
HOEPA, which are contained in the Board's Regulation Z. HOEPA 
also gives the Board responsibility for prohibiting acts or 
practices in connection with mortgage loans that the Board 
finds to be unfair or deceptive. The statute further requires 
the Board to conduct public hearings periodically, to examine 
the home equity lending market and the adequacy of existing 
laws and regulations in protecting consumers, and low-income 
consumers in particular. Under this mandate, during the summer 
of 1997 the Board held a series of public hearings. In 
connection with the hearings, consumer representatives 
testified about abusive lending practices, while others 
testified that it was too soon after the statute's October 1995 
implementation date to determine the effectiveness of the new 
law. The Board made no changes to the HOEPA rules resulting 
from the 1997 hearings.
    Over the next several years, the volume of home-equity 
lending increased significantly in the subprime mortgage 
market. With the increase in the number of subprime loans, 
there was increasing concern about a corresponding increase in 
the number of predatory loans. In response, during the summer 
of 2000 the Board held a series of public hearings focused on 
abusive lending practices and the need for additional rules. 
Those hearings were the basis for rulemaking under HOEPA that 
the Board initiated in December 2000 to expand HOEPA's 
protections.
    The Board issued final revisions to the HOEPA rules in 
December 2001. These amendments lowered HOEPA's rate trigger 
for first-lien mortgage loans to extend HOEPA's protections to 
a larger number of high-cost loans. The 2001 final rules also 
strengthened HOEPA's prohibition on unaffordable lending by 
requiring that creditors generally document and verify 
consumers' ability to repay a high-cost HOEPA loan. In 
addition, the amendments addressed concerns that high-cost 
HOEPA loans were ``packed'' with credit life insurance or other 
similar products that increased the loan's cost without 
commensurate benefit to consumers. The Board also used the 
rulemaking authority in HOEPA that authorizes the Board to 
prohibit practices that are unfair, deceptive, or associated 
with abusive lending. Specifically, to address concerns about 
``loan flipping'' the Board prohibited a HOEPA lender from 
refinancing one of its own loans with another HOEPA loan within 
the first year unless the new loan is in the borrower's 
interest. The December 2001 final rule addressed other issues 
as well.
    As the subprime market continued to grow, concerns about 
``predatory lending'' grew. During the summer of 2006, the 
Board conducted four public hearings throughout the country to 
gather information about the effectiveness of its HOEPA rules 
and the impact of the state predatory lending laws. By the end 
of 2006, it was apparent that the nation was experiencing an 
increase in delinquencies and defaults, particularly for 
subprime mortgages, in part as a result of lenders' relaxed 
underwriting practices, including qualifying borrowers based on 
discounted initial rates and the expanded use of ``stated 
income'' or ``no doc'' loans. In response, in March 2007, the 
Board and other federal financial regulatory agencies published 
proposed interagency guidance addressing certain risks and 
emerging issues relating to subprime mortgage lending 
practices, particularly adjustable-rate mortgages. The agencies 
finalized this guidance in June 2007.
    Also in June 2007, the Board held a fifth hearing to 
consider ways in which the Board might use its HOEPA rulemaking 
authority to further curb abuses in the home mortgage market, 
including the subprime sector. This became the basis for the 
new HOEPA rules that the Board proposed in December 2007 and 
finalized in July 2008. Among other things, the Board's 2008 
final rules adopt the same standard for subprime mortgage loans 
that the statute previously required for high cost HOEPA 
loans--a prohibition on making loans without regard to 
borrowers' ability to repay the loan from income and assets 
other than the home's value. The July 2008 final rule also 
requires creditors to verify the income and assets they rely 
upon to determine borrowers' repayment ability for subprime 
loans. In addition, the final rules restrict creditors' use of 
prepayment penalties and require creditors to establish escrow 
accounts for property taxes and insurance. The rules also 
address deceptive mortgage advertisements, and unfair practices 
related to real estate appraisals and mortgage servicing.
    We can certainly understand the desire of Congress to 
provide timelines for regulation development and 
implementation. This could be especially important to address a 
crisis situation. However, in the case of statutory provisions 
that require consumer disclosure for implementation, we hope 
that any statutory timelines would account for robust consumer 
testing in order to make the disclosures useful and effective. 
Consumer testing is an iterative process, so it can take some 
additional time, but we have found that it results in much 
clearer disclosures. Additionally, interagency rulemakings are 
also more time consuming. While they have the potential benefit 
of bringing different perspectives to bear on an issue, 
arriving at consensus is always more time consuming than when 
regulations are assigned to a single rule writer. Moreover, 
assigning rulewriting responsibility, to multiple agencies can 
result in diffused accountability, with no one agency clearly 
responsible for outcomes.
                                ------                                


       RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
                     FROM DANIEL K. TARULLO

Q.1. Will each of you commit to do everything within your power 
to prevent performing loans from being called by lenders? 
Please outline the actions you plan to take.

A.1. The Federal Reserve's survey of senior loan officers at 
banks has indicated that banks have been tightening standards 
for both new commercial and industrial loans and new consumer 
loans since the beginning of 2008, although the net percentage 
of banks that have tightened standards in both categories has 
diminished a bit in recent months. We also are aware of reports 
that some banking organizations have declined to renew or 
extend new credit to borrowers that had performed on previously 
provided credit, or have exercised their rights to lower the 
amount of credit available to performing customers under 
existing lines of credit, such as home equity lines of credit. 
There is a variety of factors that potentially could influence 
a banking organization's decision to not renew or extend credit 
to a currently performing borrower, or reduce the amount of 
credit available to such a borrower. Many of these factors may 
be unique to the individual transaction, customer or banking 
organization involved. However, other more general factors also 
may be involved.
    For example, due to the ongoing turmoil in the financial 
markets, many credit and securitization markets have 
experienced substantial disruptions in the past year and a 
half, which have limited the ability of banking organizations 
to find outlets for their loans and obtain the financing to 
support new lending activities. In addition, losses on 
mortgage-related and other assets reduced the capital position 
of many banking organizations, which also weakened their 
ability to make or renew loans. The Federal Reserve, working in 
conjunction with the Treasury Department, has taken a number of 
important steps to help restore the flow of credit to 
households and businesses. For example, the Term Asset-Backed 
Securities Leading Facility (TALF), which began operations in 
March 2009, is designed to restart the securitization markets 
for several types of consumer and commercial credit. In 
addition, the recently completed Supervisory Capital Assessment 
Program was designed to ensure that the largest banking 
organizations have the capital necessary to fulfill their 
critical credit intermediation functions even in seriously 
adverse economic conditions.
    Besides these actions, we continue to actively work with 
banking organizations to encourage them to continue lending 
prudently to creditworthy borrowers and work constructively 
with troubled customers in a manner consistent with safety and 
soundness. I note that, in some instances, it may be 
appropriate from a safety and soundness perspective for a 
banking organization to review the creditworthiness of an 
existing borrower, even if the borrower is current on an 
existing loan from the institution. For example, the collateral 
supporting repayment of the loan may have declined in value.
    However, we are very cognizant of the need to ensure that 
banking organizations do not make credit decisions that are not 
supported by a fair and sound analysis of creditworthiness, 
particularly in the current economic environment. Striking the 
right balance between credit availability and safety and 
soundness is difficult, but vitally important. The Federal 
Reserve has long-standing policies and procedures in place to 
promote sound risk identification and management practices at 
regulated institutions that also support bank lending, the 
credit intermediation process, and working with borrowers. For 
example, guidance issued as long ago as 1991, during the 
commercial real estate crisis that began in the late 1980s, 
specifically instructs examiners to ensure that regulatory 
policies and actions do not inadvertently curtail the 
availability of credit to sound borrowers. \1\ The 1991 
guidance also states that examiners are to ``ensure that 
supervisory personnel are reviewing loans in a consistent, 
prudent, and balanced fashion and to ensure that all interested 
parties are aware of the guidance.''
---------------------------------------------------------------------------
     \1\ ``Interagency Policy Statement on the Review and 
Classification of Commercial Real Estate Loans,'' (November 1991).
---------------------------------------------------------------------------
    This emphasis on achieving an appropriate balance between 
credit availability and safety and soundness continues today. 
To the extent that institutions have experienced losses, hold 
less capital, and are operating in a more risk-sensitive 
environment, supervisors expect banks to employ appropriate 
risk-management practices to ensure their viability. At the 
same time, it is important that supervisors remain balanced and 
not place unreasonable or artificial constraints on lenders 
that could hamper credit availability.
    As part of our effort to help stimulate appropriate bank 
lending, the Federal Reserve and the other federal banking 
agencies issued a statement in November 2008 to encourage banks 
to meet the needs of creditworthy borrowers. \2\ The statement 
was issued to encourage bank lending in a manner consistent 
with safety and soundness--specifically, by taking a balanced 
approach in assessing borrowers' ability to repay and making 
realistic assessments of collateral valuations. This guidance 
has been reviewed and discussed with examination staff within 
the Federal Reserve System.
---------------------------------------------------------------------------
     \2\ ``Interagency Statement on Meeting the Needs of Credit Worthy 
Borrowers,'' (November 2008).
---------------------------------------------------------------------------
    Earlier, in April 2007, the federal financial institutions 
regulatory agencies issued a statement encouraging financial 
institutions to work constructively with residential borrowers 
who are financially unable to make their contractual payment 
obligations on their home loans. \3\ The statement noted that 
``prudent workout arrangements that are consistent with safe 
and sound lending practices are generally in the long-term 
interest of both the financial institution and the borrower.'' 
The statement also noted that ``the agencies will not penalize 
financial institutions that pursue reasonable workout 
arrangements with borrowers who have encountered financial 
problems.'' It further stated that, ``existing supervisory 
guidance and applicable accounting standards do not require 
institutions to immediately foreclose on the collateral 
underlying a loan when the borrower exhibits repayment 
difficulties.'' This guidance has also been reviewed by 
examiners within the Federal Reserve System.
---------------------------------------------------------------------------
     \3\ ``Federal Regulators Encourage Institutions To Work With 
Mortgage Borrowers Who Are Unable To Make TheirPayments,'' (April 
2007).
---------------------------------------------------------------------------
    More generally, we have directed our examiners to be 
mindful of the pro-cyclical effects of excessive credit 
tightening and to encourage banks to make economically viable 
loans, provided such lending is based on realistic asset 
valuations and a balanced assessment of borrowers' repayment 
capacities. Banks are also expected to work constructively with 
troubled borrowers and not unnecessarily call loans or 
foreclose on collateral. Across the Federal Reserve System, we 
have implemented training and outreach to underscore these 
objectives.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                     FROM SCOTT M. POLAKOFF

Q.1. Consumer Protection Regulation--Some have advocated that 
consumer protection and prudential supervision should be 
divorced, and that a separate consumer protection regulation 
regime should be created. They state that one source of the 
financial crisis emanated from the lack of consumer protection 
in the underwriting of loans in the originate-to-distribute 
space.
    What are the merits of maintaining it in the same agency? 
Alternatively, what is the best argument each of you can make 
for a new consumer protection agency?

A.1. The key advantage of creating a separate agency for 
consumer protection would be its single-focus on consumer 
protection. One hundred percent of its resources would be 
devoted to consumer protection, regulations and the balance and 
tension between both aspects is extraordinarily beneficial, 
policies, and enforcement. However, safety and soundness and 
consumer protection concerns are interconnected. For example, 
requiring that a lender responsibly consider a borrower's 
repayment ability has implications for both areas. 
Consequently, if consumer protection and prudential supervision 
were separated, the new consumer protection agency would not be 
in a position to take into account the safety and soundness 
dimensions of consumer protection issues. Placing consumer 
compliance examination activities in a separate organization 
would reduce the effectiveness of both programs by removing the 
ability for regulators to evaluate an institution across both 
the safety and soundness and compliance functions. The same is 
true for rulemaking functions.
    With respect to consumer protection regulation, some may 
argue that assigning one agency responsibility for writing all 
consumer protection regulations would speed the process. 
However, past experience indicates that providing one agency 
such exclusive responsibility does not guarantee this result. 
Moreover, such a strategy may weaken the outcome because it 
deprives other agencies of the opportunity to make 
contributions based on their considerable expertise.

Q.2. Regulatory Gaps or Omissions--During a recent hearing, the 
Committee has heard about massive regulatory gaps in the 
system. These gaps allowed unscrupulous actors like AIG to 
exploit the lack of regulatory oversight. Some of the 
counterparties that AIG did business with were institutions 
under your supervision.
    Why didn't your risk management oversight of the AIG 
counterparties trigger further regulatory scrutiny? Was there a 
flawed assumption that AIG was adequately regulated, and 
therefore no further scrutiny was necessary?

A.2. OTS actions demonstrate that we had a progressive level of 
supervisory criticism of AIG's corporate governance. OTS 
criticisms addressed AIG's risk management, corporate 
oversight, and financial reporting. There was not a flawed 
assumption that AIG was adequately regulated. Instead, OTS did 
not recognize in time the extent of the liquidity risk to AIG 
of the ``super senior'' credit default swaps in AIG Financial 
Products' (AIGFP) portfolio. In hindsight, we focused too 
narrowly on the perceived creditworthiness of the underlying 
securities and did not sufficiently assess the susceptibility 
of highly illiquid, complex instruments to downgrades in the 
ratings of the company or the underlying securities, and to 
declines in the market value of the securities. No one 
predicted the amount of funds that would be required to meet 
collateral calls and cash demands on the credit default swap 
transactions.

Q.3. Was there dialogue between the banking regulators and the 
state insurance regulators? What about the SEC?

A.3. The OTS role in reaching out to insurance regulators (both 
domestic and foreign) was to obtain information regarding 
functionally regulated entities. This included information 
regarding examination efforts and results, requests for 
approval for transactions, market conduct activities and other 
items of a regulatory nature. In the U.S., state insurance 
departments conduct financial examinations of insurance 
companies every 3-5 years, depending on state law. In addition, 
regulatory approval is required for certain types of 
transactions or activities. OTS contact with state insurance 
regulators was done with the intent to identify issues with 
regulated insurance companies and to determine if regulatory 
actions were being taken. In addition, regulatory 
communications were maintained in an informal way to ensure 
that the lines of communication remained open.
    Annually, OTS hosted a supervisory conference that provided 
an opportunity for insurance (and banking) regulators to share 
information regarding the company. At each of the three annual 
conferences held, OTS provided general information regarding 
our examination approach, plans for our supervisory efforts and 
current concerns. Other regulators attending the sessions 
provided the same type of information and the session provided 
an opportunity to discuss these concerns.
    Collateralized debt obligation (CDO) activities at AIG were 
housed in AIGFP, an unregulated entity. AIGFP is not a 
regulated insurance company or depository institution. State 
insurance departments did not have the legal authority to 
examine or regulate AIGFP activities. Therefore, OTS did not 
engage in discussions with state insurance departments 
regarding AIGFP. The types of activities engaged in, and the 
products sold, are not the types of activities that insurance 
structures typically engage in within regulated insurance 
company subsidiaries. Also, since AIGFP was not a regulated 
insurance company, OTS did not contact state regulators to 
discuss AIGFP or its activities. Upon the announcement of 
Federal Reserve intervention in the company, OTS engaged in 
many calls with regulators in the U.S. and abroad.
    AIG did have a network of registered investment advisers, 
retail investment brokerage firms and mutual funds, all 
supervised by the SEC. OTS stayed abreast of AIG's compliance 
with SEC laws and regulations through a monthly regulatory 
issues report. OTS also interacted with an individual placed at 
AIG by the SEC and Department of Justice as an independent 
monitor in connection with the 2005 settlement regarding 
accounting irregularities. The independent monitor is still 
working within AIG, and he interacts directly with the 
Regulatory Group.

Q.4. If the credit default swap contracts at the heart of this 
problem had been traded on an exchange or cleared through a 
clearinghouse, with requirement for collateral and margin 
payments, what additional information would have been 
available? How would you have used it?

A.4. There is no centralized exchange or clearing house for 
credit default swap (CDS) transactions. Currently, CDS trade as 
a bilateral contract between two counterparties that are done 
on the over-the-counter (OTC) market. They are not traded on an 
exchange and there are no specific record-keeping requirements 
of who traded, how much, and when. As a result, the market is 
opaque, lacking the transparency that would be expected for a 
market of its size, complexity, and importance. The lack of 
transparency creates significant opportunity for manipulation 
and insider trading in the CDS market as well as in the 
regulated markets for securities. Also, the lack of 
transparency allows the CDS market to be largely immune to 
market discipline.
    The creation of a central counterparty (CCP) would be an 
important first step in maintaining a fair, orderly, and 
efficient CDS market and thereby helping to mitigate systemic 
risk. It would help to reduce the counterparty risks inherent 
in CDS market. A central clearing house could further reduce 
systemic risk by novating trades to the CCP, which means that 
two dealers would no longer be exposed to each others' credit 
risk. Other benefits would include reducing the risk of 
collateral flows by netting positions in similar instruments, 
and by netting all gains and losses across different 
instruments; helping to ensure that eligible trades are cleared 
and settled in a timely manner, thereby reducing the 
operational risks associated with significant volumes of 
unconfirmed and failed trades; helping to reduce the negative 
effects of misinformation and rumors; and serving as a source 
of records for CDS transactions. Furthermore, this would likely 
allow for much greater market discipline, increased 
transparency, enhanced liquidity, and improved price discovery.
    The presence of an exchange with margin and daily position 
marking would have given regulators greater visibility into the 
dangerous concentration of posted collateral. Regulators could 
have had more time and flexibility to react through the firm's 
risk management and corporate governance units if a CDS 
exchange existed. Also, if a counterparty had failed to post 
required margin/collateral, its positions may have been 
liquidated sooner in the process.
    We have learned there is a need for consistency and 
transparency in over-the-counter (OTC) CDS contracts. The 
complexity of CDS contracts masked risks and weaknesses. The 
OTS believes standardization and simplification of these 
products would provide more transparency to market participants 
and regulators. We believe many of these OTC contracts should 
be subject to exchange-traded oversight, with daily margining 
required. This kind of standardization and exchange-traded 
oversight can be accomplished when a single regulator is 
evaluating these products. Congress should consider legislation 
to bring such OTC derivative products under appropriate 
regulation.

Q.5. Liquidity Management--A problem confronting many financial 
institutions currently experiencing distress is the need to 
roll-over short-term sources of funding. Essentially these 
banks are facing a shortage of liquidity. I believe this 
difficulty is inherent in any system that funds long-term 
assets, such as mortgages, with short-term funds. Basically the 
harm from a decline in liquidity is amplified by a bank's level 
of ``maturity-mismatch.''
    I would like to ask each of the witnesses, should 
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to 
do so?

A.5. Maturity mismatches are a significant supervisory concern 
from both a liquidity risk and interest rate risk standpoint. 
However, OTS does not believe that regulators should try to 
simply minimize the mismatch without consideration of different 
business models, portfolio structures, and mitigating factors. 
Furthermore, maturity mismatches are heavily affected by 
unknowns such as loan prepayments and deposit withdrawals which 
can have serious implications on an institution's cash needs 
and sources. The embedded optionality in some instruments can 
lead to a rapid shortening of stated maturities and can 
compromise the effectiveness of following a simple maturity gap 
measure in the management of liquidity risk.
    Given the thrift industry's heavy reliance on longer-term 
mortgages and shorter-term funding, however, OTS has always 
placed a heavy emphasis on maturity-mismatch risk management 
and we are constantly exploring ways to improve our supervisory 
process in light of the ongoing crisis.
    On an international basis, OTS is a member of the Basel 
Committee for Banking Supervision's Working Group on Liquidity 
which is currently seeking to identify a range of measures and 
metrics to better assess liquidity risk at regulated 
institutions. Metrics specifically dealing with maturity-
mismatch are being considered as part of this work. On the 
domestic front, OTS's supervisory process has long stressed the 
need for OTS-regulated banks to identify and manage the 
maturity mismatch inherent in their operations; and OTS 
examiners routinely assess this aspect of a bank's operation 
during their on-site safety and soundness examinations.
    From an off-sight monitoring perspective, OTS utilizes 
information from the Thrift Financial Report to identify 
institutions with a heavy reliance on short-term or volatile 
sources of funding. In addition, OTS is exploring ways to 
better lever the information it collects from institutions for 
interest rate risk purposes. Each quarter, OTS collects 
detailed interest rate data, re-pricing characteristics, and 
maturity information from most of its thrifts through a 
specialized reporting schedule called Consolidated Maturity and 
Rate (Schedule CMR). The CMR data is fed into a proprietary 
interest rate risk model called the Net Portfolio Value (NPV) 
Model. The NPV Model was created in 1991, in response to the 
industry's significant interest rate risk problems which were a 
major contributor to the savings and loan crisis. The NPV Model 
provides a quarterly analysis of an institution's interest rate 
risk profile and plays an integral role in the examination 
process.
    Interest rate risk and ``maturity-mismatch'' risk are 
intimately related. Indeed, much of the same information that 
is used for interest rate risk purposes can also be used to 
provide a more structured view of liquidity risk and maturity 
mismatch. As a first step, OTS is using the model to generate 
individual Maturing Gap Reports for a large segment of the 
industry. This report provides a snapshot of a bank's current 
maturity-mismatch as well as how that mismatch changes under 
different interest rate stress scenarios.

Q.6. Regulatory Conflict of Interest--Federal Reserve Banks 
which conduct bank supervision are run by bank presidents that 
are chosen in part by bankers that they regulate.
    Mr. Polakoff, does the fact that your agencies' funding 
stream is affected by how many institutions you are able to 
keep under your charters affect your ability to conduct 
supervision?

A.6. No it does not. The OTS conducts its supervisory function 
in a professional, consistent, and fair manner. Ensuring the 
safety and soundness of the institutions that we supervise is 
always paramount. Moreover, the use of assessments on the 
industry to fund the agency has many advantages. It permits the 
agency to develop a budget that is based on the supervisory 
needs of the industry. The agency does not rely on the 
Congressional appropriations process and can assess the 
industry based on a number of factors including the number, 
size, and complexity of regulated institutions. Such a method 
of funding also provides the agency the ability to determine 
whether fees should be increased as a result of supervisory 
concerns.
    This funding mechanism permits the agency to sustain itself 
financially. Funding an agency differently may lead to 
conflicts of interest with congress or any other entity that 
determines the budget necessary to run the agency. As a result, 
political pressure or matters outside the control of the agency 
may negatively affect the agency's ability to supervise its 
regulated institutions. An agency that must supervise 
institutions on a regular basis needs to have more control over 
its funding and budget than is possible through an 
appropriations process. Funding through assessments also 
eliminates the concern that taxpayers are responsible for 
paying for the running of the agency.

Q.7. Too-Big-To-Fail--Chairman Bair stated in her written 
testimony that ``the most important challenge is to find ways 
to impose greater market discipline on systemically important 
institutions. The solution must involve, first and foremost, a 
legal mechanism for the orderly resolution of those 
institutions similar to that which exists for FDIC-insured 
banks. In short we need to end too big to fail.'' I would agree 
that we need to address the too-big-to-fail issue, both for 
banks and other financial institutions.
    Could each of you tell us whether putting a new resolution 
regime in place would address this issue?

A.7. The events of the past year have put into stark focus the 
need to address whether a resolution regime is necessary for 
nonbank financial companies. Whatever resolution regime is 
adopted would address too big to fail issue but it may not 
bring it to a final conclusion. There currently exists a 
resolution mechanism for federally insured depository 
institutions and instances have arisen in which an insured 
institution has been found to be too big to fail. As the 
framers of the resolution develop the mechanism for nonbank 
financial companies, it will be important to establish whether 
there will be a circumstance in which such a company will not 
be allowed to fail or the circumstances under which it will be 
permitted. A resolution mechanism will make it less likely that 
a company will be determined to be too big to fail.

Q.8. How would we be able to convince the market that these 
systemically important institutions would not be protected by 
taxpayer resources as they had been in the past?

A.8. There are two ways that the market can be convinced that 
systemically important institutions will not be protected by 
taxpayer resources. The first is if they are permitted to fail 
and do not receive the benefit of taxpayer funds. The second is 
through the establishment of a resolution mechanism that 
provides for funding through assessments on the institutions 
that may be resolved. Even the second alternative would not 
preclude that the taxpayer might not ultimately pay for part of 
the resolution.
    In the creation of the resolution mechanism, the funding of 
the entity and the process would need to be specifically 
addressed and communicated to the market.

Q.9. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank 
capital regulation. Some commentators have endorsed a concept 
requiring banks to hold more capital when good conditions 
prevail, and then allow banks to temporarily hold less capital 
in order not to restrict access to credit during a downturn. 
Advocates of this system believe that counter-cyclical policies 
could reduce imbalances within financial markets and smooth the 
credit cycle itself.
    What do you see as the costs and benefits of adopting a 
more counter-cyclical system of regulation?

A.9. Different proposals have been raised to achieve a more 
counter-cyclical system of capital regulation. One of the most 
promising ideas would mandate that banks build up an additional 
capital buffer during good times that would be available to 
draw upon in bad times, essentially a rainy day fund. In our 
view, such a fund would be an amount of allocated retained 
earnings that would be over and above the bank's minimum 
capital requirement. Initially, it would appear that for an 
individual bank, the cost of such a requirement would be a 
decreased level of available retained earnings: fewer funds 
would be available for dividends and share buybacks for 
example. The benefit would be that the rainy day fund might 
save the bank from failing (or threat of failure) when economic 
conditions deteriorate and therefore help the bank remain in 
sound condition so that it can continue lending. Systemically, 
a restriction on banks' retained earnings would act as a 
restraint on bank activity during high points in the economic 
cycle and could diminish share prices when times are good. It 
might also curtail some lending at high points in the economic 
cycle. However, the availability of those funds when conditions 
deteriorate ought to allow banks to continue lending at more 
reasonable levels even when economic conditions deteriorate.

Q.10. Do you see any circumstances under which your agencies 
would take a position on the merits of counter-cyclical 
regulatory policy?

A.10. Yes, we support the concept of a counter-cyclical policy. 
There are a variety of ideas as to how to achieve this 
including the concept we have outlined above. Together with the 
other Federal Banking Agencies we are participating in 
international Basel Committee efforts to consider various 
counter-cyclical proposals with the goal of having a uniform 
method, not only within the United States, but internationally 
as well--so as to create a more level competitive environment 
for U.S. Banks and a sound counter-cyclical proposal.

Q.11. G20 Summit and International Coordination--Many foreign 
officials and analysts have said that they believe the upcoming 
G20 summit will endorse a set of principles agreed to by both 
the Financial Stability Forum and the Basel Committee, in 
addition to other government entities. There have also been 
calls from some countries to heavily re-regulate the financial 
sector, pool national sovereignty in key economic areas, and 
create powerful supranational regulatory institutions. 
(Examples are national bank resolution regimes, bank capital 
levels, and deposit insurance.) Your agencies are active 
participants in these international efforts.
    What do you anticipate will be the result of the G20 
summit?

A.11. At the conclusion of the G20 summit, several documents 
were issued by G20 working groups and by the Financial 
Stability Forum (now renamed the Financial Stability Board). 
These laid out principles for international cooperation between 
supervisors and stressed the importance of coordinated 
supervisory action. With its largest firms, OTS has for some 
years held annual college meetings to foster communication 
between regulators, and understands the value of cross-border 
cooperation. OTS believes that insofar as the agreements coming 
out of the G20 summit encourage greater international 
cooperation, supervision overall will be enhanced.

Q.12. Do you see any examples or areas where supranational 
regulation of financial services would be effective?

A.12. As a member of the Basel Committee, OTS has been involved 
in the past efforts of that body to set capital and other 
regulatory standards. We believe there is value in coordinating 
such standards at the international level, primarily for two 
reasons. First, such coordination is a vehicle for enshrining 
high quality standards. In a globally interconnected capital 
market, it is important that all players be subject to basic 
requirements. Second, common standards foster a level playing 
field for U.S. institutions that must compete internationally.

Q.13. How far do you see your agencies pushing for or against 
such supranational initiatives?

A.13. As indicated above, OTS supports active cooperation among 
supervisors and the setting of international regulatory 
standards, where appropriate. Ultimately, of course, authority 
must be commensurate with responsibility, and OTS would not be 
supportive of initiatives that would diminish its capacity to 
carry out its responsibility to preserve the safety and 
soundness of the institutions it regulates or the rights and 
protections of the customers they serve.

Q.14. Effectiveness of Functional Regulation \1\--Mr. Polakoff, 
in your testimony you point out that the OTS, as the holding 
company supervisor of AIG, relies on the specific functional 
regulators for information regarding regulated subsidiaries of 
AIG's holding company.
---------------------------------------------------------------------------
     \1\ Mr. Polakoff has been on leave from OTS since March 26, 2009, 
and will retire from the agency effective July 3, 2009. The answers to 
the Committee's supplemental questions were prepared by other OTS staff 
members.
---------------------------------------------------------------------------
    When did the OTS first learn of the problems related to 
AIG's securities lending program? Did any state insurance 
commissioner alert the OTS, as the holding company supervisor, 
of these problems?

A.14. Annually, the OTS hosted a supervisory conference that 
provided an opportunity for regulators (insurance and banking) 
to share information regarding the AIG. At each of the three 
annual conferences held, the OTS provided general information 
regarding our examination approach, plans for our supervisory 
efforts and current concerns. Other regulators attending the 
sessions provided the same type of information and the session 
provided an opportunity to discuss these concerns.
    The OTS was first advised of potential financial problems 
in the AIG Securities Lending Program (SLP) during the OTS 
Annual AIG Supervisor's Conference on November 7, 2007, when 
the representative from the Texas Department of Insurance's 
(DOI) office raised the issue during the Supervisor's 
roundtable session. This representative stated the Texas DOI 
was looking into the exposure that the various Texas-based life 
companies had to the SLP and was seeking assurance from AIG 
that any market value losses would be covered by the corporate 
parent.
    Subsequently, on November 27, 2007, the OTS met with Price 
Waterhouse Coopers (PwC) as part of its regular supervisory 
process. During this meeting the SLP exposure topic was raised 
and a discussion ensued. PwC advised that as of Q3 2007, the 
exposure to market value decline in the portfolio was $1.3 
billion and expected to worsen in Q4. PwC further advised that 
AIG was planning to indemnify its subsidiary companies for 
losses up to $5 billion. This was verified in the year end 2007 
regulatory financial statement filings (required by state 
insurance departments) by the AIG life insurance subsidiaries. 
The disclosure went on to cite AIG's indemnification agreement 
to reimburse losses of up to $5 billion for all (not each) of 
AIG's impacted subsidiaries.

Q.15. Holding Company Regulation--Mr. Polakoff, AIG's Financial 
Products subsidiary has been portrayed in the press as a 
renegade subsidiary that evaded regulation by operating from 
London. A closer examination reveals, however, that a majority 
of its employees and many of its officers were located in the 
United States.
    Did the OTS have adequate authority to supervise AIG's 
Financial Products subsidiary? If not why did the OTS fail to 
inform Congress about this hole in its regulatory authority, 
especially since your agency had identified serious 
deficiencies in Financial Products' risk management processes 
since 2005? How was the Financial Products subsidiary able to 
amass such a large, unhedged position on credit default swaps 
(CDS)?

A.15. AIG became a savings and loan holding company in 2000. At 
that time. the OTS's supervision focused primarily on the 
impact of the holding company enterprise on the subsidiary 
savings association. With the passage of Gramm-Leach-Bliley, 
and not long before AIG became a savings and loan holding 
company, the OTS recognized that large corporate enterprises, 
made up of a number of different companies or legal entities, 
were changing the way they operated and needed to be 
supervised. These companies, commonly called conglomerates, 
began operating differently and in a more integrated fashion as 
compared to traditional holding companies. These conglomerates 
required a more enterprise-wide review of their operations. 
Consistent with changing business practices and how 
conglomerates were managed at that time, in late 2003 the OTS 
embraced a more enterprise-wide approach to supervising 
conglomerates. This approach aligned well with core supervisory 
principles adopted by the Basel Committee and with requirements 
implemented in 2005 by European Union (EU) regulators that 
required supplemental regulatory supervision at the 
conglomerate level. The OTS was recognized as an equivalent 
regulator for the purpose of AIG consolidated supervision 
within the EU, a process that was finalized with a 
determination of equivalence by AIG's French regulator, 
Commission Bancaire.
    AIG Financial Products' (AIGFP) CDS portfolio was largely 
originated in the 2003 to 2005 period and was facilitated by 
AIG's full and unconditional guarantee (extended to all AIGFP 
transactions since its creation), which enabled AIGFP to assume 
the AAA rating for market transactions and counterparty 
negotiations. AIGFP made the decision to stop origination of 
these derivatives in December 2005 based on the general 
observation that underwriting standards for mortgages backing 
securities were declining. At the time the decision was made, 
however, AIGFP already had $80 billion of CDS commitments. This 
activity stopped before the OTS targeted examination which 
commenced March 6, 2006.
    The OTS actions demonstrate a progressive level of 
supervisory criticism of AIG's corporate governance. The OTS 
criticisms addressed AIG's risk management, corporate 
oversight, and financial reporting. There was not a flawed 
assumption that AIG was adequately regulated. Instead, the OTS 
did not fully recognize the extent of the liquidity risk to AIG 
of the ``super senior'' credit default swaps in AIGFP's 
portfolio or the profound systemic impact of a nonregulated 
financial product. There was a narrow focus on the perceived 
creditworthiness of the underlying securities rather than an 
assessment of the susceptibility of highly illiquid, complex 
instruments to downgrades in the public ratings of the company 
or the underlying securities, and to declines in the market 
value of the securities. No one predicted the amount of funds 
that would be required to meet collateral calls and cash 
demands on the credit default swap transactions.
    CDS are financial products that are not regulated by any 
authority and impose serious challenges to the ability to 
supervise this risk proactively without any prudential 
derivatives regulator or standard market regulation. There is a 
need to fill the regulatory gaps the CDS market has exposed. 
There is a need for consistency and transparency in CDS 
contracts. The complexity of CDS contracts masked risks and 
weaknesses in the program that led to one type of CDS 
performing extremely poorly. The current regulatory means of 
measuring off-balance sheet risks do not fully capture the 
inherent risks of CDS. The OTS believes standardization of CDS 
contracts would provide more transparency to market 
participants and regulators.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                     FROM SCOTT M. POLAKOFF

Q.1. It is clear that our current regulatory structure is in 
need of reform. At my subcommittee hearing on risk management, 
March 18, 2009, GAO pointed out that regulators often did not 
move swiftly enough to address problems they had identified in 
the risk management systems of large, complex financial 
institutions.
    Chair Bair's written testimony for today's hearing put it 
very well: `` . . . the success of any effort at reform will 
ultimately rely on the willingness of regulators to use their 
authorities more effectively and aggressively.''
    My questions may be difficult, but please answer the 
following:

    If this lack of action is a persistent problem 
        among the regulators, to what extent will changing the 
        structure of our regulatory system really get at the 
        issue?

    Along with changing the regulatory structure, how 
        can Congress best ensure that regulators have clear 
        responsibilities and authorities, and that they are 
        accountable for exercising them ``effectively and 
        aggressively''?

A.1. A change in the structure of the regulatory system alone 
will not achieve success. While Congress should focus on 
ensuring that all participants in the financial markets are 
subject to the same set of regulations, the regulatory agencies 
must adapt using the lessons learned from the financial crisis 
to improve regulatory oversight. OTS conducts internal failed 
bank reviews for thrifts that fail and has identified numerous 
lessons learned from recent financial institution failures. The 
agency has revised its policies and procedures to correct gaps 
in regulatory oversight. OTS has also been proactive in 
improving the timeliness of formal and informal enforcement 
action.

Q.2. How do we overcome the problem that in the boom times no 
one wants to be the one stepping in to tell firms they have to 
limit their concentrations of risk or not trade certain risky 
products? What thought has been put into overcoming this 
problem for regulators overseeing the firms? Is this an issue 
that can be addressed through regulatory restructure efforts?

A.2. OTS believes that the best way to improve the regulatory 
oversight of financial activities is to ensure that all 
entities that provide specific financial services are subject 
to the same level of regulatory requirements and scrutiny. For 
example, there is no justification for mortgage brokers not to 
be bound by the same laws and rules as banks. A market where 
unregulated or under-regulated entities can compete alongside 
regulated entities offering complex loans or other financial 
products to consumers provides a disincentive to protect the 
consumer. Any regulatory restructure effort must ensure that 
all entities engaging in financial services are subject to the 
same laws and regulations.
    In addition, the business models of community banks versus 
that of commercial banks are fundamentally different. 
Maintaining and strengthening a federal regulatory structure 
that provides oversight of these two types of business models 
is essential. Under this structure, the regulatory agencies 
will need to continue to coordinate regulatory oversight to 
ensure they apply consistent standards for common products and 
services.

Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, 
some financial institution failures emanated from institutions 
that were under federal regulation. While I agree that we need 
additional oversight over and information on unregulated 
financial institutions, I think we need to understand why so 
many regulated firms failed.
    Why is it the case that so many regulated entities failed, 
and many still remain struggling, if our regulators in fact 
stand as a safety net to rein in dangerous amounts of risk-
taking?

A.3. While undesirable, failures are inevitable in a dynamic 
and competitive market. The housing downturn and resulting 
economic strain highlights that even traditionally lower-risk 
lending activities can become higher-risk when products evolve 
and there is insufficient regulatory oversight covering the 
entire market. There is no way to predict with absolute 
certainty how economic factors will combine to cause stress. 
For example, in late 2007, financial institutions faced severe 
erosion of liquidity due to secondary markets not functioning.
    This problem compounded for financial institutions engaged 
in mortgage banking who found they could not sell loans from 
their warehouse, nor could they rely on secondary sources of 
liquidity to support the influx of loans on their balance 
sheets. While the ideal goal of the regulatory structure is to 
limit and prevent failures, it also serves as a safety net to 
manage failures with no losses to insured depositors and 
minimal cost to the deposit insurance fund.

Q.4. While we know that certain hedge funds, for example, have 
failed, have any of them contributed to systemic risk?

A.4. Hedge funds are unregulated entities that are considered 
impermissible investments for thrifts. As such, OTS has no 
direct knowledge of hedge fund failures or how they have 
specifically contributed to systemic risk. Anecdotally, 
however, we understand that many of these entities were highly 
exposed to sub-prime loans through their investment in private 
label securities backed by subprime or Alt-A loan collateral, 
and they were working with higher levels of leverage than were 
commercial banks and savings institutions. As defaults on these 
loans began to rise, the value of those securities fell, losses 
mounted and capital levels declined. As this occurred, margin 
calls increased and creditors began cutting these firms off or 
stopped rolling over lines of credit. Faced with greater 
collateral requirements, creditors demanding lower levels of 
leverage, eroding capital, and dimming prospects on their 
investments, these firms often perceived the sale of these 
unwanted assets as the best option. The glut of these 
securities coming to the market and the lack of private sector 
buyers likely further depressed prices.

Q.5. Given that some of the federal banking regulators have 
examiners on-site at banks, how did they not identify some of 
these problems we are facing today?

A.5. The problem was not a lack of identifying risk areas, but 
in understanding and predicting the severity of the economic 
downturn and its resulting impact on entire asset classes, 
regardless of risk. The magnitude and severity of the economic 
downturn was unprecedented. The confluence of events leading to 
the financial crisis extends beyond signals that bank examiners 
alone could identify or correct. OTS believes it is important 
for Congress to establish a systemic risk regulator that will 
work with the federal bank regulatory agencies to identify 
systemic risks and how they affect individual regulated 
entities.
    There is evidence in reports of examination and other 
supervisory documents that examiners identified several of the 
problems we are facing, particularly the concentrations of 
assets. There was no way to predict how rapidly the market 
would reverse and housing prices would decline. The agency has 
taken steps to improve its regulatory oversight through the 
lessons learned during this economic cycle. For its part, OTS 
has strengthened its regulatory oversight, including the 
timeliness of enforcement actions and monitoring practices to 
ensure timely corrective action.

Q.6. There have been many thrifts that failed under the watch 
of the OTS this year. While not all thrift or bank failures can 
or should be stopped, the regulators need to be vigilant and 
aware of the risks within these financial institutions. Given 
the convergence within the financial services industries, and 
that many financial institutions offer many similar products, 
what is distinct about thrifts? Other than holding a certain 
proportion of mortgages on their balance sheets, do they not 
look a lot like other financial institutions?

A.6. In recent years, financial institutions of all types have 
begun offering many of the same products and services to 
consumers and other customers. It is hard for customers to 
distinguish one type of financial institution from another. 
This is especially true of insured depository institutions. 
Despite the similarities, savings associations have statutory 
limitations on the assets they may have or in the activities in 
which they may engage. They still must have 65 percent of their 
assets in housing related loans, as defined. As a result, 
savings associations are not permitted to diversify to the same 
extent as are national banks or state chartered banks. Within 
the confines of the statute, savings associations have begun to 
engage in more small business and commercial real estate 
lending in order to diversify their activities, particularly in 
times of stress in the mortgage market.
    Savings associations are the insured depositories that 
touch the consumer. They are local community banks providing 
services that families and communities need and value. Many of 
the institutions supervised by the OTS are in the mutual form 
of ownership and are small. While many savings associations 
offer a variety of lending and deposit products and they are 
competitors in communities nationwide, they generally are 
retail, customer driven community banks.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                     FROM SCOTT M. POLAKOFF

Q.1. The convergence of financial services providers and 
financial products has increased over the past decade. 
Financial products and companies may have insurance, banking, 
securities, and futures components. One example of this 
convergence is AIG. Is the creation of a systemic risk 
regulator the best method to fill in the gaps and weaknesses 
that AIG has exposed, or does Congress need to reevaluate the 
weaknesses of federal and state functional regulation for 
large, interconnected, and large firms like AIG?

A.1. There have been positive results of the convergence of 
financial services providers. Consumers and customers seeking 
financial products have benefited from products and services 
that are more varied and specifically targeted to meet their 
needs. At the same time, the regulatory oversight framework has 
not kept pace with the developments in all areas of the 
companies offering these products and services. If a systemic 
risk regulator had existed, it may not have filled in all of 
the gaps, but such a regulator would have looked at the entire 
organization with a view to identifying concerns in all areas 
of the company and would have identified how the operations of 
one line of business or business unit would affect the company 
as a whole. A systemic risk regulator with access to 
information about all aspects of a company's operations would 
be responsible for evaluating the overall condition and 
performance of the entity and the impact a possible failure 
would have on the rest of the market. Such a broad overview 
would enable the systemic regulator to work with the functional 
regulators to ensure that the risks of products and the 
interrelationships of the businesses are understood and 
monitored.
    The establishment of a systemic risk regulator need not 
eliminate functional regulators for the affiliated entities in 
a structure. Functional regulators are necessary to supervise 
the day to day activities of the entities and provide input on 
the entities and activities to the systemic risk regulator. 
Working together with the functional regulators and putting 
data and developments into a broader context would provide the 
ability to identify and close gaps in regulation and oversight. 
In order to benefit from having a framework with a systemic 
risk regulator and functional regulation of the actual 
activities and products, information sharing arrangements among 
the regulators must be established.
    Further, the systemic risk regulator would need access to 
information regarding nonsystemically important institutions in 
order to monitor trends, but would not regulate or supervise 
those entities.

Q.2. Recently there have been several proposals to consider for 
financial services conglomerates. One approach would be to move 
away from functional regulation to some type of single 
consolidated regulator like the Financial Services Authority 
model. Another approach is to follow the Group of 30 Report 
which attempts to modernize functional regulation and limit 
activities to address gaps and weaknesses. An in-between 
approach would be to move to an objectives-based regulation 
system suggested in the Treasury Blueprint. What are some of 
the pluses and minuses of these three approaches?

A.2. A number of proposals to change the financial services 
regulatory framework have been issued in the past year. Some of 
these proposals would establish a new framework for financial 
services regulation and others would make changes by merging 
existing regulatory agencies. The proposals of recent months 
all have identified the supervision of conglomerates as a key 
element to be addressed in any restructuring. There are pros 
and cons to each of the proposals for supervision of 
conglomerates. Three recommendations represent different 
perspectives on how to accomplish the goals.
    The example of the single consolidated regulator similar to 
the Financial Services Authority has been highlighted by its 
proponents as a solution to the regulation of large 
conglomerates that offer a variety of products and services 
through a number of affiliates. Because the single regulator 
model using a principles based approach to regulation and 
supervision has been in place in the UK since 1997, the 
benefits and negative aspects of this type of regulatory 
framework can be viewed from the perspective of actual 
practice.
    A single regulator, instead of functional regulators for 
different substantive businesses, coupled with a principles 
based approach to regulation was not successful in avoiding a 
financial crisis in the UK. The causes of the crisis in the UK 
are similar to those identified as causes in the U.S., and 
elsewhere, and the FSA model for supervision did not fully 
eliminate the gaps in regulation or mitigate other risk factors 
that lead to the crisis. Several factors may have contributed 
to the shortcomings in the FSA model. The most frequently cited 
factor was principles based regulation. Critics of this 
framework have identified the lack of close supervision and 
enforcement over conglomerates, their component companies and 
other financial services companies. The FSA employed a system 
that did not adequately require ongoing supervision or account 
for changes in the risk profiles of the entities involved. 
Finally, in an effort to streamline the framework and eliminate 
regulatory overlap, important roles were not fulfilled.
    The Group of 30 issued a report on January 15, 2009, that 
included a number of recommendations for financial stability. 
The recommendations presented in the report respond to the same 
factors that have become the focus of the causes of the current 
crisis. The first core recommendation is that gaps and 
weaknesses in the coverage of prudential regulation and 
supervision must be eliminated, the second is that the quality 
and effectiveness of prudential regulation and supervision must 
be improved, the third is that institutional policies and 
standards must be strengthened, with particular emphasis on 
standards of governance, risk management, capital and liquidity 
and finally, financial markets and products must be more 
transparent with better aligned risk and prudential incentives.
    The first core recommendation is one about which there is 
little disagreement. The elimination of gaps and weakness in 
the coverage of prudential regulation and supervision is an 
important goal in a number of areas. Whether it is the 
unregulated participants in the mortgage origination process, 
hedge funds or creators and sellers of complex financial 
instruments changing the regulatory framework to include those 
entities is a priority for a number of groups making 
recommendations for change. The benefits of the adaptation of 
the current system are evident and the core principles proposed 
by the Group of 30 are common themes in addressing supervision 
of conglomerates.
    A final proposal is the Treasury Blueprint that was issued 
in March 2008. That document was a top to bottom review of the 
current regulatory framework, with result that financial 
institutions would be regulated by a market stability 
regulator, a prudential regulator and/or a business conduct 
regulator. In addition, an optional federal charter would be 
created for insurance companies, a regulator for payment 
systems would be established, and a corporate finance regulator 
would be created. This approach to regulation would move toward 
the idea that supervision should be product driven and not 
institution driven. The framework proposed would not use the 
positive features in the current system, but a systemic 
regulator would be created.

Q.3. If there are institutions that are too big to fail, how do 
we identify that? How do we define the circumstance where a 
single company is so systemically significant to the rest of 
our financial circumstances and our economy that we must not 
allow it to fail?

A.3. Establishing the criteria by which financial institutions 
or other companies are identified as too big to fail is not 
easy. Establishing a test with which to judge whether an entity 
is of a size that makes it too big to fail, or the business is 
sufficiently interconnected, requires looking at a number of 
factors, including the business as a whole. The threshold is 
not simply one of size. The degree of integration of the 
company with the financial system also is a consideration. A 
company does not need to be a bank, an insurance company or a 
securities company to be systemically important. As we have 
seen in recent months, manufacturing companies as well as 
financial services conglomerates are viewed differently because 
of the impact that the failure would have on the economy as a 
whole. The identification of companies that are systemically 
important should be decided after a subjective analysis of the 
facts and circumstances of the company and not just based on 
the size of the entity.
    The factors used to make the determination might include: 
the risks presented by the other parties with which the company 
and its affiliates do business; liquidity risks, capital 
positions; interrelationships of the affiliates; relationships 
of the affiliates with nonaffiliated companies; and the 
prevalence of the product mix in the market.

Q.4. We need to have a better idea of what this notion of too 
big to fail is--what it means in different aspects of our 
industry and what our proper response to it should be. How 
should the federal government approach large, multinational, 
and systemically significant companies?

A.4. The array of lessons learned from the crisis will be 
debated for years. One lesson is that some institutions have 
grown so large and become so essential to the economic well-
being of the nation that they must be regulated in a new way. 
The establishment of a systemic risk regulator is an essential 
outcome of any initiative to modernize bank supervision and 
regulation. OTS endorses the establishment of a systemic risk 
regulator with broad authority to monitor and exercise 
supervision over any company whose actions or failure could 
pose a risk to financial stability. The systemic risk regulator 
should have the ability and the responsibility for monitoring 
all data about markets and companies including, but not limited 
to, companies involved in banking, securities, and insurance.
    For systemically important institutions, the systemic risk 
regulator should supplement, not supplant, the holding company 
regulator and the primary federal bank supervisor. A systemic 
regulator should have the authority and resources to supervise 
institutions and companies during a crisis situation. The 
regulator should have ready access to funding sources that 
would provide the capability to resolve problems at these 
institutions, including providing liquidity when needed.
    Given the events of the past year, it is essential that 
such a regulator have the ability to act as a receiver and to 
provide an orderly resolution to companies. Efficiently 
resolving a systemically important institution in a measured, 
well-managed manner is an important element in restructuring 
the regulatory framework. A lesson learned from recent events 
is that the failure or unwinding of systemically important 
companies has a far reaching impact on the economy, not just on 
financial services. The continued ability of banks and other 
entities in the United States to compete in today's global 
financial services marketplace is critical. The systemic risk 
regulator would be charged with coordinating the supervision of 
conglomerates that have international operations. Safety and 
soundness standards, including capital adequacy and other 
factors, should be as comparable as possible for entities that 
have multinational businesses.

Q.5. What does ``fail'' mean? In the context of AIG, we are 
talking about whether we should have allowed an orderly Chapter 
11 bankruptcy proceeding to proceed. Is that failure?

A.5. In the context of AIG, OTS views the financial failure of 
a company as occurring when it can no longer repay its 
liabilities or satisfy other obligations from its liquid 
financial resources. OTS is not in a position to state whether 
AIG should have proceeded to a Chapter 11 bankruptcy. As stated 
in the March 18, 2009, testimony on Lessons Learned in Risk 
Management Oversight at Federal Financial Regulators and the 
March 19, 2009, testimony on Modernizing Bank Supervision and 
Regulation, OTS endorses establishing a systemic risk regulator 
with broad regulatory and monitoring authority of companies 
whose failure or activities could pose a risk to financial 
stability. Such a regulator should be able to access funds, 
which would present options to resolve problems at these 
institutions.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
                     FROM SCOTT M. POLAKOFF

Q.1. Two approaches to systemic risk seem to be identified: (1) 
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to 
fail'' or ``too systemically important to fail'' or (2) impose 
an additional regulator and additional rules and market 
discipline on institutions that are considered systemically 
important.
    Which approach do you endorse? If you support approach one 
how you would limit institution size and how would you identify 
new areas creating systemic importance?
    If you support approach two how would you identify 
systemically important institutions and what new regulations 
and market discipline would you recommend?

A.1. OTS endorses the establishment of a systemic risk 
regulator with broad authority, including regular monitoring, 
over companies that if, due to the size or interconnected 
nature of their activities, their actions or their failure 
would pose a risk to the financial stability of the country. 
Such a regulator should be able to access funds, which would 
present options to resolve problems at these institutions. The 
systemic risk regulator should have the ability and the 
responsibility for monitoring all data about markets and 
companies including, but not limited to, companies involved in 
banking, securities, and insurance.
    Any systemic regulator should have all of the authority 
necessary to supervise institutions and companies especially in 
a crisis situation, but this regulator would be in addition to 
the functional regulator. The systemic risk regulator would not 
have supervisory authority over nonsystemically important 
banks. However, the systemic risk regulator would need access 
to data regarding the health and activities of these 
institutions for purposes of monitoring trends and other 
matters influencing monetary policy.
    In addition, the systemic risk regulator would be charged 
with coordination of supervision of conglomerates that have 
international operations. The safety and soundness standards 
including capital adequacy and other measurable factors should 
be as comparable as possible for entities that have 
multinational businesses. The ability of banks and other 
entities in the United States to compete in today's global 
financial services market place is critical.
    The identification of systemically important entities would 
be accomplished by looking at those entities whose business is 
so interconnected with the financial services market that its 
failure would have a severe impact on the market generally. Any 
systemic risk regulator would have broad authority to monitor 
the market and products and services offered by a systemically 
important entity or that dominate the market. Important 
additional regulations would include additional requirements 
for transparency regarding the entity and the products. 
Further, such a regulator would have the authority to require 
additional capital commensurate with the risks of the 
activities of the entity and would monitor liquidity with the 
risks of the activities of the entity. Finally, such a 
regulator would have authority to impose a prompt corrective 
action regime on the entities it regulates.

Q.2. Please identify all regulatory or legal barriers to the 
comprehensive sharing of information among regulators including 
insurance regulators, banking regulators, and investment 
banking regulators. Please share the steps that you are taking 
to improve the flow of communication among regulators within 
the current legislative environment.

A.2. The most significant barrier to disclosure is that if a 
regulator discloses confidential supervisory information to 
another regulator, the disclosure could lead to further, 
unintended disclosure to other persons. Disclosure to another 
regulator raises two significant risks: the risk that 
information shared with the other regulator will not be 
maintained confidential by that regulator, or that legal 
privileges that apply to the information will be waived by 
sharing.
    The regulator in receipt of the information may not 
maintain confidentiality of the information because the 
regulator is required by law to disclose the information in 
certain circumstances or because the regulator determines that 
it is appropriate to do so. For example, most regulators in the 
United States or abroad may be required to disclose 
confidential information that they received from another 
supervisor in response to a subpoena related to litigation in 
which the regulator may or may not be a party. While the 
regulator may seek to protect the confidentiality of the 
information that it received, the court overseeing the 
litigation may require disclosure. In addition, the U.S. 
Congress and other legislative bodies may require a regulator 
to disclose confidential information received by that regulator 
from another regulator. Moreover, if a regulator receives 
information from another regulator that indicates that a crime 
may have been committed, the regulator in receipt of the 
information may provide the information to a prosecutor. Other 
laws may require or permit a regulator in receipt of 
confidential information to disclose the information, for 
example, to an authority responsible for enforcement of anti-
trust laws. These laws mean that the regulator that provides 
the information can no longer control disclosure of it because 
the regulator in receipt of the information cannot guarantee 
that it will not disclose the information further.
    With respect to waiver of privileges through disclosure to 
another regulator, legislation provides only partial protection 
against the risk that legal privileges that apply to the 
information will be waived by sharing. When privileged 
information is shared among covered U.S. federal agencies, 
privileges are not waived. 12 U.S.C. 1821(t). This statutory 
protection does not, however, extend to state regulators (i.e., 
insurance regulators) or foreign regulators.
    To reduce these risks, OTS has information-sharing 
arrangements with all but one state insurance regulator, 16 
foreign bank regulators, and one foreign insurance regulator. 
(Some of these foreign bank regulators may also regulate 
investment banking or insurance.) OTS is in the process of 
negotiating information-sharing arrangements with approximately 
20 additional foreign regulators.
    OTS also shares information with regulators with which it 
does not have an information-sharing arrangement on a case-by-
case basis, subject to an agreement to maintain confidentiality 
and compliance with other legal requirements. See 12 U.S.C. 
1817(a)(2)(C), 1818(v), 3109(b); 12 C.F.R. 510.5.
    In terms of practical steps to ensure a robust flow of 
communication, OTS, as part of its supervisory planning, 
identifies foreign and functional regulators responsible for 
major affiliates of its thrifts and maintains regular contact 
with them. This interaction includes phone and e-mail 
communication relating to current supervisory matters, as well 
as exchanging reports of examination and other supervisory 
documentation as appropriate. With its largest holding 
companies, OTS sponsors an annual supervisory conference to 
which U.S. and foreign regulators are invited to discuss group-
wide supervisory issues.
                                ------                                


       RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
                     FROM SCOTT M. POLAKOFF

Q.1. Will each of you commit to do everything within your power 
to prevent performing loans from being called by lenders? 
Please outline the actions you plan to take.

A.1. OTS is encouraging financial institutions to develop 
effective loan modification programs in lieu of calling loans, 
whether they are performing or delinquent. OTS and OCC are 
working jointly to produce a quarterly Mortgage Metrics Report 
that analyzes mortgage servicing data and also provides data on 
the affordability and sustainability of loan modifications. The 
2008 fourth quarter report revealed that delinquencies were 
still rising, but financial institutions were also increasing 
efforts aimed at home retention, including loan modifications 
or payment plans.
    The first quarter 2009 data continued to show increases in 
seriously delinquent prime mortgages and a jump in the number 
of foreclosures in process across all risk categories as a 
variety of moratoria on foreclosures expired during the first 
quarter of 2009. A positive development is the significant 
increase in the number of modifications made by servicers. In 
addition to the increase in the overall numbers of 
modifications, servicers also implemented a higher percentage 
of modifications that reduced monthly payments than in previous 
quarters. Modifications with lower payments continued to show 
fewer delinquencies each month following modification than 
those that left payments unchanged or increased payments. 
Therefore, even in the midst of an overall worsening of 
conditions in mortgage performance, there is a strong industry 
response in the form of increased modifications. The OTS will 
continue to monitor the types of home retention actions 
implemented by servicers in efforts to stem home foreclosure 
actions.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                   FROM JOSEPH A. SMITH, JR.

Q.1. Consumer Protection Regulation--Some have advocated that 
consumer protection and prudential supervision should be 
divorced, and that a separate consumer protection regulation 
regime should be created. They state that one source of the 
financial crisis emanated from the lack of consumer protection 
in the underwriting of loans in the originate-to-distribute 
space.
    What are the merits of maintaining it in the same agency? 
Alternatively, what is the best argument each of you can make 
for a new consumer protection agency?

A.1. CSBS believes safety and soundness and consumer protection 
should be maintained for the benefit of the system. While CSBS 
recognizes there is a tension between consumer protection and 
safety and soundness supervision, we believe these two forms of 
supervision strengthen the other. Consumer protection is 
integral to the safety and soundness of consumer protections. 
The health of a financial institution ultimately is connected 
to the health of its customers. If consumers lack confidence in 
their institution or are unable to maintain their economic 
responsibilities, the institution will undoubtedly suffer. 
Similarly, safety and soundness of our institutions is vital to 
consumer protection. Consumers are protected if the 
institutions upon which they rely are operated in a safe and 
sound manner. Consumer complaints have often spurred 
investigations or even enforcement actions against institutions 
or financial service providers operating in an unsafe and 
unsound manner.
    States have observed that federal regulators, without the 
checks and balances of more locally responsive state regulators 
or state law enforcement, do not always give fair weight to 
consumer issues or lack the local perspective to understand 
consumer issues fully. CSBS considers this a weakness of the 
current system that would be exacerbated by creating a consumer 
protection agency.
    Further, federal preemption of state law and state law 
enforcement by the OCC and the OTS has resulted in less 
responsive consumer protections and institutions that are much 
less responsive to the needs of consumers in our states.
    CSBS is currently reviewing and developing robust policy 
positions upon the administration's proposed financial 
regulatory reform plan. Our initial thoughts, however, are 
pleased the administration has recognized the vital role states 
play in preserving consumer protection. We agree that federal 
standards should be applicable to all financial entities, and 
must be a floor, allowing state authorities to impose more 
stringent statutes or regulations if necessary to protect the 
citizens of our states. CSBS is also pleased the 
administration's plan would allow for state authorities to 
enforce all applicable law--state and federal--on those 
financial entities operating within our state, regardless of 
charter type.

Q.2. Regulatory Gaps or Omissions--During a recent hearing, the 
Committee has heard about massive regulatory gaps in the 
system. These gaps allowed unscrupulous actors like AIG to 
exploit the lack of regulatory oversight. Some of the 
counterparties that AIG did business with were institutions 
under your supervision.
    Why didn't your risk management oversight of the AIG 
counterparties trigger further regulatory scrutiny? Was there a 
flawed assumption that AIG was adequately regulated, and 
therefore no further scrutiny was necessary?
    Was there dialogue between the banking regulators and the 
state insurance regulators? What about the SEC?
    If the credit default swap contracts at the heart of this 
problem had been traded on an exchange or cleared through a 
clearinghouse, with requirement for collateral and margin 
payments, what additional information would have been 
available? How would you have used it?

A.2. CSBS believes this is a question best answered by the 
Federal Reserve and the OCC. However, we believe this provides 
an example of why consolidated supervision would greatly weaken 
our system of financial oversight. Institutions have become so 
complex in size and scope, that no single regulator is capable 
of supervising their activities. It would be imprudent to 
lessen the number of supervisors. Instead, Congress should 
devise a system which draws upon the strength, expertise, and 
knowledge of all financial regulators.

Q.3. Liquidity Management--A problem confronting many financial 
institutions currently experiencing distress is the need to 
roll-over short-term sources of funding. Essentially these 
banks are facing a shortage of liquidity. I believe this 
difficulty is inherent in any system that funds long-term 
assets, such as mortgages, with short-term funds. Basically the 
harm from a decline in liquidity is amplified by a bank's level 
of ``maturity-mismatch.''
    I would like to ask each of the witnesses, should 
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to 
do so?

A.3. While banks tend to have an inherent maturity-mismatch, 
greater access to diversified funding has mitigated this risk. 
Beyond traditional retail deposits, banks can access brokered 
deposits, public entity deposits, and secured borrowings from 
the FHLB. Since a bank essentially bids or negotiates for these 
funds, they can structure the term of the funding to meet their 
asset and liability management objectives.
    In the current environment, the FDIC's strict 
interpretation of the brokered deposit rule has unnecessarily 
led banks to face a liquidity challenge. Under the FDIC's 
rules, when a bank falls below ``well capitalized'' they must 
apply for a waiver from the FDIC to continue to accept brokered 
deposits. The FDIC has been overly conservative in granting 
these waivers or allowing institutions to reduce their 
dependency on brokered deposits over time, denying an 
institution access to this market. Our December 2008 letter to 
the FDIC on this topic is attached.

Q.4. Regulatory Conflict of Interest--Federal Reserve Banks 
which conduct bank supervision are run by bank presidents that 
are chosen in part by bankers that they regulate.
    Mr. Tarullo, do you see the potential for any conflicts of 
interest in the structural characteristics of the Fed's bank 
supervisory authorities?
    Mr. Dugan and Mr. Polakoff does the fact that your 
agencies' funding stream is affected by how many institutions 
you are able to keep under your charters affect your ability to 
conduct supervision?

A.4. I believe these questions are best answered by the Federal 
Reserve, the OCC, and the OTS.

Q.5. Too-Big-To-Fail--Chairman Bair stated in her written 
testimony that ``the most important challenge is to find ways 
to impose greater market discipline on systemically important 
institutions. The solution must involve, first and foremost, a 
legal mechanism for the orderly resolution of those 
institutions similar to that which exists for FDIC-insured 
banks. In short we need to end too big to fail.'' I would agree 
that we need to address the too-big-to-fail issue, both for 
banks and other financial institutions.
    Could each of you tell us whether putting a new resolution 
regime in place would address this issue?
    How would we be able to convince the market that these 
systemically important institutions would not be protected by 
taxpayer resources as they had been in the past?

A.5. CSBS strongly agrees with Chairman Bair that we must end 
``too big to fail.'' Our current crisis has shown that our 
regulatory structure was incapable of effectively managing and 
regulating the nation's largest institutions and their 
affiliates.
    Further, CSBS believes a regulatory system should have 
adequate safeguards that allow financial institution failures 
to occur while limiting taxpayers' exposure to financial risk. 
The federal government, perhaps through the FDIC, must have 
regulatory tools in place to manage the orderly failure of the 
largest financial institutions regardless of their size and 
complexity. The FDIC's testimony effectively outlines the 
checks and balances provided by a regulator with resolution 
authority and capability.
    Part of this process must be to prevent institutions from 
becoming ``too big to fail'' in the first place. Some methods 
to limit the size of institutions would be to charge 
institutions additional assessments based on size and 
complexity, which would be, in practice, a ``too big to fail'' 
premium. In a February 2009 article published in Financial 
Times, Nassim Nicholas Taleb, author of The Black Swan, 
discusses a few options we should avoid. Basically, Taleb 
argues we should no longer provide incentives without 
disincentives. The nation's largest institutions were 
incentivized to take risks and engage in complex financial 
transactions. But once the economy collapsed, these 
institutions were not held accountable for their failure. 
Instead, the U.S. taxpayers have further rewarded these 
institutions by propping them up and preventing their failure. 
Accountability must become a fundamental part of the American 
financial system, regardless of an institution's size.

Q.6. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank 
capital regulation. Some commentators have endorsed a concept 
requiring banks to hold more capital when good conditions 
prevail, and then allow banks to temporarily hold less capital 
in order not to restrict access to credit during a downturn. 
Advocates of this system believe that counter-cyclical policies 
could reduce imbalances within financial markets and smooth the 
credit cycle itself.
    What do you see as the costs and benefits of adopting a 
more counter-cyclical system of regulation?
    Do you see any circumstances under which your agencies 
would take a position on the merits of counter-cyclical 
regulatory policy?

A.6. Our legislative and regulatory efforts should be counter-
cyclical. In order to have an effective counter-cyclical 
regulatory regime, we must have the will and political support 
to demand higher capital standards and reduce risk-taking when 
the economy is strong and companies are reporting record 
profits. We must also address accounting rules and their impact 
on the depository institutions, recognizing that we need these 
firms to originate and hold longer-term, illiquid assets. We 
must also permit and encourage these institutions to build 
reserves for losses over time. Similarly, the FDIC must be 
given the mandate to build upon their reserves over time and 
not be subject to a cap. This will allow the FDIC to reduce 
deposit insurance premiums in times of economic stress.
    A successful financial system is one that survives market 
booms and busts without collapsing. The key to ensuring our 
system can survive these normal market cycles is to maintain 
and strengthen the diversity of our industry and our system of 
supervision. Diversity provides strength, stability, and 
necessary checks-and-balances to regulatory power.
    Consolidation of the industry or financial supervision 
could ultimately produce a financial system of only mega-banks, 
or the behemoth institutions that are now being propped up and 
sustained by taxpayer bailouts. An industry of only these types 
of institutions would not be resilient. Therefore, Congress 
must ensure this consolidation does not take place by 
strengthening our current system and preventing supervisory 
consolidation.

Q.7. G20 Summit and International Coordination--Many foreign 
officials and analysts have said that they believe the upcoming 
G20 summit will endorse a set of principles agreed to by both 
the Financial Stability Forum and the Basel Committee, in 
addition to other government entities. There have also been 
calls from some countries to heavily re-regulate the financial 
sector, pool national sovereignty in key economic areas, and 
create powerful supranational regulatory institutions. 
(Examples are national bank resolution regimes, bank capital 
levels, and deposit insurance.) Your agencies are active 
participants in these international efforts.
    What do you anticipate will be the result of the G20 
summit?
    Do you see any examples or areas where supranational 
regulation of financial services would be effective?
    How far do you see your agencies pushing for or against 
such supranational initiatives?

A.7. This question is obviously targeted to the federal 
financial agencies. However, while our supervisory structure 
will continue to evolve, CSBS does not believe international 
influences or the global marketplace should solely determine 
the design of regulatory initiatives in the United States. CSBS 
believes it is because of our unique dual banking system, not 
in spite of it, that the United States boasts some of the most 
successful institutions in the world. U.S. banks are required 
to hold high capital standards compared to their international 
counterparts. U.S. banks maintain the highest tier 1 leverage 
capital ratios but still generate the highest average return on 
equity. The capital levels of U.S. institutions have resulted 
in high safety and soundness standards. In turn, these 
standards have attracted capital investments worldwide because 
investors are confident in the strength of the U.S. system.
    Viability of the global marketplace and the international 
competitiveness of our financial institutions are important 
goals. However, our first priority as regulators must be the 
competitiveness between and among domestic banks operating 
within the United States. It is vital that regulatory 
restructuring does not adversely affect the financial system in 
the U.S. by putting banks at a competitive disadvantage with 
larger, more complex institutions. The diversity of financial 
institutions in the U.S. banking system has greatly contributed 
to our economic success.
    CSBS believes our supervisory structure should continue to 
evolve as necessary and prudent to accommodate our institutions 
that operate globally as well as domestically.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                   FROM JOSEPH A. SMITH, JR.

Q.1. It is clear that our current regulatory structure is in 
need of reform. At my subcommittee hearing on risk management, 
March 18, 2009, GAO pointed out that regulators often did not 
move swiftly enough to address problems they had identified in 
the risk management systems of large, complex financial 
institutions.
    Chairman Bair's written testimony for today's hearing put 
it very well: `` . . . the success of any effort at reform will 
ultimately rely on the willingness of regulators to use their 
authorities more effectively and aggressively.''
    My questions may be difficult, but please answer the 
following:

    If this lack of action is a persistent problem 
        among the regulators, to what extent will changing the 
        structure of our regulatory system really get at the 
        issue?

    Along with changing the regulatory structure, how 
        can Congress best ensure that regulators have clear 
        responsibilities and authorities, and that they are 
        accountable for exercising them ``effectively and 
        aggressively''?

A.1. First of all, CSBS agrees completely with Chairman Bair. 
In fact, in a letter to the Government Accountability Office 
(GAO) in December 2008, CSBS Executive Vice President John Ryan 
wrote, ``While there are clearly gaps in our regulatory system 
and the system is undeniably complex, CSBS has observed that 
the greater failing of the system has been one of insufficient 
political and regulatory will, primarily at the federal 
level.'' Perhaps the resilience of our financial system during 
previous crises gave policymakers and regulators a false sense 
of security and a greater willingness to defer to powerful 
interests in the financial industry who assured them that all 
was well.
    From the state perspective, it is clear that the nation's 
largest and most influential financial institutions have 
themselves been major contributors to our regulatory system's 
failure to prevent the current economic collapse. All too 
often, it appeared as though legislation and regulation 
facilitated the business models and viability of our largest 
institutions, instead of promoting the strength of consumers or 
encouraging a diverse financial industry.
    CSBS believes consolidating supervisory authority will only 
exacerbate this problem. Regulatory capture by a variety of 
interests would become more likely with a consolidated 
supervisory structure. The states attempted to check the 
unhealthy evolution of the mortgage market and it was the 
states and the FDIC that were a check on the flawed assumptions 
of the Basel II capital accord. These checks should be enhanced 
by regulatory restructuring, not eliminated.
    To best ensure that regulators exercise their authorities 
``effectively and aggressively,'' I encourage Congress to 
preserve and enhance the system of checks and balances amongst 
regulators and to forge a new era of cooperative federalism. It 
serves the best interest of our economy, our financial services 
industry, and our consumers that the states continue to have a 
role in financial regulation. States provide an important 
system of checks and balances to financial oversight, are able 
to identify emerging trends and practices before our federal 
counterparts, and have often exhibited a willingness to act on 
these trends when our federal colleagues did not.
    Therefore, CSBS urges Congress to implement a 
recommendation made by the Congressional Oversight Panel in 
their ``Special Report on Regulatory Reform'' to eliminate 
federal preemption of the application of state consumer 
protection laws. To preserve a responsive system, states must 
be able to continue to produce innovative solutions and 
regulations to provide consumer protection.
    Further, the federal government would best serve our 
economy and our consumers by advancing a new era of cooperative 
federalism. The SAFE Act enacted by Congress requiring 
licensure and registration of mortgage loan originators through 
NMLS provides a mode for achieving systemic goals of high 
regulatory standards and a nationwide regulatory roadmap and 
network, while preserving state authority for innovation and 
enforcement. The SAFE Act sets expectations for greater state-
to-state and state-to-federal regulatory coordination.
    Congress should complete this process by enacting a federal 
predatory lending standard as outlined in H.R. 1728, the 
Mortgage Reform and Anti-Predatory Lending Act. However, a 
static legislative solution would not keep pace of market 
innovation. Therefore, any federal standard must be a floor for 
all lenders that does not stifle a state's authority to protect 
its citizens through state legislation that builds upon the 
federal standard. States should also be allowed to enforce-in 
cooperation with federal regulators-both state and federal 
predatory lending laws for institutions that act within their 
state.
    Finally, rule writing authority by the federal banking 
agencies should be coordinated through the FFIEC. Better state/
federal coordination and effective lending standards is needed 
if we are to establish rules that are appropriately written and 
applied to financial services providers. While the biggest 
institutions are federally chartered, the vast majority of 
institutions are state chartered and regulated. Also, the 
states have a breadth of experience in regulating the entire 
financial services industry, not just banks. Unlike our federal 
counterparts, my state supervisory colleagues and I oversee all 
financial service providers, including banks, thrifts, credit 
unions, mortgage banks, and mortgage brokers.

Q.2. How do we overcome the problem that in the boom times no 
one wants to be the one stepping in to tell firms they have to 
limit their concentrations of risk or not trade certain risky 
products?
    What thought has been put into overcoming this problem for 
regulators overseeing the firms?
    Is this an issue that can be addressed through regulatory 
restructure efforts?

A.2. Our legislative and regulatory efforts must be counter-
cyclical. A successful financial system is one that survives 
market booms and busts without collapsing. The key to ensuring 
our system can survive these normal market cycles is to 
maintain and strengthen the diversity of our industry and our 
system of supervision. Diversity provides strength, stability, 
and necessary checks-and-balances to regulatory power.
    Consolidation of the industry or financial supervision 
could ultimately product a financial system of only mega-banks, 
or the behemoth institutions that are now being propped up and 
sustained by taxpayer bailouts. An industry of only these types 
of institutions would not be resilient. Therefore, Congress 
must ensure this consolidation does not take place by 
strengthening our current system and preventing supervisory 
consolidation.

Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, 
some financial institution failures emanated from institutions 
that were under federal regulation. While I agree that we need 
additional oversight over and information on unregulated 
financial institutions, I think we need to understand why so 
many regulated firms failed.
    Why is it the case that so many regulated entities failed, 
and many still remain struggling, if our regulators in fact 
stand as a safety net to rein in dangerous amounts of risk-
taking?
    While we know that certain hedge funds, for example, have 
failed, have any of them contributed to systemic risk?
    Given that some of the federal banking regulators have 
examiners on-site at banks, how did they not identify some of 
these problems we are facing today?

A.3. To begin, the seeming correlation between federal 
supervision and success now appears to be unwarranted and 
should be better understood. The failures we have seen are 
divided between institutions that are suffering because of an 
extreme business cycle, and others that had more fundamental 
flaws that precipitated the downturn. In a healthy and 
functional economy, financial oversight must allow for some 
failures. In a competitive marketplace, some institutions will 
cease to be feasible. Our supervisory structure must be able to 
resolve failures. Ultimately, more damage is done to the 
financial system if toxic institutions are allowed to remain in 
business, instead of allowed to fail. Propping up these 
institutions can create lax discipline and risky practices as 
management relies upon the government to support them if their 
business models become untenable.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                   FROM JOSEPH A. SMITH, JR.

Q.1. The convergence of financial services providers and 
financial products has increased over the past decade. 
Financial products and companies may have insurance, banking, 
securities, and futures components. One example of this 
convergence is AIG. Is the creation of a systemic risk 
regulator the best method to fill in the gaps and weaknesses 
that AIG has exposed, or does Congress need to reevaluate the 
weaknesses of federal and state functional regulation for 
large, interconnected, and large firms like AIG?

A.1. The current economic crisis has shown that our financial 
regulatory structure in the United States was incapable of 
effectively managing and regulating the nation's largest 
institutions, such as AIG.
    Institutions, such as AIG, that provide financial services 
similar to those provided by a bank, should be subject to the 
same oversight that supervises banks.
    CSBS believes the solution, however, is not to expand the 
federal government bureaucracy by creating a new super 
regulator. Instead, we should enhance coordination and 
cooperation among federal and state regulators. We believe 
regulators must pool their resources and expertise to better 
identify and manage systemic risk. The Federal Financial 
Institutions Examination Council (FFIEC) provides a vehicle for 
working toward this goal of seamless federal and state 
cooperative supervision.

Q.2. Recently there have been several proposals to consider for 
financial services conglomerates. One approach would be to move 
away from functional regulation to some type of single 
consolidated regulator like the Financial Services Authority 
model. Another approach is to follow the Group of 30 Report 
which attempts to modernize functional regulation and limit 
activities to address gaps and weaknesses. An in-between 
approach would be to move to an objectives-based regulation 
system suggested in the Treasury Blueprint. What are some of 
the pluses and minuses of these three approaches?

A.2. Each of the models discussed would result in further 
consolidation of the financial industry, and would create 
institutions that would be inherently too big to fail. If we 
allowed our financial industry to consolidate to only a handful 
of institutions, the nation and the global economy would be 
reliant upon those institutions to remain functioning. CSBS 
believes all financial institutions must be allowed to fail if 
they become insolvent. Currently, our system of financial 
supervision is inadequate to effective supervise the nation's 
largest institutions and to resolve them in the event of their 
failure.
    More importantly, however, consolidation of the industry 
would destroy the community banking system within the United 
States. The U.S. has over 8,000 viable insured depository 
institutions to serve the people of this nation. The diversity 
of our industry has enabled our economy to continue despite the 
current recession. Community and regional banks have continued 
to make credit available to qualified borrowers throughout the 
recession and have prevented the complete collapse of our 
economy.

Q.3. If there are institutions that are too big to fail, how do 
we identify that? How do we define the circumstance where a 
single company is so systemically significant to the rest of 
our financial circumstances and our economy that we must not 
allow it to fail?

A.3. A specific definition for ``too big to fail'' will be 
difficult for Congress to establish. Monetary thresholds will 
eventually become insufficient as the market rebounds and works 
around any asset-size restrictions, just as institutions have 
avoided deposit caps for years now. Some characteristics of an 
institution that is ``too big to fail'' include being so large 
that the institution's regulator is unable to provide 
comprehensive supervision of the institution's lines of 
business or subsidiaries. An institution is also ``too big to 
fail'' if a sudden collapse of the institution would have a 
devastating impact upon separate market segments.

Q.4. We need to have a better idea of what this notion of too 
big to fail is--what it means in different aspects of our 
industry and what our proper response to it should be. How 
should the federal government approach large, multinational, 
and systemically significant companies?

A.4. The federal government should utilize methods to prevent 
companies from growing too big to fail, either through 
incentives and disincentives (such as higher regulatory fees 
and assessments for higher amounts of assets or engaging in 
certain lines of business), denying certain business mergers or 
acquisitions that allow a company to become ``systemic,'' or 
through establishing anti-trust laws that prevent the creation 
of financial monopolies. Congress should also grant the Federal 
Deposit Insurance Corporation (FDIC) resolution authority over 
all financial firms, regardless of their size or complexity. 
This authority will help instill market discipline to these 
systemic institutions by providing a method to close any 
institution that becomes insolvent. Finally, Congress should 
consider establishing a bifurcated system of supervision 
designed to meet the needs not only of the nation's largest and 
most complex institutions, but also the needs of the smallest 
community banks.

Q.5. What does ``fail'' mean? In the context of AIG, we are 
talking about whether we should have allowed an orderly Chapter 
11 bankruptcy proceeding to proceed. Is that failure?

A.5. CSBS believes failures and resolutions take on a variety 
of forms based upon the type of institution and its impact upon 
the financial system as a whole. In the context of AIG, an 
orderly Chapter 11 bankruptcy would have been considered a 
failure.
    But it is more important that we do not create an entire 
system of financial supervision that is tailored only to our 
nation's largest and most complex institutions. It is our 
belief the greatest strength of our unique financial structure 
is the diversity of the financial industry. The U.S. banking 
system is comprised of thousands of financial institutions of 
vastly different sizes. Therefore, legislative and regulatory 
decisions that alter our financial regulatory structure or 
financial incentives should be carefully considered against how 
those decisions affect the competitive landscape for 
institutions of all sizes.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
                   FROM JOSEPH A. SMITH, JR.

Q.1. Two approaches to systemic risk seem to be identified: (1) 
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to 
fail'' or ``too systemically important to fail'' or (2) impose 
an additional regulator and additional rules and market 
discipline on institutions that are considered systemically 
important.
    Which approach do you endorse? If you support approach one 
how you would limit institution size and how would you identify 
new areas creating systemic importance?
    If you support approach two how would you identify 
systemically important institutions and what new regulations 
and market discipline would you recommend?

A.1. CSBS endorses the first approach monitor institutions and 
take steps to reduce the size and activities of institutions 
that approach either ``too large to fail'' or ``too 
systemically important to fail.'' Our current crisis has shown 
that our regulatory structure was incapable of effectively 
managing and regulating the nation's largest institutions. CSBS 
believes the solution, however, is not to expand the federal 
government bureaucracy by creating a new super regulator, or 
granting those authorities to a single existing agency. 
Instead, we should enhance coordination and cooperation among 
the federal government and the states to identify systemic 
importance and mitigate its risk. We believe regulators must 
pool resources and expertise to better manage systemic risk. 
The FFIEC provides a vehicle for working towards this goal of 
seamless federal and state cooperative supervision.
    Further, CSBS believes a regulatory system should have 
adequate safeguards that allow financial institution failures 
to occur while limiting taxpayers' exposure to financial risk. 
The federal government, perhaps through the FDIC, must have 
regulatory tools in place to manage the orderly failure of the 
largest financial institutions regardless of their size and 
complexity.
    Part of this process must be to prevent institutions from 
becoming ``too big to fail'' in the first place. Some methods 
to limit the size of institutions would be to charge 
institutions additional assessments based on size and 
complexity, which would be, in practice, a ``too big to fail'' 
premium. In a February 2009 article published in Financial 
Times, Nassim Nicholas Taleb, author of The Black Swan, 
discusses a few options we should avoid. Basically, Taleb 
argues we should no longer provide incentives without 
disincentives. The nation's largest institutions were 
incentivized to take risks and engage in complex financial 
transactions. But once the economy collapsed, these 
institutions were not held accountable for their failure. 
Instead, the U.S. taxpayers have further rewarded these 
institutions by propping them up and preventing their failure. 
Accountability must become a fundamental part of the American 
financial system, regardless of an institution's size.

Q.2. Please identify all regulatory or legal barriers to the 
comprehensive sharing of information among regulators including 
insurance regulators, banking regulators, and investment 
banking regulators. Please share the steps that you are taking 
to improve the flow of communication among regulators within 
the current legislative environment.

A.2. Regulatory and legal barriers exist at every level of 
state and federal government. These barriers can be cultural, 
regulatory, or legal in nature.
    Despite the hurdles, state and federal authorities have 
made some progress towards enhancing coordination. Since 
Congress added full state representation to the FFIEC in 2006, 
federal regulators are working more closely with state 
authorities to develop processes and guidelines to protect 
consumers and prohibit certain acts or practices that are 
either systemically unsafe or harmful to consumers.
    The states, working through CSBS and the American 
Association of Residential Mortgage Regulators (AARMR), have 
made tremendous strides towards enhancing coordination and 
cooperation among the states and with our federal counterparts.
    The model for cooperative federalism among state and 
federal authorities is the CSBS-AARMR Nationwide Mortgage 
Licensing System (NMLS) and the SAFE Act enacted last year. In 
2003, CSBS and AARMR began a very bold initiative to identify 
and track mortgage entities and originators through a database 
of licensing and registration. In January 2008, NMLS was 
successfully launched with seven inaugural participating 
states. Today, 25 states plus the District of Columbia and 
Puerto Rico are using NMLS. The hard work and dedication of the 
states was recognized by Congress as you enacted the Housing 
and Economic Recovery Act of 2008 (HERA). Title V of HERA, 
known as the SAFE Act, is designed to increase mortgage loan 
originator professionalism and accountability, enhance consumer 
protection, and reduce fraud by requiring all mortgage loan 
originators be licensed or registered through NMLS.
    Combined, NMLS and the SAFE Act create a seamless system of 
accountability, interconnectedness, control, and tracking that 
has long been absent in the supervision of the mortgage market. 
Please see the Appendix of my written testimony for a 
comprehensive list of state initiatives to enhance coordination 
of financial supervision.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                      FROM GEORGE REYNOLDS

Q.1. Consumer Protection Regulation--Some have advocated that 
consumer protection and prudential supervision should be 
divorced, and that a separate consumer protection regulation 
regime should be created. They state that one source of the 
financial crisis emanated from the lack of consumer protection 
in the underwriting of loans in the originate-to-distribute 
space.
    What are the merits of maintaining it in the same agency? 
Alternatively, what is the best argument each of you can make 
for a new consumer protection agency?

A.1. A separate consumer protection regulation regime would not 
recognize state law. State legislators and regulators are in 
the first and best position to identify trends and abusive 
practices. One regulator for consumer protection eliminates the 
dual oversight that is made possible by state and federal laws 
and regulations. It would also inhibit coordination and 
cooperation between regulators or worse, provide a gap in 
regulation and oversight by the state regulatory system.
    The Treasury Blueprint for a Modernized Financial 
Regulatory Structure, presented in March 2008, suggests the 
creation of a business conduct regulator to conduct regulation 
across all types of financial firms. The business conduct 
regulator would include key aspects of consumer protection, 
including rule writing for disclosures and business practices. 
This structure proposes to eliminate gaps in oversight and 
provide effective consumer and investor protections.
    The proposed business conduct regulator at the federal 
level would be separate and distinct from the suggested 
prudential regulator. NASCUS \1\ believes such a system would 
curtail, not enhance, consumer protections.
---------------------------------------------------------------------------
     \1\ NASCUS is the professional association of state credit union 
regulatory agencies that charter, examine and supervise the nation's 
3,100 state-chartered credit unions. The NASCUS , mission is to enhance 
state credit union supervision and advocate for a safe and sound credit 
union system.
---------------------------------------------------------------------------
    The Treasury Blueprint would create a new federal 
bureaucracy, taking away most supervisory, enforcement and rule 
making authority from the states and federalizing those 
authorities in a new business conduct regulator.
    Much of the focus of attention of the OCC, OTS and NCUA has 
been on seeking preemption from state consumer protection laws. 
An example of this is the preemption efforts undertaken by 
these agencies regarding the Georgia Fair Lending Act (GFLA). 
It is vital that consumer protection statutes adopted at the 
state level apply consistently to all financial institutions 
regardless of charter type.

Q.2. Regulatory Gaps or Omissions--During a recent hearing, the 
Committee has heard about massive regulatory gaps in the 
system. These gaps allowed unscrupulous actors like AIG to 
exploit the lack of regulatory oversight. Some of the 
counterparties that AIG did business with were institutions 
under your supervision.
    Why didn't your risk management oversight of the AIG 
counterparties trigger further regulatory scrutiny? Was there a 
flawed assumption that AIG was adequately regulated, and 
therefore no further scrutiny was necessary?

A.2. NASCUS members do not have regulatory oversight of AIG. 
The answers provided by NASCUS focus on issues related to our 
expertise regulating state credit unions and issues concerning 
the state credit union system.

Q.3. Was there dialogue between the banking regulators and the 
state insurance regulators? What about the SEC?

A.3. This question does not apply to state credit union 
regulators. The answers provided by NASCUS focus on issues 
related to our expertise regulating state credit unions and 
issues concerning the state credit union system.

Q.4. If the credit default swap contracts at the heart of this 
problem had been traded on an exchange or cleared through a 
clearinghouse, with requirement for collateral and margin 
payments, what additional information would have been 
available? How would you have used it?

A.4. Credit unions did not and currently do not engage in 
credit default swap contracts to the best of our knowledge.

Q.5. Liquidity Management--A problem confronting many financial 
institutions currently experiencing distress is the need to 
roll-over short-term sources of funding. Essentially these 
banks are facing a shortage of liquidity. I believe this 
difficulty is inherent in any system that funds long-term 
assets, such as mortgages, with short-term funds. Basically the 
harm from a decline in liquidity is amplified by a bank's level 
of ``maturity-mismatch.''
    I would like to ask each of the witnesses, should 
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to 
do so?

A.5. Most credit unions supervised by state regulators have 
strong core liquidity funding in the form of member deposits. 
Unlike other financial institutions which use brokered funding, 
Internet deposit funding and other noncore funding, these 
practices are rare in credit unions.
    Many credit unions' liquidity position would be favorably 
impacted if they had access to supplemental capital. 
Supplemental capital would bolster the safety and soundness of 
credit unions and provide further stability in this 
unpredictable market. It would also provide an additional layer 
of protection to the NCUSIF thereby maintaining credit unions' 
independence from the federal government and taxpayers.
    Credit union access to supplemental capital is more 
important than ever given the impact of losses in the corporate 
system on federally insured natural-person credit unions. 
Stabilizing the corporate credit union system requires natural-
person federally insured credit unions to write off their 
existing one percent deposit in the NCUSIF, as well as an 
assessment of a premium to return NCUSIF's equity ratio to 1.3 
percent. Additionally, credit unions with capital investments 
in the retail corporate credit union could be forced to write-
down as much as another $2 billion in corporate capital. This 
will impact the bottom line of many credit unions, and 
supplemental capital could have helped their financial position 
in addressing this issue.
    State regulators are committed to taking every feasible 
step to protect credit union safety and safety and soundness--
we must afford the nation's credit unions with the opportunity 
to protect and grow liquidity as well as the tools to react to 
unusual market conditions. The NASCUS Board of Directors and 
NASCUS state regulators urge you to enact legislation allowing 
supplemental capital.

Q.6. Too-Big-To-Fail--Chairman Bair stated in her written 
testimony that ``the most important challenge is to find ways 
to impose greater market discipline on systemically important 
institutions. The solution must involve, first and foremost, a 
legal mechanism for the orderly resolution of those 
institutions similar to that which exists for FDIC-insured 
banks. In short we need to end too big to fail.'' I would agree 
that we need to address the too-big-to-fail issue, both for 
banks and other financial institutions.
    Could each of you tell us whether putting a new resolution 
regime in place would address this issue?

A.6. While relatively few credit unions fall into the category 
of ``too big to fail,'' with the exception perhaps of some of 
the larger corporate credit unions, I believe as a general rule 
that if an institution is too big to fail, then perhaps it is 
also too large to exist. Perhaps the answer is to functionally 
separate and decouple the risk areas of a ``too big to fail'' 
organization so that a component area can have the market 
discipline of potential failure, without impairing the entire 
organization. Financial institutions backed by federal deposit 
insurance need to have increased expectations of risk control 
and risk management.

Q.7. How would we be able to convince the market that these 
systemically important institutions would not be protected by 
taxpayer resources as they had been in the past?

A.7. Again this area has relatively little application to 
state-chartered credit unions. But the most effective message 
can be conveyed to the marketplace by clearly indicating that 
these riskier decoupled operations will not be supported by 
taxpayer resources and then following through by letting these 
entities enter bankruptcy or fail without government 
intervention.

Q.8. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank 
capital regulation. Some commentators have endorsed a concept 
requiring banks to hold more capital when good conditions 
prevail, and then allow banks to temporarily hold less capital 
in order not to restrict access to credit during a downturn. 
Advocates of this system believe that counter-cyclical policies 
could reduce imbalances within financial markets and smooth the 
credit cycle itself.
    What do you see as the costs and benefits of adopting a 
more counter-cyclical system of regulation?
    Do you see any circumstances under which your agencies 
would take a position on the merits of counter-cyclical 
regulatory policy?

A.8. Perhaps the most needed measure relative to a counter-
cyclical system of regulation is the need to increase deposit 
insurance premiums during periods of heightened earnings, as 
opposed to the current practice of basing these assessment on 
deposit insurance losses. Financial institutions end up with 
high assessments typically at the same time that their capital 
and earnings are under pressure due to asset quality concerns. 
The deposit insurance funds need to be built up during the good 
times and banks and credit unions need to be able to have lower 
assessments during periods of economic uncertainty.
    It would also be wise to review examination processes to 
see where greater emphasis can be placed on developing counter-
cyclical processes and procedures. This will always be a 
challenge during periods of economic expansion, where financial 
institutions are experiencing low levels of nonperforming loans 
and loan losses, strong capital and robust earnings. Under 
these circumstances supervisors are subject to being accused by 
financial institutions and policy makers as impeding economic 
progress and credit availability. It would be beneficial to 
take a stronger and more aggressive posture regarding 
concentration risk and funding and asset/liability management 
risk during periods of economic expansion.

Q.9. G20 Summit and International Coordination--Many foreign 
officials and analysts have said that they believe the upcoming 
G20 summit will endorse a set of principles agreed to by both 
the Financial Stability Forum and the Basel Committee, in 
addition to other government entities. There have also been 
calls from some countries to heavily re-regulate the financial 
sector, pool national sovereignty in key economic areas, and 
create powerful supranational regulatory institutions. 
(Examples are national bank resolution regimes, bank capital 
levels, and deposit insurance.) Your agencies are active 
participants in these international efforts.
    What do you anticipate will be the result of the G20 
summit?
    Do you see any examples or areas where supranational 
regulation of financial services would be effective?
    How far do you see your agencies pushing for or against 
such supranational initiatives?

A.9. To ensure a comprehensive regulatory system for credit 
unions, Congress should consider the current dual chartering 
system as a regulatory model. Dual chartering and the value 
offered to consumers by the state and federal systems provide 
the components that make a comprehensive regulatory system. 
Dual chartering also reduces the likelihood of gaps in 
financial regulation because there are two interested 
regulators. Often, states are in the first and best position to 
identify current trends that need to be regulated and this 
structure allows the party with the most information to act to 
curtail a situation before it becomes problematic. Dual 
chartering should continue. This system provides accountability 
and the needed structure for effective and aggressive 
regulatory enforcement.
    The dual chartering system has provided comprehensive 
regulation for 140 years. Dual chartering remains viable in the 
financial marketplace because of the distinct benefits provided 
by each charter, state and federal. This system allows each 
financial institution to select the charter that benefits its 
members or consumers the most. Ideally, for any system, the 
best elements of each charter should be recognized and enhanced 
to allow for competition in the marketplace so that everyone 
benefits. In addition, the dual chartering system allows for 
the checks and balances between state and federal government 
necessary for comprehensive regulation. Any regulatory system 
should recognize the value of the dual chartering system and 
how it contributes to a comprehensive regulatory structure. 
Regulators should evaluate products and services based on 
safety and soundness and consumer protection criterion. This 
will maintain the public's confidence.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                      FROM GEORGE REYNOLDS

Q.1. It is clear that our current regulatory structure is in 
need of reform. At my subcommittee hearing on risk management, 
March 18, 2009, GAO pointed out that regulators often did not 
move swiftly enough to address problems they had identified in 
the risk management systems of large, complex financial 
institutions.
    Chair Bair's written testimony for today's hearing put it 
very well: `` . . . the success of any effort at reform will 
ultimately rely on the willingness of regulators to use their 
authorities more effectively and aggressively.''
    My questions may be difficult, but please answer the 
following: If this lack of action is a persistent problem among 
the regulators, to what extent will changing the structure of 
our regulatory system really get at the issue?

A.1. We do not perceive that lack of action is a problem among 
the state credit union regulators. In fact, the authority given 
to state regulators by state legislatures allows state 
regulators to move quickly to mitigate problems and address 
risk in their state-chartered credit unions. NASCUS \1\ 
believes that the dual chartering structure which allows for 
both a strong state and federal regulator is an effective 
regulatory structure for credit unions.
---------------------------------------------------------------------------
     \1\ NASCUS is the professional association of state credit union 
regulatory agencies that charter, examine and supervise the nation's 
3,100 state-chartered credit unions. The NASCUS mission is to enhance 
state credit union supervision and advocate for a safe and sound credit 
union system.
---------------------------------------------------------------------------
    State and federal credit union regulators regularly 
exchange information about the credit unions they supervise; it 
is a cooperative relationship. The Federal Credit Union Act 
(FCUA) provides that ``examinations conducted by State 
regulatory agencies shall be utilized by the Board for such 
purposes to the maximum extent feasible.'' \2\ Further, 
Congress has recognized and affirmed the distinct roles played 
by state and federal regulatory agencies in the FCUA by 
providing a system of consultation and cooperation between 
state and federal regulators. \3\ It is important that all 
statutes and regulations written in the future include 
provisions that require consultation and cooperation between 
state and federal credit union regulators to prevent regulatory 
and legal barriers to the comprehensive information sharing. 
This cooperation helps regulators identify and act on issues 
before they become a problem.
---------------------------------------------------------------------------
     \2\ 12 U.S. Code 1781(b)(1).
     \3\ The ``Consultation and Cooperation With State Credit Union 
Supervisors'' provision contained in The Federal Credit Union Act, 12 
U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).
---------------------------------------------------------------------------
    State regulators play an important role in protecting the 
safety and soundness of the state credit union system. It is 
imperative that any regulatory structure preserve state 
regulators role in overseeing and writing regulations for state 
credit unions. In addition, it is critical that state 
regulators and National Credit Union Administration (NCUA) have 
parity and comparable systemic risk authority with the Federal 
Deposit Insurance Corporation (FDIC).

Q.2. Along with changing the regulatory structure, how can 
Congress best ensure that regulators have clear 
responsibilities and authorities, and that they are accountable 
for exercising them ``effectively and aggressively''?

A.2. To ensure a comprehensive regulatory system, Congress 
should consider the current dual chartering system as a 
regulatory model. Dual chartering and the value offered to 
consumers by the state and federal systems provide the 
components that make a comprehensive regulatory system. Dual 
chartering also reduces the likelihood of gaps in financial 
regulation because there are two interested regulators. Often, 
states are in the first and best position to identify current 
trends that need to be regulated and this structure allows the 
party with the most information to act to curtail a situation 
before it becomes problematic. Dual chartering should continue. 
This system provides accountability and the needed structure 
for effective and aggressive regulatory enforcement.
    The dual chartering system has provided comprehensive 
regulation for 140 years. Dual chartering remains viable in the 
financial marketplace because of the distinct benefits provided 
by each charter, state and federal. This system allows each 
financial institution to select the charter that benefits its 
members or consumers the most. Ideally, for any system, the 
best elements of each charter should be recognized and enhanced 
to allow for competition in the marketplace so that everyone 
benefits. In addition, the dual chartering system allows for 
the checks and balances between state and federal government 
necessary for comprehensive regulation. Any regulatory system 
should recognize the value of the dual chartering system and 
how it contributes to a comprehensive regulatory structure. 
Regulators should evaluate products and services based on 
safety and soundness and consumer protection criterion. This 
will maintain the public's confidence.

Q.3. How do we overcome the problem that in the boom times no 
one wants to be the one stepping in to tell firms they have to 
limit their concentrations of risk or not trade certain risky 
products?
    What thought has been put into overcoming this problem for 
regulators overseeing the firms?
    Is this an issue that can be addressed through regulatory 
restructure efforts?

A.3. The current credit union regulatory structure 
appropriately provides state credit union regulators rulemaking 
and enforcement authority. This authority helps state 
regulators respond to problems and trends at state-chartered 
credit unions and it places them in a position to help state 
credit unions manage risks on their balance sheets.
    It is sometimes difficult, particularly during a period of 
economic expansion to motivate financial institutions to reduce 
concentration risk when institutions are strongly capitalized 
and have robust earnings. This is, nevertheless, the 
appropriate role of a regulator and it is not really a factor 
that can be addressed through regulatory restructuring. It can 
only be impacted by having effective, experienced and well 
trained examiners that are supported in consistent manner by 
experienced supervisory management.

Q.4. As Mr. Tarullo and Mrs. Bair noted in their testimony, 
some financial institution failures emanated from institutions 
that were under federal regulation. While I agree that we need 
additional oversight over and information on unregulated 
financial institutions, I think we need to understand why so 
many regulated firms failed.
    Why is it the case that so many regulated entities failed, 
and many still remain struggling, if our regulators in fact 
stand as a safety net to rein in dangerous amounts of risk-
taking?

A.4. The current economic crisis and resulting destabilization 
of portions of the financial services system has revealed 
certain gaps and lapses in overall regulatory oversight. 
Currently, state and federal regulators are assessing those 
lapses, identifying gaps, and working diligently to address 
weaknesses in the system. As part of this process, it is also 
important to recognize regulatory oversight that worked, 
whether preventing failure, or identifying undue risk in a 
manner that allowed for an orderly unwinding of a going 
concern.
    To the extent that regulators miscalculated a calibration 
of acceptable risk, as opposed to undue risk, it may be safe to 
conclude that undue reliance was placed on underlying market 
assumptions that failed upon severe market dislocation.

Q.5. While we know that certain hedge funds, for example, have 
failed, have any of them contributed to systemic risk?

A.5. NASCUS members do not regulate hedge funds. The answers 
provided by NASCUS focus solely on issues related to our 
expertise regulating state credit unions and issues concerning 
the state credit union system.

Q.6. Given that some of the federal banking regulators have 
examiners on-site at banks, how did they not identify some of 
these problems we are facing today?

A.6. Given NASCUS members regulatory scope, this question does 
not apply. The answers provided by NASCUS focus solely on 
issues related to our expertise regulating state credit unions 
and issues concerning the state credit union system.
    NASCUS background: The NASCUS, \4\ mission is to enhance 
state credit union supervision and advocate for a safe and 
sound credit union system. NASCUS represents the interests of 
state agencies before Congress and is the liaison to federal 
agencies, including the National Credit Union Administration 
(NCUA). NCUA is the chartering authority for federal credit 
unions and the administrator of the National Credit Union Share 
Insurance Fund (NCUSIF), the insurer of most state-chartered 
credit unions.
---------------------------------------------------------------------------
     \4\ NASCUS is the professional association of state credit union 
regulatory agencies that charter, examine and supervise the nation's 
3,100 state-chartered credit unions.
---------------------------------------------------------------------------
    Credit unions in this country are structured in three 
tiers. The first tier consists of 8,088 natural-person credit 
unions \5\ that provide services to consumer members. 
Approximately 3,100 of these institutions are state-chartered 
credit unions and are regulated by state regulatory agencies. 
There are 27 \6\ retail corporate credit unions, which provide 
investment, liquidity and payment system services to credit 
unions; corporate credit unions do not serve consumers. The 
final tier of the credit union system is a federal wholesale 
corporate that acts as a liquidity and payment systems provider 
to the corporate system and indirectly to the consumer credit 
unions.
---------------------------------------------------------------------------
     \5\ Credit Union Report, Year-End 2008, Credit Union National 
Association.
     \6\ There are 14 state-chartered retail corporate credit unions 
and 13 federally chartered corporate credit unions.
---------------------------------------------------------------------------
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                      FROM GEORGE REYNOLDS

Q.1. The convergence of financial services providers and 
financial products has increased over the past decade. 
Financial products and companies may have insurance, banking, 
securities, and futures components. One example of this 
convergence is AIG. Is the creation of a systemic risk 
regulator the best method to fill in the gaps and weaknesses 
that AIG has exposed, or does Congress need to reevaluate the 
weaknesses of federal and state functional regulation for 
large, interconnected, and large firms like AIG?

A.1. NASCUS \1\ members do not have oversight responsibilities 
for AIG. The answers provided by NASCUS focus on issues related 
to our expertise regulating state credit unions and issues 
concerning the state credit union system. Although NASCUS does 
not have specific comments related to AIG, the following views 
on systemic risk are provided for your consideration.
---------------------------------------------------------------------------
     \1\ NASCUS is the professional association of state credit union 
regulatory agencies that charter, examine and supervise the nation's 
3,100 state-chartered credit unions.
---------------------------------------------------------------------------
    It is important that systemic risk that is outside of the 
normal supervisory focus of financial institution regulators be 
monitored and controlled, but it is also imperative that the 
systemic risk process not interfere or add additional 
regulatory burden to financial institutions that are already 
supervised by their chartering authorities (state and federal) 
and their deposit insurers.
    Regarding systemic risk, NASCUS believes that systemic risk 
and concentration risk can be mitigated through state and 
federal regulation cooperation. Regardless of which approach is 
selected to mitigate systemic risk, it presents all regulators 
with challenges, even those without direct jurisdiction over 
the entity representing the risk. By drawing on the expertise 
of many regulatory agencies, state and federal regulators could 
improve their ability to detect and address situations before 
they achieve critical mass.
    State regulators play an important role in mitigating 
systemic risk in the state credit union system. Congress 
provides and affirms this distinct role in the Federal Credit 
Union Act (FCUA) by providing a system of ``consultation and 
cooperation'' between state and federal regulators. \2\ It is 
imperative that any regulatory structure preserve state 
regulators role in overseeing and writing regulations for state 
credit unions. In addition, it is critical that state 
regulators and NCUA have parity and comparable systemic risk 
authority with the Federal Deposit Insurance Corporation 
(FDIC). NASCUS would be concerned about systemic risk 
regulation that introduces a new layer of regulation for credit 
unions or proposes to consolidate regulators and state and 
federal credit union charters.
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     \2\ The Consultation and Cooperation With State Credit Union 
Supervisors provision contained in The Federal Credit Union Act, 12 
U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).

Q.2. Recently there have been several proposals to consider for 
financial services conglomerates. One approach would be to move 
away from functional regulation to some type of single 
consolidated regulator like the Financial Services Authority 
model. Another approach is to follow the Group of 30 Report 
which attempts to modernize functional regulation and limit 
activities to address gaps and weaknesses. An in-between 
approach would be to move to an objectives-based regulation 
system suggested in the Treasury Blueprint. What are some of 
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the pluses and minuses of these three approaches?

A.2. The Treasury Blueprint for a Modernized Financial 
Regulatory Structure, presented in March 2008, suggests an 
objectives-based approach to address market failures. NASCUS 
opposes this approach because it does not recognize the 
supervisory, enforcement and rule-making authority of the 
states. The suggested prudential financial regulator usurps the 
role of the National Credit Union Administration (NCUA) and it 
eliminates the National Credit Union Share Insurance Fund 
(NCUSIF), a fund that federally insured credit unions 
recapitalized in 1985 by depositing one percent of their shares 
into the Share Insurance Fund.
    The Blueprint would eliminate the credit union dual 
chartering system, a system that is based on the important 
foundation of competition and choice between state and federal 
charters.
    Disruption of the current dual chartering structure would 
have various negative impacts. It would diminish state and 
federal regulator cooperation, tip the balance of power between 
states and the federal government and minimize the economic 
benefit and enhanced consumer protections available to states 
through state-chartered institutions. State legislators and 
regulators would no longer determine what is appropriate for a 
state-chartered institution.

Q.3. If there are institutions that are too big to fail, how do 
we identify that? How do we define the circumstance where a 
single company is so systemically significant to the rest of 
our financial circumstances and our economy that we must not 
allow it to fail?

A.3. While relatively few credit unions fall into the category 
of ``too big to fail,'' with the exception of perhaps some of 
the larger corporate credit unions, I believe as a general rule 
that if an institution is ``too big to fail,'' then perhaps it 
is also too large to exist. Perhaps the answer is to 
functionally separate and decouple the risk areas of a ``too 
big to fail'' organization so that a component area can have 
the market discipline of potential failure, without impairing 
the entire organization. Financial institutions backed by 
federal deposit insurance need to have increased expectations 
of risk control and risk management.
    Clearly it is important to take steps to reduce systemic 
risk and lessen the impact of ``too big to fail.'' Many of the 
credit unions that I supervise in Georgia would argue that the 
result of having these large institutions with systemic risk is 
that when problems arise, they get passed on to smaller credit 
unions through increased deposit insurance assessments.

Q.4. We need to have a better idea of what this notion of too 
big to fail is--what it means in different aspects of our 
industry and what our proper response to it should be. How 
should the federal government approach large, multinational, 
and systemically significant companies?

A.4. See response to previous question above.

Q.5. What does ``fail'' mean? In the context of AIG, we are 
talking about whether we should have allowed an orderly Chapter 
11 bankruptcy proceeding to proceed. Is that failure?

A.5. While AIG does not directly relate to the state-chartered 
credit unions supervised by NASCUS state regulators, my general 
view as a financial services regulator is that institutions 
which become insolvent should face market based solutions; 
either bankruptcy or some type of corporate reorganization. 
Seeking government based solutions under these circumstances 
encourages excessive risk taking and creates moral hazard.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
                      FROM GEORGE REYNOLDS

Q.1. Two approaches to systemic risk seem to be identified: (1) 
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to 
fail'' or ``too systemically important to fail'' or (2) impose 
an additional regulator and additional rules and market 
discipline on institutions that are considered systemically 
important.
    Which approach do you endorse? If you support approach one 
how you would limit institution size and how would you identify 
new areas creating systemic importance?
    If you support approach two how would you identify 
systemically important institutions and what new regulations 
and market discipline would you recommend?

A.1. NASCUS \1\ believes that systemic risk can be mitigated 
through state and federal regulator cooperation. Regardless of 
which approach is selected to mitigate systemic risk, it 
presents all regulators with challenges, even those without 
direct jurisdiction over the entity representing the risk. By 
drawing on the expertise of many regulatory agencies, state and 
federal regulators could improve their ability to detect and 
address situations before they achieve critical mass.
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     \1\ NASCUS is the professional association of state credit union 
regulatory agencies that charter, examine and supervise the nation's 
3,100 state-chartered credit unions. The NASCUS mission is to enhance 
state credit union supervision and advocate for a safe and sound credit 
union system.
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    State regulators play an important role mitigating systemic 
risk in the state credit union system. It is imperative that 
any regulatory structure preserve state regulators role in 
overseeing and writing regulations for state credit unions. In 
addition, it is critical that state regulators and National 
Credit Union Administration (NCUA) have parity and comparable 
systemic risk authority with the Federal Deposit Insurance 
Corporation (FDIC).
    Systemic risk mitigation should recognize and utilize both 
state and federal credit union regulators and draw on their 
combined regulatory expertise. NASCUS would be concerned about 
a systemic risk regulation that introduces a new layer of 
regulation for credit unions or proposes to consolidate 
regulators and state and federal credit union charters.

Q.2. Please identify all regulatory or legal barriers to the 
comprehensive sharing of information among regulators including 
insurance regulators, banking regulators, and investment 
banking regulators. Please share the steps that you are taking 
to improve the flow of communication among regulators within 
the current legislative environment.

A.2. NASCUS does not believe that any regulatory or legal 
barriers to the comprehensive sharing of information between 
state and federal credit union regulators are insurmountable. 
Cooperation exists between state and federal credit union 
regulators and they regularly exchange information about the 
credit unions they supervise; it is a cooperative relationship. 
The Federal Credit Union Act (FCUA) provides that 
``examinations conducted by State regulatory agencies shall be 
utilized by the [NCUA] Board for such purposes to the maximum 
extent feasible.'' \2\ Further, Congress has recognized and 
affirmed the distinct roles played by state and federal 
regulatory agencies in the FCUA by providing a system of 
consultation and cooperation between state and federal 
regulators. \3\ It is important that all statutes and 
regulations written in the future include provisions that 
require consultation and cooperation between state and federal 
credit union regulators to prevent barriers that could impede 
comprehensive information sharing.
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     \2\ 12 U.S. Code 1781(b)(1).
     \3\ The Consultation and Cooperation With State Credit Union 
Supervisors provision contained in The Federal Credit Union Act, 12 
U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).
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    There are processes established for comprehensive 
information sharing. Two examples come to mind: State 
regulators signed both a memorandum of understanding with the 
Financial Crimes Enforcement Network and a Document of 
Cooperation with the NCUA to facilitate the critical 
information sharing necessary for regulatory compliance.
    The memorandum of understanding sets forth procedures for 
the exchange of information between the Financial Crimes 
Enforcement Network (FinCEN), a bureau within the U.S. 
Department of the Treasury and state financial regulatory 
agencies. Information exchange is intended to assist FinCEN in 
fulfilling its role as administrator of the Bank Secrecy Act 
and it assists state agencies in fulfilling their role as the 
financial institution supervisor. It fulfills the collective 
goal of the parties to enhance communication and coordination 
that help financial institutions identify and deter terrorist 
activities.
    The Document of Cooperation is the formal agreement between 
NASCUS, on behalf of state regulatory agencies and the NCUA, 
the federal credit union regulator and administrator of the 
National Share Insurance Fund. The purpose of the document is 
to show the alliance between state and federal regulators to 
work with the common goal of providing solid credit union 
examination and supervision.
    Both of these documents illustrate the respect and mutual 
cooperation that exists between state and federal credit union 
regulators.
