[Senate Hearing 111-141]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 111-141
 
   LESSONS LEARNED IN RISK MANAGEMENT OVERSIGHT AT FEDERAL FINANCIAL 
                               REGULATORS 

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

                                HEARING

                               before the

                 SUBCOMMITTE ON SECURITIES, INSURANCE, 
                             AND INVESTMENT

                                 OF THE

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

 DISCUSSING THE ROLE OF FEDERAL FINANCIAL REGULATORS IN THE FINANCIAL 
CRISIS IN THE UNITED STATES AND REFORMING REGULATION TO ENSURE A STRONG 
                            FINANCIAL SYSTEM

                               __________

                             MARCH 18, 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 and Counsel

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                   JACK REED, Rhode Island, Chairman

                 JIM BUNNING, Kentucky, Ranking Member

TIM JOHNSON, South Dakota
CHARLES E. SCHUMER, New York         MEL MARTINEZ, Florida
EVAN BAYH, Indiana                   ROBERT F. BENNETT, Utah
ROBERT MENENDEZ, New Jersey          MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii              DAVID VITTER, Louisiana
SHERROD BROWN, Ohio                  MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             BOB CORKER, Tennessee
MICHAEL F. BENNET, Colorado
CHRISTOPHER J. DODD, Connecticut

                     Didem Nisanci,  Staff Director

              William Henderson, Republican Staff Director

                         Rob Lee, GAO Detailee

                      Randy Fasnacht, GAO Detailee

                                  (ii)


















                            C O N T E N T S

                              ----------                              

                       WEDNESDAY, MARCH 18, 2009

                                                                   Page

Opening statement of Senator Reed................................     1
Opening statements, comments, or prepared statements of:
    Senator Bunning..............................................     3

                               WITNESSES

Orice M. Williams, Director, Financial Markets and Community 
  Investment, Government Accountability Office...................     4
    Prepared statement...........................................    30
Roger T. Cole, Director, Division of Banking Supervision and 
  Regulation, Board of Governors of the Federal Reserve System...     6
    Prepared statement...........................................    63
    Response to written questions of Senator Vitter..............    94
Timothy W. Long, Senior Deputy Comptroller, Bank Supervision 
  Policy and Chief National Bank Examiner, Office of the 
  Comptroller of the Currency....................................     8
    Prepared statement...........................................    70
    Response to written questions of Senator Vitter..............    98
Scott M. Polakoff, Acting Director, Office of Thrift Supervision.     9
    Prepared statement...........................................    79
    Response to written questions of Senator Vitter..............   101
Erik Sirri, Director, Division of Trading and Markets, Securities 
  and Exchange Commission........................................    11
    Prepared statement...........................................    87
    Response to written questions of Senator Vitter..............   175

                                 (iii)


   LESSONS LEARNED IN RISK MANAGEMENT OVERSIGHT AT FEDERAL FINANCIAL
                               REGULATORS

                              ----------                              


                       WEDNESDAY, MARCH 18, 2009

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 3:34 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Jack Reed (Chairman of the 
Subcommittee) presiding.

             OPENING STATEMENT OF SENATOR JACK REED

    Senator Reed. Let me call the hearing to order. Let me 
first apologize for the extra delay. We were engaged in voting, 
and these things take longer than we usually expect, but thank 
you very much.
    I want to thank you all for joining us here today. This 
financial crisis has demonstrated that, contrary to the 
presumption of many, financial institutions were unprepared and 
in many cases incapable of adequately assessing the risks that 
they were bearing on their books. The governance structures, 
the firm managers, and sophisticated models all failed to 
capture the magnitude of the risks that were building. Now the 
mistakes and poor risk management by these financial 
institutions and their regulators have become the taxpayers' 
problems, with the effects spiraling through the broader global 
economy.
    The trillions of dollars in losses stand as witness to the 
many failures of risk management at these firms. Blame must 
primarily be placed at the feet of these financial institutions 
which gambled and then cashed in on exorbitant transaction fees 
for creating exotic new financial products.
    The guiding presumption of many, including former Federal 
Reserve Chairman Alan Greenspan, was that self-interest would 
keep these firms from engaging in overly risky behavior; and if 
that was not sufficient, then surely market discipline would 
rein in excesses. But, in reality, both proved inadequate to 
constrain excessive risk taking. The drive for short-term 
profits led to irrational behavior that affected many, not just 
a few firms.
    When self-interest and market discipline break down, we 
hope that the safety net of regulators will guide us out of the 
storm. However, if the people engaging in these complex 
transactions did not understand the risk, the regulators, it 
appears, based upon the report we have been given today, might 
have known even less. The capacity to conduct oversight of the 
risk management function at these firms was in many cases 
lacking.
    During the good times, when all the excesses were building 
up, the regulators did not press hard enough. Yet it is during 
these times that it is most important, as excesses encourage a 
sense of fearlessness about risk taking, that the regulators 
act promptly to constrain the exuberance.
    Perhaps more fundamentally, the regulators should be asking 
hard questions. When new financial products are drawing in 
unprecedented profits, they should be asking pointed questions 
about the cash-flows and how the products work, including how 
they perform in good times and bad. Reverse engineering these 
products is critical if regulators are to understand how they 
operate and know their embedded risk.
    Regulators also need a firm-view on risk. As we heard in 
testimony last week concerning AIG, the firm stopped offering 
credit default swaps on CDOs and mortgage-backed securities in 
one area of the firm, at the same time it started risky 
securities lending in another area of the firm.
    Another bank claimed it was never involved in subprime 
lending, yet it was buying mortgage lenders engaged in the 
practice and securitizing such products.
    Last June, I called a similar hearing to discuss risk 
management and its implications for systemic risk. 
Unfortunately, further variances in risk management have taken 
place since that time.
    The purpose of this hearing is to bring to light the 
specific problems and to find a positive way forward. This 
hearing is particularly important given the need for swift and 
yet deliberate regulatory reform.
    GAO at my request, after last June's risk management 
hearing, undertook a study of the risk management function of 
those regulators responsible for large financial institutions. 
GAO reviewed a sample of large, complex financial institutions 
to determine what the regulators knew, when they knew it, and 
what changes were requested as a result of the regulatory 
examinations and inquiries. While GAO will be sharing this in 
testimony, I wanted to highlight a few findings that I found 
particularly troubling.
    Regulators found problems as early as 2005, 4 years ago, 
with the risk management systems at large, complex financial 
institutions, but often were not aggressive in insisting on 
changes at firms until market events made the problem self-
evident.
    A Federal Reserve review conducted in 2006 concludes that 
no large, complex financial institutions they reviewed had 
sufficient enterprise-wide stress tests to determine what 
economic or other scenarios might render the entire company 
insolvent. Moreover, many large, complex financial institutions 
could not sufficiently measure or manage all of their risk at a 
consolidated level; rather, they focused on risk within various 
subsidiaries without looking at the health of the entire 
holding company. Even knowing this, regulators did not 
significantly change their ratings of such firms until the 
crisis emerged.
    Because of the sensitive nature of the information, I would 
ask that my colleagues avoid asking about any currently ongoing 
financial institution by name. Instead, I think the focus here 
is on the performance of the regulator and also in general the 
performance of these regulated entities.
    The GAO's review comes at an important time in our history. 
It is the kind of deep analysis that should guide us forward as 
we take up questions on regulatory reform that will serve as 
the foundation for financial oversight as we go forward. In 
short, major regulatory reform is coming. I hope that we can 
learn from what has transpired, move forward with a stronger 
safety net, and build a strong financial system.
    At this time, I would like to recognize the Ranking Member, 
Senator Bunning. Senator.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Chairman Reed. This is my first 
hearing working with you on this Subcommittee. I am glad to be 
here, and I look forward to working with you for years to come.
    I think what we are going to hear today from our witnesses 
is that failures in risk management that contributed to our 
current economic crisis were not just the result of problems 
with our laws or poor decisions by firms. No, there was also a 
failure by regulators to recognize the dangers and, even worse, 
a lack of will to do something about the problems that they did 
find.
    Mr. Chairman, I find that deeply troubling. I also find the 
example of the 2006 Federal Reserve study mentioned in the 
report to be extremely troubling. The Fed found that none of 
the institutions it looked at had stress tests that covered the 
entire company and none of the tests to see what would make 
them insolvent. That is bad and shows the irresponsibility of 
the firms. But as far as I can tell, the Fed also did little or 
nothing about it. That is worse and should throw cold water on 
the idea of some that the Fed should be the new risk regulator.
    I find the admission by some regulators to GAO that they 
did not understand the real risk or the importance of 
contributing factors to be refreshing, but still very 
troubling. Those admissions should raise questions about 
whether we can ever create a risk regulator that will 
understand and act to stop systemwide risk. In a system of 
``too big too fail'' when market discipline has been removed by 
bailouts, we have to rely on regulators to make sure firms do 
not get into trouble.
    But if our regulators are unable to find problems and 
unwilling to do something about them, we are in real trouble, 
and maybe we need to reconsider the whole concept of relying on 
regulators to be the last line of defense against all problems.
    Why should we think a few changes in the law will magically 
make them more effective the next time around? We can try to 
fix problems with our current system, but we cannot legislate 
will or competency. Instead, we need to build a system where 
everyone is accountable and has incentives to perform due 
diligence, a sort of check-and-balance, so if any one party 
does not do so, it will not lead to an overall failure.
    The system also needs to be robust enough to handle the 
failure of individual firms, and we should assume that firms 
will fail, because they do. To handle that, we need to improve 
the authority of regulators to take control of and shut down 
failing firms through some type of orderly bankruptcy. We also 
need to hold directors and executives accountable. If everyone 
knows they will face the consequences of their actions, they 
will be more careful in the future. I think that will go a long 
way in the future to creating a stable financial system than 
rearranging the furniture downtown at various regulators.
    Again, thank you, Mr. Chairman. I am looking forward to 
hearing from the witnesses.
    Senator Reed. Thank you, Senator Bunning. I, too, look 
forward not only to hearing from the witnesses, but working 
with you on this Subcommittee. Thank you very much.
    Let me introduce our panel. Ms. Orice Williams is the 
Director of the Financial Markets and Community Investment 
group at the Government Accountability Office.
    Mr. Roger Cole is Director of the Division of Banking 
Supervision and Regulation, Federal Reserve Board.
    Mr. Timothy Long is the Senior Deputy Comptroller, Bank 
Supervision Policy and Chief National Bank Examiner for the 
Office of the Comptroller of the Currency.
    Mr. Scott Polakoff is the Acting Director of the Office of 
Thrift Supervision.
    And Dr. Erik Sirri is the Director, Division of Trading and 
Markets, U.S. Securities and Exchange Commission.
    All of your testimony will be made part of the record. You 
may summarize if you wish. In fact, that is encouraged. And I 
understand both Ms. Williams and Mr. Polakoff have had a long 
day of testimony, so thank you particularly for waiting and 
being with us today.
    Ms. Williams, would you please begin?

STATEMENT OF ORICE M. WILLIAMS, DIRECTOR, FINANCIAL MARKETS AND 
     COMMUNITY INVESTMENT, GOVERNMENT ACCOUNTABILITY OFFICE

    Ms. Williams. Mr. Chairman and Ranking Member Bunning, I am 
pleased to be here today to discuss lessons learned from risk 
management oversight at large, complex institutions. At your 
request, we initiated work in December to review the risk 
management oversight of large institutions by the banking and 
securities regulators, namely, the Federal Reserve, the Office 
of the Comptroller of the Currency, the Office of Thrift 
Supervision, the Securities and Exchange Commission, and FINRA.
    Our objectives were to: one, identify how regulators 
oversee risk management at large institutions; two, identify 
the extent to which regulators identified shortcomings in risk 
management at selected institutions prior to the financial 
crisis; and, three, how some aspects of the regulatory system 
may have contributed to or hindered their oversight.
    However, I need to note that Section 714 of the Federal 
Banking Agency Audit Act generally prohibits GAO from 
disclosing nonpublic information about an open bank. Therefore, 
I will not disclose the banking institutions included in our 
sample or provide detailed information obtained from the 
examinations or interviews with examination staff.
    First, we found the regulators generally maintained 
continuous contact with large complex institutions using a 
risk-based examination approach that aims to identify areas of 
risk and assess these institutions' risk management systems. 
But the approaches of the banking and securities regulators 
varies somewhat.
    Likewise, the regulators generally use a combination of 
tools and activities to assess the quality of risk management. 
For example, bank examiners review the activities, products, 
and services that an institution engaged in to identify risk 
and then, through continuous monitoring and targeted 
examinations, assess how the institution manages those risks. 
When regulators identify weaknesses in risk management at an 
institution, they have a number of formal and/or informal 
supervisory tools they can use for enforcement and to effect 
change.
    For the examinations we reviewed, we found that regulators 
had identified numerous weaknesses in institutions' risk 
management systems prior to the beginning of the financial 
crisis. However, regulators did not effectively address the 
weaknesses or in some cases fully understand their magnitude 
until the institutions were stressed. In hindsight, the 
regulators told us that they had not fully appreciated the 
risks to the institutions or the implications of the identified 
weaknesses for the stability of the overall financial system.
    We also found that some aspects of the regulatory system 
may have hindered regulators' oversight of risk management. For 
example, no regulator systematically and effectively looks 
across all large, complex institutions to identify factors that 
could have a destabilizing effect on the overall financial 
system.
    In closing, I will share a few observations.
    First, while an institution's risk managers directors, and 
auditors, all have key roles to play in effective corporate 
governance, regulators, as outside assessors of the overall 
adequacy of the system of risk management, also have an 
important role in assessing risk management. Yet the current 
financial crisis has revealed that many institutions had not 
adequately identified, measured, and managed all core 
components of sound risk management. We also found that for the 
limited number of large, complex institutions we reviewed, the 
regulators failed to identify the magnitude of these 
weaknesses, and that when weaknesses were identified, they 
generally did not take forceful action to prompt these 
institutions to address them.
    Second, while our recent work is based on a limited number 
of institutions, these examples highlight the significant 
challenges regulators face in assessing risk management systems 
at large, complex institutions. While the painful lessons 
learned during the current crisis bolster market discipline and 
regulatory authority in the short term, effective regulation 
requires that regulators critically assess their regulatory 
approaches, especially during good times, to ensure that they 
are aware of potential regulatory blind spots. This means 
constantly re-evaluating regulatory and supervisory approaches 
and understanding inherent biases in regulatory assumptions.
    While we commend recent supervisory efforts to respond to 
the current crisis, the new guidance we have seen tends to 
focus on issues specific to this crisis rather than on broader 
lessons learned about the need for more forward-looking 
assessments and on the reasons that regulation failed.
    Finally, the current institution-centric approach has 
resulted in regulators all too often focusing on the risks of 
individual institutions and regulators looking at how 
institutions are managing individual risks, while missing the 
implications of the collective strategy which is premised on 
the institution having little liquidity risk and adequate 
capital. Whether the failures of some institutions ultimately 
come about because of a failure to manage a particular risk, 
such as liquidity or credit risk, these institutions often lack 
some of the basic components of good risk management, for 
example, having boards of directors and senior managers set the 
tone for proper risk management across the enterprise.
    Mr. Chairman, Ranking Member, this concludes my oral 
statement, and I would be happy to answer any questions at the 
appropriate time.
    Senator Reed. Thank you, Ms. Williams.
    Mr. Cole, please. Is your microphone on, Mr. Cole?
    Senator Bunning. Would you put your microphone up to your 
mouth a little closer?
    Senator Reed. Thank you.

   STATEMENT OF ROGER T. COLE, DIRECTOR, DIVISION OF BANKING 
 SUPERVISION AND REGULATION, BOARD OF GOVERNORS OF THE FEDERAL 
                         RESERVE SYSTEM

    Mr. Cole. Chairman Reed, Ranking Member Bunning, it is my 
pleasure today to discuss the state of risk management in the 
banking industry and the steps taken by supervisors to address 
risk management shortcomings.
    The Federal Reserve continues to take vigorous and 
concerted steps to correct the risk management weaknesses at 
banking organizations revealed by the current financial crisis. 
In addition, we are taking actions internally to improve 
supervisory practices addressing issues identified by our own 
internal review.
    The U.S. financial system is experiencing unprecedented 
disruptions that have emerged with unusual speed. Financial 
institutions have been adversely affected by the financial 
crisis itself, as well as by the ensuing economic downturn.
    In the period leading up to the crisis, the Federal Reserve 
and other U.S. banking supervisors took several important steps 
to improve the safety and soundness of banking organizations 
and the resilience of the financial system, such as improving 
banks' business continuity plans and the compliance with the 
Bank Secrecy Act and anti-money-laundering requirements after 
the September 11 terrorist attacks.
    In addition, the Federal Reserve, working with the other 
U.S. banking agencies, issued several pieces of supervisory 
guidance before the onset of the crisis such as for 
nontraditional mortgages, commercial real estate, and subprime 
lending, and this was to highlight the emerging risks and point 
bankers to prudential risk management practices they should 
follow.
    We are continuing and expanding the supervisory actions 
mentioned by Vice Chairman Kohn last June before this 
Subcommittee to improve risk management at banking 
organizations. While additional work is necessary, supervised 
institutions are making progress. Where we do not see 
sufficient progress, we demand corrective action from senior 
management and boards of directors.
    Bankers are being required to look not just at risks from 
the past, but also to have a good understanding of their risks 
going forward. For instance, we are monitoring the major firms' 
liquidity positions on a daily basis, discussing key market 
developments with senior management and requiring strong 
contingency funding plans. We are conducting similar activities 
for capital planning and capital adequacy, requiring banking 
organizations to maintain strong capital buffers over 
regulatory minimums.
    Supervised institutions are being required to improve their 
risk identification practices. Counterparty credit risk is also 
receiving considerable focus. In all of our areas of review, we 
are requiring banks to consider the impact of prolonged, 
stressful environments.
    The Federal Reserve continues to play a leading role in the 
work of the Senior Supervisors Group whose report on risk 
management practices at major U.S. and international firms has 
provided a tool for benchmarking current progress. Importantly, 
our evaluation of banks' progress in this regard is being 
incorporated into the supervisory exam process going forward to 
make sure that they are complying and are making the 
improvements we are expecting.
    In addition to the steps taken to improve banks' practices, 
we are taking concrete steps to enhance our own supervisory 
practices. The current crisis has helped us recognize areas in 
which we can improve. Vice Chairman Kohn is leading a 
systematic internal process to identify lessons learned and 
develop recommendations. As you know, we are also meeting with 
Members of Congress and other Government bodies, including the 
Government Accountability Office, to consult on lessons learned 
and to hear additional suggestions for improving supervisory 
practices.
    We have already augmented our internal process to 
disseminate information to examination staff about emerging 
risks within the industry. Additionally, with the recent 
Federal Reserve issuance of supervisory guidance on 
consolidated supervision, we are not only enhancing the 
examination of large, complex firms with multiple legal 
entities, but also improving our understanding of markets and 
counterparties, contributing to our broader financial stability 
efforts.
    Looking forward, we see opportunity to improve our 
communication of supervisory expectations to firms we regulate 
to ensure those expectations are understood and heeded. We 
realize now more than ever that when times are good and when 
bankers are particularly confident, we must have even firmer 
resolve to hold firms accountable for prudent risk management 
practices.
    Finally, despite our good relationship with fellow U.S. 
regulators, there are gaps and operational challenges in the 
regulation and supervision of the overall U.S. financial system 
that should be addressed in an effective manner.
    I would like to thank you and the Subcommittee for holding 
this second hearing on risk management, a crucially important 
issue in understanding the failures that have contributed to 
the current crisis. Our actions with the support of Congress 
will help strengthen institutions' risk management practices 
and the supervisory and regulatory process itself--which 
should, in turn, greatly strengthen the banking system and the 
broader economy as we recover from the current difficulties.
    I look forward to answering your questions.
    Senator Reed. Mr. Long.

 STATEMENT OF TIMOTHY W. LONG, SENIOR DEPUTY COMPTROLLER, BANK 
SUPERVISION POLICY AND CHIEF NATIONAL BANK EXAMINER, OFFICE OF 
                THE COMPTROLLER OF THE CURRENCY

    Mr. Long. Chairman Reed, Ranking Member Bunning, my name is 
Tim Long. I am the Senior Deputy Comptroller for Bank 
Supervision Policy at the OCC. I appreciate this opportunity to 
discuss the OCC's views on risk management and the role it 
plays in banks we supervise, the weaknesses and gaps that we 
have identified in risk management practices and the steps we 
are taking to address those issues, and how we supervise risk 
management at the largest national banks.
    Recent events have revealed a number of weaknesses in 
banks' risk management processes that we in the industry must 
address, and we are taking steps to ensure this happens. More 
importantly, these events have reinforced that even the best 
policy manuals and risk models are not a substitute for a 
strong corporate governance and risk management culture, a tone 
and approach to business that must be set at the top of the 
organization and instilled throughout the company.
    While risk management practices are legitimately the focus 
of much current attention, risk management is hardest when 
times are good and problems are scarce. It is in those times 
when bank management and supervisors have the difficult job of 
determining when accumulating risks are getting too high and 
that the foot needs to come off the accelerator. These are 
never popular calls to make, but in retrospect, we and bankers 
erred in not being more aggressive in addressing our concerns.
    However, we must also not lose sight that banks are in the 
business of managing financial risks. Banks must be allowed to 
compete and innovate, and this may at times result in a bank 
incurring losses. The job of risk management is not to 
eliminate risk, but to ensure that those risks are identified 
and understood so that bank management can make informed 
choices.
    Among the lessons we have learned are: Underwriting 
standards matter, regardless of whether the loans are held or 
sold. Risk concentrations can excessively accumulate across 
products and business lines. Asset-based liquidity is critical. 
Back-room operations and strong infrastructure matters. And 
robust capital and capital planning are essential.
    As described in my written testimony, we are taking steps 
to address all of these issues. Because the current problems 
are global in nature, we are working closely with my colleagues 
here and internationally. Critical areas of focus are on 
improved liquidity risk management, stronger enterprise-wide 
risk management, including rigorous stress testing, and further 
strengthening the Basel II capital framework.
    Risk management is a key focus of our large bank 
supervision program. Our program is organized with a national 
perspective. It is centralized and headquartered in Washington 
and structured to promote consistent and uniform supervision 
across the banking organizations. We establish core strategic 
objectives annually based on emerging risks. These objectives 
are incorporated into the supervisory strategies for each bank 
and carried out by our resident onsite staff with assistance 
from specialists in our Policy and Economics Unit.
    Examination activities within a bank are often supplemented 
with horizontal reviews across a set of banks. This allows us 
to look at trends not only within but across the industry.
    Throughout our resident staff, we maintain an ongoing 
program of risk assessment and communication with bank 
management and the board of directors. Where we find 
weaknesses, we direct management to take corrective action. For 
example, we have directed banks to make changes in personnel 
and organizational structures to ensure that risk managers have 
sufficient stature and ability to constrain business activities 
when warranted.
    Through our examinations and reviews, we have directed 
banks to be more realistic about recognizing credit risks, to 
improve their valuation techniques for certain complex 
transactions, to aggressively build loan loss reserves, to 
correct various risk management weaknesses, and to raise 
capital as market opportunities permit.
    Finally, the Subcommittee requested the OCC's views on the 
findings that Ms. Williams from the GAO will be discussing with 
you today. Because we only recently received the GAO's summary 
statement of findings, we have not had an opportunity to review 
and assess their full report. We take the findings from GAO 
very seriously, and we would be happy to provide the 
Subcommittee with a written response to this report once we 
receive it.
    My preliminary assessment based on the summary we were 
provided is that the GAO raised a number of legitimate issues, 
some of which I believe we are already addressing; and others, 
as they pertain to the OCC, may require further action on our 
part.
    Thank you, and I will be happy to answer questions you may 
have.
    Senator Reed. Thank you.
    Mr. Polakoff, please.

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

    Mr. Polakoff. Good afternoon, Chairman Reed, Ranking Member 
Bunning. Thank you for inviting me to testify on behalf of OTS 
on the lessons the current economic crisis has taught us about 
risk management.
    The topic is timely and important because, as you know, the 
heart of bank supervision is in monitoring for risks, to help 
prevent them from endangering the health of regulated financial 
institutions. Some of the risks I will discuss today not only 
endangered institutions during this crisis, but played major 
roles in some failures.
    The financial crisis has had serious consequences for our 
economy and for public confidence in the safety of their bank 
accounts and investments. This confidence and the trust it 
engenders are necessary for both the smooth operation of our 
financial system and the larger economy. Restoring confidence 
is essential to achieving full economic recovery.
    In my comments today, I will focus on three risks that I 
think are most significant: concentration risk, liquidity risk, 
and the risk to the financial system from unevenly regulated 
companies, individuals, and products. Shortcomings in 
responding to each of these risks have significant 
consequences.
    Let me start with concentration risk, which is basically 
the risk of a financial institution having too many of its eggs 
in one basket. If something bad happens to that basket, the 
institution is in trouble. Although concentration risk is one 
of the main risks that our examiners traditionally watch 
closely, the current crisis exposed a new twist to 
concentration risk, and the OTS has acted to address that risk.
    The new twist was the risk of a business model heavily 
reliant on originating mortgage loans for sale into the private 
label secondary market. The freeze-up in this market for 
private label mortgage-backed securities in the fall of 2007 
exposed this risk for institutions with an originate-to-sell 
business model. Their warehouse and pipeline loans could no 
longer be sold and had to be kept on their books, causing 
severe strain.
    To prevent this problem in the future, the OTS reviewed all 
of its institutions for exposure to this risk, updated its 
examination handbook in September 2008, and distributed a 
letter to the chief executive officers of OTS-regulated thrifts 
on best practices for monitoring and managing this type of 
risk.
    The financial crisis also taught us lessons about liquidity 
risk when some of our institutions experienced old-fashioned 
runs on the bank by panicked customers. In some cases, the size 
and speed of the deposit withdrawals were staggering. The event 
showed that the prompt corrective action tool created to 
prevent a gradual erosion of capital during the financial 
crisis of the late 1980s and early 1990s is inadequate to 
address a rapidly accelerating liquidity crisis. Rather than 
seeking a new type of prompt corrective action for liquidity, 
Federal banking regulators plan to issue guidance to examiners 
and financial institutions to incorporate lessons learned on 
managing liquidity risk.
    Finally, I would like to discuss the risk to the financial 
system and the larger economy by companies, individuals, and 
products that are not regulated at the Federal level or, in 
some cases, at any level. These gaps in regulation are, in my 
mind, the root cause of the crisis. If you could distill the 
cause to a single sentence, I think it would be this: Too much 
money was loaned to too many people who could not afford to pay 
it back.
    The simple lesson is that all financial products and 
services should be regulated in the same manner, whether they 
are offered by a mortgage broker, a State-licensed mortgage 
company, or a federally regulated depository institution. To 
protect American consumers and safeguard our economy, 
consistent regulation across the financial services landscape 
is essential.
    Thank you again, Mr. Chairman, for having us here today. I 
look forward to answering your questions.
    Senator Reed. Thank you, Mr. Polakoff.
    Dr. Sirri?

  STATEMENT OF ERIK SIRRI, DIRECTOR, DIVISION OF TRADING AND 
          MARKETS, SECURITIES AND EXCHANGE COMMISSION

    Mr. Sirri. Chairman Reed, Ranking Member Bunning, and 
members of the Subcommittee, I am pleased to have the 
opportunity today to testify concerning insights gained from 
the SEC's administration of the Consolidated Supervised 
Entities, or CSE, program, as well as the SEC's long history of 
regulating the financial operation of broker-dealers and 
protecting customer funds and securities.
    The turmoil in the global financial system is unprecedented 
and has tested the resiliency of financial institutions and the 
assumptions underpinning many financial regulatory programs. I 
believe that hearings such as this, where supervisors reflect 
on and share their experiences from this past year, will 
enhance our collective efforts to improve risk management 
oversight of complex financial institutions.
    A registered broker-dealer entity within the CSE group was 
supervised by an extensive staff of folks at the SEC and at 
FINRA, the broker SRO. All U.S. broker-dealers are subject to 
the SEC's rigorous financial responsibility rules, including 
the net capital rules, the customer protection rules, and other 
rules designed to ensure that firms operate in a manner that 
permit them to meet all obligations to customers, 
counterparties, and market participants.
    The CSE program was designed to be broadly consistent with 
the Federal Reserve oversight of bank holding companies. 
Broker-dealers have to maintain the minimum of $5 billion of 
tentative net capital to qualify for the program and no firm 
fell below this requirement.
    The CSE regime was also tailored to reflect two fundamental 
differences between investment bank and commercial bank holding 
companies. First, the CSE regime reflected the resilience of 
securities firms on mark-to-market--the reliance of securities 
firms on mark-to-market accounting as a critical risk and 
governance control.
    Second, the CSE firms were required to engage in liquidity 
stress testing and hold substantial liquidity pools at the 
holding company.
    We also required firm-wide stress testing as a prerequisite 
to being allowed to enter the program, a requirement that was 
put in place well before the crisis started. For most firms, 
the stress testing comprised a series of historical or 
hypothetical scenarios that were applied across all positions, 
not just across one product or business line. While the set of 
scenarios did not cover every plausible scenario, they included 
major financial shocks or stresses to the market, such as the 
fall 1988 failure of long-term capital in the Russian default 
as well as the 1987 stock market crash. The CSE firms later 
expanded these scenarios or created others to stress their 
hedge fund counterparty credit risk exposures.
    I, too, appreciate the work that GAO did to review the 
supervision of financial institutions' risk management programs 
across the various regulators and find their observations on 
these programs very helpful. We are reviewing the 
recommendations and findings and we look forward to working 
with GAO as we fully consider their report.
    The SEC's supervision of investment banks has always 
recognized that capital is not synonymous with liquidity and 
the ability of a securities firm to withstand stress events 
depends on having sufficient liquid assets, cash and high-
quality instruments, such as U.S. Treasuries, that can be used 
as collateral to meet their financial obligations as they 
arise. For this reason, the CSE program required stress testing 
of liquidity and substantial liquidity pools at the holding 
company to allow firms to continue to operate normally in 
stressed market environments. But what the CSE regulatory 
approach did not anticipate was the possibility that secured 
funding, even that funding backed by high-quality collateral, 
such as U.S. Treasury and agency securities, would become 
unavailable.
    Thus, one lesson of the SEC's oversight of CSEs, Bear 
Stearns in particular, is that no parent company liquidity pool 
can withstand a run on the bank. Such a liquidity pool would 
not suffice in an extended financial crisis of the magnitude we 
are now experiencing. In addition, these liquidity constraints 
are exacerbated when clearing agencies' sizable amounts of 
capital for clearing deposits to protect themselves against 
intraday exposures to the firm.
    Another lesson relates to the need for supervisory focus on 
the concentration of illiquid assets held by financial firms, 
particularly in entities other than a U.S.-registered broker-
dealer. Such monitoring is relatively straightforward with 
larger U.S. broker-dealers, which must disclose illiquid assets 
on a monthly basis in financial reports that are filed with 
their regulators. For the consolidated entities, supervisors 
must be well acquainted with the quality of assets on a group-
wide basis and monitor the amount of illiquid assets and drill 
down on their relative quality.
    Leverage tests are not accurate measures of financial 
strength for investment banks, in particular due to their 
sizable matchbook or derivatives business. Leverage tests do 
not account for the quality or liquidity of assets. Rather, 
they rely on overly simplistic measures of risk, such as 
leverage ratios. Regulators of financial firms have gone to a 
great deal of effort to develop and continue to refine capital 
rules that are risk sensitive and act as limiters on the amount 
of risk that can be taken by a firm.
    Finally, any regulator must have the ability to get 
information about the holding company and other affiliates, 
particularly about issues and transactions that impact capital 
and liquidity. As we have witnessed with Lehman Brothers, the 
bankruptcy filing of a material affiliate had a cascading 
effect that can bring down the other entities in the group.
    For these reasons and to protect the broker and its 
customer assets, the SEC would want not only to be consulted 
before any such liquidity drain occurs at the parent, but to 
have a say, likely in coordination with other interested 
regulators, in the risk, capital, and liquidity standards that 
the holding company must maintain. Our experience last year 
with the failure of Lehman's U.K. broker and the fact that the 
U.S.-registered broker-dealers were well capitalized and liquid 
throughout the turmoil has redoubled our belief that we must 
rely on and protect going forward the soundness and the 
regulatory regime of the principal subsidiaries.
    Thank you for this opportunity to discuss these important 
issues and I am happy to take your questions.
    Senator Reed. Thank you very much.
    Senator Bunning had to step out. He will rejoin us for his 
questioning, but let me begin.
    I want to address a question to all the regulators. first, 
let me say that I thought the GAO did a very responsible and 
thorough examination. Thank you and your colleagues Ms. 
Williams. But the basic questions are, and I will begin with 
Mr. Cole, just as you happen to be sitting next to Ms. 
Williams, but when did you first institutionally become aware 
of the significance of the risk difficulties in your supervised 
entities, and how did you communicate these concerns both to 
your supervisors, to your fellow regulators, and to a broader 
audience, and when did that communication become public? Mr. 
Cole?
    Mr. Cole. Well, I really need to go back somewhat in time 
in answering that, but in 1995, we issued a supervisory letter 
to our examiners directing them in terms of taking a systematic 
approach to assessing the risk management, including the major 
risk categories of credit risk, market risk, operational risk, 
liquidity, reputational, and legal risk, and then that became 
part of the formal exam process and rating process.
    Kind of fast forwarding to the 9/11-type situation, as I 
mentioned in my testimony, we focused on some significant risk 
issues there that we thought needed to be addressed, and some 
of them tended to focus on, say, operational risks, such as 
payments and settlements, others on contingency planning, 
locating backup facilities at appropriate different distances, 
and then very importantly on BSA/AML, Bank Secrecy/Anti-Money 
Laundering. In that regard, with regard to one of the 
institutions in question, we took very strong action to require 
a significant change in their business risk management and that 
was accomplished with a very forceful hand in terms of 
requiring them to make those changes. So I think that is a good 
example of where, when we see a significant problem, we do act.
    Senator Reed. Let me be more specific. The issue, I think, 
that the GAO has revealed is a lack of the capacity of large 
complex financial institutions, which all of you regulate, to 
assess adequately all of the risks they face, not so much a 
particular risk----
    Mr. Cole. OK.
    Senator Reed.----but the fact that they did not have 
systems in place to adequately assess the risk, which I think 
is a fair conclusion of the report of the GAO. At what point 
did this fact or this observation become resonant with the Fed 
and how was it communicated to the banking community, to the 
regulating community, and on to the broader audience, the 
Congress, for one?
    Mr. Cole. We have been engaged consistently, I think, 
since--just going back, say, to the 1995 letter, in terms of 
working with institutions to enhance the risk management 
process. Now, in terms of moving right to the current 
situation, this stress testing example is a good example 
because we believe going into that stress test that there was a 
significant opportunity to put pressure on the big firms to 
improve their ability to pull positions together on a firm-wide 
basis and develop a really robust stress test.
    The horizontal review that we did provided very significant 
information for us on a peer basis that they were not able to 
do that, that the stress that they typically came up with was 
one quarter's worth of earnings, and that was based on a fairly 
flawed system of not being able to comprehensively pull the 
positions together on an integrated firm-wide basis.
    Senator Reed. That was----
    Mr. Cole. We used that as a major tool in terms of pushing 
on those firms. It was feedback from that exercise and saying, 
look, you need to do more here, and that is one of the main 
tools that we have, is that type of horizontal review. So that 
occurred, say, in June 2007, that kind of feedback with the 
firms on the findings from that stress testing.
    Then I would move just a little bit further----
    Senator Reed. Can I just clarify? Is it June 2007 or 2006?
    Mr. Cole. The actual exercise was in 2006. We did the 
report in 2007 and then the feedback to the firms, I think was 
in June of 2007.
    Senator Reed. It raises an issue, which is that in 2006, 
you had at least had serious concerns because of the stress 
testing that these firms could not handle or have systems in 
place to deal with the risk The whole point, I think, of the 
report of the GAO is that having that knowledge of those 
suspicions, it didn't seem to produce a timely, rapid 
response----
    Mr. Cole. Well, Senator, I think that at the same time that 
we were doing the stress testing, we were also reviewing and 
having very significant interactions with these firms in terms 
of various aspects of their risk process----
    Senator Reed. Let me just ask. Did you communicate in 2006 
with other supervisors, OTS, Comptroller, SEC, your concerns 
that some of the institutions that you were the overall 
supervisor had these deficiencies in risk assessment?
    Mr. Cole. Well, we have very frequent conversations with--
--
    Senator Reed. Would you say fairly that you communicated 
these concerns to the other regulators, or you heard similar 
concerns from them?
    Mr. Cole. I would say fairly that, as we are working on, 
for example, infrastructure requirements for the use of models 
and so on, we have had consistent communications with the other 
regulators that there are significant deficiencies in risk 
management.
    Senator Reed. And let me just ask a final question, because 
I do want your colleagues to respond, too. What broader 
audience did you communicate these concerns about the lack of 
adequate systems in place?
    Mr. Cole. We have throughout the development, for example, 
of qualifying criteria for the use of Basel II and the so-
called Pillar 2 criteria indicated the need for improvement to 
the firms we have been working with.
    Senator Reed. Mr. Long, similar questions. When did you, 
not personally, but the organization, become aware, if you did, 
of failings in the management of risk by entities you 
supervised? Did you communicate them to your fellow 
supervisors? Did they communicate with you, and then what 
broader audience?
    Mr. Long. Yes, I do think we began to communicate pretty 
well in the 2006 range, as my colleague says, but let me back 
up to answer you. I want to make sure I answer your question.
    As I stated in my written testimony--it is difficult at 
times to strike that balance of letting a bank keep competitive 
and innovative at the same time and order a bank to constrain a 
certain business activity because we believe they are taking on 
too much risk. It is always a delicate balance and it is 
something we work hard to do.
    But I think we did, going back to 2004. I know at the OCC 
and amongst other regulators, we did begin to see this buildup 
of risk and this buildup of excessive aggregation of risk. We 
issued guidance going back to 2004. We had the interagency 
credit card guidance. We issued guidance on home equity 
lending, on non-traditional mortgage products, on commercial 
real estate lending, and then most recently some interagency 
guidance on complex structured products. As we issued guidance 
to the industry, our examiners were in the banks and they were 
examining for this. We frequently cited matters requiring 
attention and began taking actions, various types of actions, 
surrounding these guidance.
    So from 2004 up to 2007, I think we all saw the 
accumulation of risk. At the OCC, we looked vertically very 
well into those companies. If there were lessons learned by us, 
it was probably in two things. Number one, we underestimated 
the magnitude of the effects of the global shut-down beginning 
in August of 2007, and we did not rein in the excesses driven 
by the market.
    So a real lesson learned, and I think you have heard it in 
some of the statements and in the GAO report, the ability to 
look vertically into these companies is good. The ability to 
look across the companies in terms of the firms we supervise, 
we need to get better at that, and looking horizontally across 
the system is something I think we all need to do.
    A good example of that is in the firms that we supervise, 
we underestimated the amount of subprime exposure they had. We 
basically kicked the subprime lenders out of the national 
banking system. Our banks were underwriting very little of the 
subprime loans. What we didn't realize is that affiliates and 
subsidiaries of the banks that we supervised were turning 
around, buying those loans, structuring them, and bringing that 
risk back in in another division in the bank, and that is a 
good example of being able to look horizontally across a 
company and see that coming.
    Senator Reed. What inhibited you from looking across these 
other subsidiaries?
    Mr. Long. Well, Senator, there are two things. You know, 
internally, from the OCC's standpoint, we need to get better at 
doing more horizontal work, and I think we have. I think we 
started doing that probably a year and a half ago, where we 
have networking groups. We do more horizontal-type exams to 
where REICs can share information amongst themselves.
    Where we are continuing to work with our other colleagues 
with the other agencies is making sure that we try to gather 
the risk in the entire system. But obviously all of us are 
constrained somewhat by GLBA.
    Senator Reed. Let me, Mr. Polakoff can I finish this line 
of questioning and then I will recognize you, Jim.
    Senator Bunning. I will stay as long as you want.
    Senator Reed. Thank you.
    Mr. Polakoff. Senator, thank you. I don't want to embellish 
on what my colleagues have said. It is a consistent message.
    I would say a trip-wire date for us was June of 2007 when 
the liquidity market shut down. What it proved to us and 
probably all of us at this table is we did not stress test 
models sufficiently for that kind of catastrophic event. So 
risk management turned upside down at that point in time. When 
any of these models predicted a stress scenario, and even a 
more stress scenario, none of us, none of the entities still 
predicted or had a model that stressed a scenario for what 
ultimately we saw starting in June of 2007 forward. That is a 
critical lesson learned for all of us.
    Senator Reed. Dr. Sirri?
    Mr. Sirri. The one thing I would point out that is slightly 
different with the CSEs that reentered this business in a 
different manner, the firms that we regulated under the CSE 
program came to us because of the European Union Financial 
Conglomerates Directive for that purpose. They needed a 
consolidated holding company supervisor and they didn't have 
one for that purpose.
    So we came at this from rule, not by statute. We crafted 
the regime where in exchange for certain capital treatment we 
would be given a limited amount of access to the holding 
company. What we focused on and what that access related to 
were financial and operational risk controls, and in that 
sense, I think that was very helpful, informed broker-dealer 
oversight issues as well as certain issues of the holding 
company.
    But, for example, as my colleagues have pointed out, Gramm-
Leach-Bliley limits the way we touch upon other regulated 
entities. We defer to the functional regulator in that sense. 
And so our knowledge there was more limited.
    So I think what you are really asking is a point which was 
made in the GAO report which says, if an enterprise, if a 
modern firm manages risk at an enterprise level, how can you as 
a regulator that is in many ways functionally based replicate 
that in your own regulatory program, and I acknowledge that is 
a challenge.
    Senator Reed. Let me follow up with a very quick question 
because I want to recognize Senator Bunning. Given the fact 
that you had to rely upon other regulatory agencies, what was 
the level of communication? If, in fact, by 2004 or 2005 the 
OCC was aware of buildup of risk, at 2006 the Federal Reserve 
was aware of risk, I would presume that in that same--so did 
anyone sort of, in a systematic way, say, you know, you should 
be aware that we are concerned about risk assessment, about the 
ability to manage this enterprise risk? Did that ever become 
part of the discussion?
    Mr. Sirri. I think we all--I won't speak for others. I 
think we understood, and my impression was all of these 
regulators understood, that we were limited in part. We had 
dialog amongst ourselves. Staff on the ground talked to staff 
from other regulators. In addition, the firm--it is not like 
the firms drew up walls and said, we won't give you information 
on that bank, or we won't give you information on that thrift. 
They would provide such information. But in the sense of 
integrated enterprise risk management, I think it was not what 
it could be.
    Senator Reed. Senator Bunning, and take as much time as you 
want.
    Senator Bunning. Thank you, Mr. Chairman.
    Welcome back from your vacations that you have been on for 
the last 5 years, and I say that not kiddingly. I say that as 
meaningful as I can, because if we would have had good 
regulators, we wouldn't be in the crisis we are in right now.
    Ms. Williams, at the bottom of page 24, you said the Fed 
did not identify many of the issues that led to the failure of 
some large institutions. Can you tell us what some of these 
issues that they are, what they missed?
    Ms. Williams. Absolutely. I would direct your attention to 
a couple of pages later, on page 26. We note that the Fed began 
to issue risk committee reports, and in February of 2007 they 
issued perspectives on risk, and we list a number of issues 
that we pulled from that report. For example--the report stated 
that there were no substantial issues of supervisory concern 
for large financial institutions; that asset quality across the 
systemically important institutions remains strong; in spite of 
predictions of a market crash, the housing market correction 
has been relatively mild and while price appreciation and home 
sales have slowed, inventories remain high and most analysts 
expect the housing boom to bottom out in mid-2007.
    Overall, the impact on a national level will likely be 
moderate. However, in certain areas, housing prices have 
dropped significantly. They also noted that the volume of 
mortgages being held by institutions or warehouse pipelines had 
grown rapidly to support collateralized mortgage-backed 
securities and CDOs and noted that the surging investor demand 
for high-yield bonds and leveraged loans, largely through 
structured products such as CDOs, was providing a continuing 
strong liquidity that resulted in continued access to funding 
for lower-rated firms at relatively modest borrowing costs. So 
those are some of the----
    Senator Bunning. Would you like to comment on counterparty 
exposures, particularly to hedge funds?
    Ms. Williams. This was another area that was identified. 
The regulators had focused on counterparty exposures, 
particularly to hedge funds.
    Senator Bunning. Mr. Cole, would you like to respond?
    Mr. Cole. I would indeed, and thank you for the 
opportunity, Senator. First of all, I would say that my 
understanding is that the report that the GAO has done is 
really based on review of one institution.
    Senator Bunning. That is incorrect, but that is fine.
    Mr. Cole. OK, and that we received this report with 
reference to perspectives on risk just in the last couple days. 
So we would like an opportunity to go over these findings with 
the GAO, as we typically do in GAO reviews. We have not had 
that opportunity.
    But I will say this, that I think that what Ms. Williams 
quoted from is in the report, but unfortunately, there are 
other parts that were not quoted, and one in particular is, 
quote:

        The effects of a long period of easy liquidity and benign 
        credit conditions have continued to weaken underwriting 
        standards across all major credit portfolios. Finally, we note 
        that investor demands appear to be encouraging large financial 
        institutions to originate more assets and even greater volumes 
        of low-quality assets, and in order to distribute them through 
        the capital markets.

In response to that, we took very firm actions, and that----
    Senator Bunning. When?
    Mr. Cole. That included----
    Senator Bunning. When? When did you take firm actions?
    Mr. Cole. Let me see. A perspectives of risk report was 
issued in February 2007----
    Senator Bunning. Two-thousand-and-seven?
    Mr. Cole. And we initiated major analysis of subprime 
mortgage markets in March and published an interim report in 
June of that year.
    Senator Bunning. Two-thousand-and-seven?
    Mr. Cole. That is correct.
    Senator Bunning. OK. That is about 5 years after the----
    Mr. Cole. Well, that is----
    Senator Bunning. That is about 5 years after the subprime 
and the mortgage mess hit the fan. Two-thousand-and-two and 
2003 is when it hit.
    Mr. Cole. Yes.
    Senator Bunning. OK.
    Mr. Cole. But could I also----
    Senator Bunning. No, you can't.
    Mr. Cole. OK.
    Senator Bunning. What did the Fed do about the 2006 review 
that showed institutions did not have overall stress testing 
for their own enterprise? Did you require your regulated firms 
to fix those problems?
    Mr. Cole. Yes. I actually touched upon that in a prior 
response, that we did follow up with the institutions, that a 
very critical part of this type of horizontal peer review is 
going back to the institutions, which we did in June of 2007. 
The report was actually issued in February of 2007 and had 
communications with those firms indicating that there was 
significant need for improvement.
    We also, I am told, communicated to the primary regulator--
--
    Senator Bunning. You were told or you know?
    Mr. Cole. No, I know. I was informed in the interim of my 
last question that the primary regulators of these institutions 
were informed of the deficiencies we observed, as well as the 
President's Working Group. So it was----
    Senator Bunning. Well, that is all well and good if you 
followed up and made sure that they weren't going to repeat the 
same mistakes in the immediate future and subject the country 
to the recession that we are now in.
    Mr. Cole. Right, and----
    Senator Bunning. If you sat on your hands, which the Fed 
did in overseeing mortgages and mortgage lenders and banks that 
were under your jurisdiction, then I think that the Fed is a 
failure in doing what they are supposed to do.
    For anyone, did the board of directors understand the risk 
their firms were taking?
    Mr. Polakoff. Senator, I would say they understood the risk 
for the period of time that they were operating in, but failed 
to----
    Senator Bunning. In other words, what I am trying to get 
at, there is a reasonable rate of return on equity that 
everybody expected at a given point in time. Somehow, that got 
out of kilter, and instead of being happy with a 7 or 8 percent 
return on equity, people were leveraging from--and I don't 
blame anybody, but regulators ought to be looking at the rate 
of return on equity and not giving permission for these firms 
to get into mischief, and that is what happened. That is why we 
are here today asking you these questions. The regulators 
should have stopped the risk takers taking undue risk with 
taxpayers' money or with equity that has been invested. Now the 
taxpayers are paying the price.
    So go ahead, finish your answer.
    Mr. Polakoff. I agree with what you said, Senator.
    Senator Bunning. And how do we improve senior management 
and boards' understanding of an accountability for risk? How do 
we get that regulated?
    Mr. Polakoff. Well, across the spectrum, all of the boards, 
I believe, are held accountable for the risk and----
    Senator Bunning. Is that right? Is that why we are paying 
bonuses to each and every one at AIG for--they were the board, 
they were the people that were supposed to regulate AIG. So we 
are paying them bonuses for taking $160 billion in taxpayers' 
money. Are you kidding me? Explain that to the American people.
    Mr. Polakoff. AIG right now is not a regulated company. I--
--
    Senator Bunning. It is. It is owned by the Federal 
Government, so the Federal Government is the regulator. It is 
owned by the Federal Government. The contracts that have been 
paid out were OKed by the Federal Government. So it is 
regulated.
    Mr. Polakoff. Yes, sir. I was speaking only from an OTS 
perspective.
    Senator Bunning. OK. It is not yours. It is ours.
    How did you miss the risk and possibility of liquidity 
drying up? How did you miss it?
    Mr. Sirri. I can speak for the firms that we regulate. For 
a trading firm, for a securities firm, they do not take 
deposits as a commercial bank or a thrift does. Their primary 
means of funding is through the capital markets, especially 
through a market known as the repurchase market.
    Senator Bunning. I am familiar.
    Mr. Sirri. What a firm does is it takes the security it 
has, it gives it someone who lends it out----
    Senator Bunning. I am familiar.
    Mr. Sirri.----it comes back. Because that is a secured 
lending market, the lenders were thought to be not sensitive to 
the health of the firm, but sensitive to the quality of the 
collateral they got. So our thought was always that if you as a 
firm gave someone a Treasury bill or gave them an agency 
security, they would take that and fund you, even if you as a 
firm were in trouble. That was an assumption we made, and that 
is, I think, many in the financial community made. And we were 
wrong.
    When firms got in trouble, other funding counterparties--
money market funds, people with cash to lend--would not take 
Treasury's to fund, and that was something we had never seen 
before.
    Senator Bunning. Mr. Long, what changes in law do you 
suggest to protect against future failures like we are in right 
now?
    Mr. Long. Senator, I do not know if I can think of a change 
in law that we need. We need to continue to have rigorous 
supervision around these companies. As I said in my written 
statement, you need a strong corporate culture, and it needs to 
start at the top of the organization, and it needs to be led by 
the Chairman and put down into the company. It is a simple----
    Senator Bunning. That, unfortunately, is not an answer.
    Ms. Williams, do you have any changes in law that we can 
get a hold of as we are looking for as Members of Congress to 
prevent any more of the debacle that is going on right now?
    Ms. Williams. I would just touch on a couple of issues. In 
January, GAO issued a framework for reforming the current 
financial regulatory system, and we point out a couple of 
issues. One would be clearly articulated goals; that is, 
Congress needs to be very clear about the goals that they 
expect regulators to achieve. There also needs to be a 
systemwide focus in the structure. And----
    Senator Bunning. In other words, A watching B and B 
watching C?
    Ms. Williams. Not necessarily, but systemwide from the 
perspective of not focusing on particular institutions and 
getting caught up in the institution or type of product; but 
having a regulator that can focus attention on anything that 
poses a risk to the overall system.
    Senator Bunning. Then we would need one for about 25 major 
market banks, money market banks in New York City, one 
regulator each for each one, because those are the ones that 
are too big to fail. That is what we have been told by our 
Chairman of the Fed, in fact. And we have also been told that 
by the Secretary of the Treasury. So if that is the case, we 
need an awful lot of regulators.
    Scott, do you have some suggestions?
    Mr. Polakoff. Senator, I would offer that we need to ensure 
that there is a level playing field. We have had some 
products--80 percent of subprime loans were underwritten by 
mortgage brokers. There is no Federal oversight for that.
    Senator Bunning. Well, I am sorry, but the Federal Reserve 
got that job in 1994. That was their job. I mean, we wrote a 
law that gave them that job. Whether they did it or not is 
another question, but we handed that over to the Fed.
    SEC?
    Mr. Sirri. Our charge is the broker-dealer, primarily, and 
so I am going to translate your question as: What do you need 
to make sure that we keep safe the customer's----
    Senator Bunning. No. What would give the SEC the ability to 
discover this situation that we are in now before or as it is 
happening and do something about it?
    Mr. Sirri. Drexel, Lehman Brothers taught us the same 
lesson. The lesson is that the health of a broker-dealer could 
be affected by entities outside the broker-dealer--commercial 
banks, thrifts, unregulated affiliates that deal in 
derivatives. We need to touch on those entities. We need to 
have a say-so on risk.
    Senator Bunning. In other words, we should take all manners 
of dealing with a broker-dealer, whether it be securities, 
whether it be bonds. You mentioned some other things that they 
are dealing with now. But we should have someone watching the 
store for all entities.
    Mr. Sirri. I think, again, I was focusing on the broker-
dealer, but I know that our charge is affected by risks that 
are taken outside the broker-dealer. You do not hold 
derivatives in a broker-dealer, because we haircut the 
capital--we haircut you, we charge you capital. So firms 
respond by moving the risk outside the broker-dealer, by moving 
illiquid instruments outside the broker-dealer. That still 
imperils the broker-dealer. We need to touch on those. We 
need----
    Senator Bunning. Well, then you need regulations over those 
people that are dealing in the entities.
    Mr. Sirri. For preserving the broker-dealer, that would be 
very helpful.
    Senator Bunning. Thank you very much, Mr. Chairman.
    Senator Reed. Thank you, Senator Bunning.
    Let me raise a few questions. You mentioned, Dr. Sirri, 
that really what happened, in your view, was a run on the bank. 
And I think that begs the question: What caused the run on the 
bank? There are some people that suggest the huge amount of 
leverage which the market became aware of just undercut any 
sort of willingness to accept even Treasury securities. And 
that leverage ratio was something that was approved by the 
SEC--at least not effectively disapproved--and I think you had 
the authority to do that. Can you comment on that?
    Mr. Sirri. Sure. The question of a ``run on the bank,'' 
which is the term I used, is always a difficult one because it 
implicitly depends on confidence in the institution. Of course, 
we did not have a bank, and the run was different. It was not 
deposits. But, nonetheless, it was funding with certain kinds 
of securities through the repo market.
    You know, it is hard to know why something like that 
starts. The instruments became the instruments in these firms, 
in some of the firms that are no longer with us. Lehman 
Brothers, for instance, suffered a lot of uncertainty about 
valuation, so you have a financial firm, they are typically 
opaque. You do not know exactly what is going on with them. 
That is the nature of a financial firm. Valuations become 
questions because you are holding, for example, commercial 
whole loans in the case of Lehman, where people doubted 
valuations.
    In a situation like that, people will be wary about funding 
because even if you can potentially get your money back, you 
are not in the business of getting tied up in an uncertainty. 
And that causes a situation that can cause a run.
    Senator Reed. Thank you very much.
    Let me ask a general question, which I do not think 
requires a specific answer unless you--my assumption is that 
the umbrella regulator--and each one of these large 
institutions had an umbrella regulator--had the responsibility 
for the risk assessment throughout the organization, that it 
was not a case where the overall enterprise risk assessment or 
enterprise activities were not at all under the authority of a 
regulator. Is that your understanding, Dr. Sirri, in terms of 
the law?
    Mr. Sirri. Well, I think the authority stems from different 
places. Again, we had no statutory authority.
    Senator Reed. Right, right.
    Mr. Sirri. We crafted rules. I think in other places it is 
statutory. And, again, our ability--our question of where we 
would look was governed by a certain set of precepts and risks. 
Our concern was always the broker-dealer. Risks that pertained 
to things other than the broker-dealer that might imperil other 
entities were not our charge, and our program was not crafted 
to cover those.
    Senator Reed. Mr. Polakoff, your responsibility derived 
from statute. Did you feel at OTS that those entities you were 
the umbrella supervisor, that you had responsibility for 
enterprise risk analysis, assessment by the enterprise?
    Mr. Polakoff. Yes, sir. The only thing I would offer is per 
Gramm-Leach-Bliley we did rely to a great extent on functional 
regulators within the system. But as the holding company 
regulator for our institutions, absolutely we had the overall 
umbrella responsibility.
    Senator Reed. Mr. Long, is that your understanding? I know 
OCC is--do you have an umbrella responsibility? Let me ask the 
basic----
    Mr. Long. We are the primary regulator for the bank, 
absolutely. Our authority and how we conduct our risk 
assessments I think works very well, and we feel like we have 
the proper authority.
    Senator Reed. So you understand that you have to 
collaborate with others, but that ultimately there is one 
Federal regulator under the statute--Mr. Sirri has an 
exception--that had responsibility to look across the 
organization for risk assessment, risk evaluation, and risk 
compliance?
    Mr. Long. Well, I am sorry. Maybe I did not understand your 
question. The way it works now is it is dependent on how well 
we communicate with each other and--if that is what you are 
asking, Senator. I want to make sure I am answering your 
question right. Is there a systemic umbrella regulator right 
now that----
    Senator Reed. I am not talking systemic. I am talking about 
you have a large, integrated financial organization that is 
regulated under statute. There is one regulator who is 
responsible for the overall operation, and let me ask the 
question. Is there one regulator responsible for the overall 
operation of the entire enterprise?
    Mr. Long. Well, the OCC is responsible for the bank, and 
the Fed is responsible for the holding company.
    Senator Reed. Let me talk to Mr. Cole. As the umbrella 
regulator of several large financial institutions, do you feel 
that you are responsible, the Federal Reserve is responsible 
for the overall capacity of that institution as an enterprise 
to evaluate risk?
    Mr. Cole. Yes, sir, we do, and we have gone, I think, an 
extra mile to make sure that that is very clear with the firms 
and our examiners by rolling out a Consolidated Supervision 
Program in October of last year and communicating that very 
clearly with the other agencies.
    Senator Reed. Let me go back to the point that was raised 
between Ms. Williams and Senator Bunning about the large 
financial institutions' perspective on risk, the 2005 reports, 
the 2006, 2007 reports. These were internal documents, Ms. 
Williams, of the Fed? These were not released to the public?
    Ms. Williams. Yes, these were internal.
    Senator Reed. And then there was an interruption in the 
reports, but then in April of 2007, there was a report, 
``Perspective of Risk.'' Was that an internal document, too?
    Ms. Williams. Yes, all of them were internal.
    Senator Reed. And it raises the question with respect to 
the Federal Reserve that if these documents are solely within 
the purview of the Federal Reserve, how is the broader 
financial community and the broader community and how is 
Congress to inform itself of critical issues that you feel 
could have profound consequences, which have profound 
consequences?
    Mr. Cole. One issue is just getting our own shop in order 
in terms of pulling all the information that is available to 
gather and creating a perspective on risk from a financial 
stability point of view. There is that process. We do have that 
process. We have a formal umbrella group that is in charge of 
making periodic reports to the board on information that is 
drawn from research and from our shop and other payments areas 
and so on. So we are very focused in terms of creating a 
holistic picture of what is happening in the financial system 
now. That is very important.
    Now, you know, the question in terms of how do we go kind 
of the step of somehow making that public, and it could well 
be--you know, it obviously would be worthwhile in some form to 
be public. I cannot answer that at this point.
    Senator Reed. Well, you know, I guess one presumption would 
be to have this information. I understand there is proprietary 
information that you have, and also there is a concern about 
causing market movements based not upon, you know, financial 
information but other information. But I think if such 
information was in the public domain in some capacity in 2005 
and 2006 and 2007, it was available to Congress, and there was 
no opportunity for testimony to communicate that, that there 
might have been earlier prompter and more effective action to 
deal with some of these issues which are bedeviling us at the 
moment.
    In that regard, too, I know, because we have had the chance 
to meet, that the Federal Reserve and all those agencies are 
taking a serious look backwards. You know, you have described 
some of your conclusions. Ms. Williams and her colleagues have 
provided some perspective. But these reports--I will use the 
term I learned as a youth. These After Action Reports have to 
become public, particularly in the context of organizing a 
systemic regulator. Because if we are unaware, if you remain, 
you know, opaque, it is hard for us, I think, to make a 
reasoned judgment about who should have responsibilities, what 
could be the lines of communications.
    I know Governor Kohn and his colleagues are working on this 
report.
    Mr. Cole. Yes.
    Senator Reed. I would hope it would be public.
    Let me ask another question, and it comes from the GAO 
report, which is the comment and the conclusion that in many 
respects you are captives of the information of the 
organization you are regulating, that you have to rely to a 
certain degree on their models, their information. And in some 
cases, I think talking with respect to counterparty risk, there 
are intuitions about the creditworthiness of counterparties. Is 
that a fair summary of your conclusions, Ms. Williams?
    Ms. Williams. Basically.
    Senator Reed. Let me begin with Dr. Sirri and work the 
other way, which is, you know, being a captive to information 
to systems to model sometimes does not give you the leverage 
you need to take action. Is that, one, accurate? And, two, how 
do you change that?
    Mr. Sirri. I think there is an element of accuracy to that, 
but I think there are tools available to us as regulators. Let 
me give you a specific instance.
    You are right, a particular complex financial firm will 
develop a model for risk, but they will have a process around 
that model for risk. And we care about the processes and the 
robustness of the processes and controls. So, for example, a 
model for risk is developed. Who validates it? Who verifies it? 
Who runs that model?
    If they report to the trading desk whose assets they are 
pricing, that is not helpful and that is problematic.
    If they report to an independent third-party that perhaps 
reports directly to the CFO or a risk officer, much stronger 
structure, gives you some comfort.
    Again, let me take a second one, a price verification 
group. You may have a firm that trades assets, but they have 
problems valuing assets, as you do when liquidity dries up. 
When valuations are struck, how are those valuations struck? 
There may be a model. Who validates the model? And how do you 
resolve disputes? If the trader says it is worth more than the 
risk person says it is worth, how do you resolve that? Is there 
a process where it could go up to the audit committee? And if 
it goes to the audit committee, does the After Action Report--
the phrase you used--for that instance, does that go to the 
board of directors? Such processes, if they are in place, tell 
you that that firm is taking their job seriously.
    Senator Reed. I would presume, and correct me, that those 
procedures, those appropriate procedures you described, were 
not being deployed very successfully at Bear Stearns or Lehman 
Brothers. Were you aware of kind of those deficiencies 
contemporaneously with their----
    Mr. Sirri. I do not want to comment on any one firm, but 
what I will say is that there was considerable variation across 
the firms, especially with--let us take that same point, 
pricing. And one thing we saw--and this is mentioned--issues 
like this are dealt with in the Senior Supervisors report that 
the New York Fed led. The stronger your governance, the 
stronger your controls, it turns out the better you probably 
weathered the storm. The best-run firms had good processes, and 
some of the firms that got into the most trouble had distinct 
weaknesses. It varied from firm to firm.
    Senator Reed. Just to follow up, the firms that you saw, 
and some of which have failed, did you note those weaknesses? 
Did you communicate those weaknesses to the board? It goes to 
the essence of many of the questions we have raised. You know, 
making the diagnosis that you are ill and then not treating the 
patient is, you know, malpractice. What do you think?
    Mr. Sirri. We had escalation procedures, and we used them. 
I do not want to come here and tell you that every time we did 
it perfectly. But I personally met with audit committee members 
when I felt that there was an issue that was not being resolved 
properly. But I do not want to overstate and say in each way we 
escalated as far as we should have looking back. We probably 
should have done more at times.
    Senator Reed. Mr. Polakoff, same general line of questions 
about the reliance upon internal models, the data of the 
company, sort of captive of what they are doing versus being--
having the resources to leverage appropriately behavior.
    Mr. Polakoff. Senator, I would say that there is an element 
of truth to that statement in the report, but it probably does 
not capture the entire universe. What we do and we do very well 
is put boots on the ground. We have examiners that go onsite 
from one large institution to another large institution. And 
while there may be a stable--and there is a stable examiner in 
charge, we send specialists from institution to institution, 
which allows a horizontal review, which allows an assessment of 
best practices. So whether it is modeling, whether it is 
pricing, whether it is risk factors, we do not silo the 
examination approach. And that is very helpful in addressing 
these kind of issues. That is number one.
    Number two, we look to the outside parties, so whether it 
is the external auditors, whether it is the external 
accountants, we work with them on models, because they also 
bring a similar expertise of looking horizontally across a 
number of institutions for best practices in a number of areas.
    And then, number three, like Erik said, we look at the 
corporate governance of the institution itself; how is it 
structured, how robust is the risk management committee, how 
robust is the audit committee as part of the board, how are the 
reporting lines handled.
    Each of those three areas, I think, allows us to very 
independently assess and judge whether it is the risk models or 
other factors.
    Senator Reed. Having listened to that, it is, I think, very 
insightful, and it seems to be a great approach. It just does 
not seem to have worked in the case of some of the institutions 
that you regulated. What would you point--that was not the 
approach that was being used in 2004, 2005, and 2006? Or it was 
an approach, but something else undermined it?
    Mr. Polakoff. It was the approach. Senator, the one common 
theme that all of us see is an economic cycle that was 
unprecedented in its deterioration. All of our institutions, 
all of our risk management practices, all of our examination 
approaches work well, but it is difficult to look at all the 
risk models and stress them to unprecedented degrees and then 
require institutions to operate within those stress models.
    You know, in hindsight, we should have predicted a little 
better in 2004 and 2005 what the economy was going to look like 
now, but the economy we are operating in now has an absolute 
direct effect on the performance.
    Senator Reed. Well, let me raise--because this has been 
publicly discussed. I think we actually discussed it last week. 
In 2005, the Financial Products Division of AIG concludes that 
mortgage-backed securities are too risky a bet. At the same 
time, the securities lending operation decides that they want 
to take the cash that they are getting and invest it decisively 
in these types of securities.
    You know, where was the risk assessment at the enterprise, 
as you described it? And where was the OTS to say, wait a 
second, you cannot have two contradictory approaches based 
upon, one, this is the best investment, and, two, this is the 
worst investment?
    Mr. Polakoff. So, Senator, you are right, and you 
identified what is either a hole or an overlap, depending on 
one's view. Those activities, as you remember, were regulated 
by the State insurance commissioners. So under Gramm-Leach-
Bliley, the umbrella regulator typically will defer to the 
functional regulator to assess the risks and then report up to 
the umbrella regulator.
    Senator Reed. But, you know, it goes back to the question I 
raised before, to which I think you affirmatively responded, 
that in terms of overall risk mechanisms or risk compliance, 
that it was clear that the umbrella regulator had that 
responsibility. And here, if you had communicated with the 
supervisor and they had indicated that this was the investment 
pattern of the securities lending--their regulated insurance 
part, it would have seemed to have raised a huge red flag. You 
both cannot be right.
    Mr. Polakoff. Senator, I can assure you that there was 
ample communication between OTS in its umbrella responsibility 
and the functional regulators. But you are identifying an 
absolute inconsistency, which is, Why did we stop one function 
from performing that kind of activity? And why did another 
functional regulator allow its entities to move forward with 
it? There has to be a postmortem on what broke down in that 
process.
    Senator Reed. Yes. Mr. Long, the same sort of set of issues 
about reliance upon information and being a captive of the 
regulated entity.
    Mr. Long. Well, I agree with what Scott said. I am not 
going to repeat it. I think we have ample authority to take 
whatever action we need. I think it is an oversimplification to 
say that this was a modeling problem. If you go back to the 
last time we went through this and you talk to the CEOs that 
went through this back in the late 1980s and early 1990s, they 
are going to tell you there are two things that got them: one 
was the concentrations, and number two, mitigating the policy 
overrides on the underwriting.
    Quite frankly, I think that is really the center of this 
thing. This was not that we missed a bunch of models. Clearly, 
the banks were not modeling in their tail risk that there would 
be a complete shutdown of the liquidity across the system. And 
that was a problem with their models.
    But this goes to basic underwriting, and it goes to basic 
concentration risk. They had too much of a bad deal, and that 
has compounding effects on liquidity, and on capital. And when 
the global liquidity market shut down, they had a real problem.
    So, yes, we look at all of it. We look at corporate 
governance. We look at underwriting. We look at all of the risk 
areas. And, clearly, we look at modeling, too. We have rigorous 
stress testing around those models. And, quite frankly, a lot 
of people missed it--they would stress tail risk in the 
company. They did not stress tail risk across the world.
    Senator Reed. Mr. Cole, briefly, if you could, please. I 
have additional questions.
    Mr. Cole. Indeed, Senator, we clearly, as umbrella 
oversight supervisors, rely significantly on the functional 
regulators. I will say, though, that in terms of really doing 
our job, if we sense that there are deficiencies and need to do 
more than the functional regulator is doing, we do reserve the 
ability, I think--under Gramm-Leach-Bliley, in fact, by 
authority to go in and do more.
    Senator Reed. Ms. Williams, you talked about and we have 
had a discussion about communicating concerns, looking at 
regulatory structures, looking at the governance, et cetera. 
But there is another way sort of to get the message across to 
the marketplace, and that is enforcement action. That is public 
enforcement action that is clear to everyone that there is not 
only a particular situation, but a category of situations that 
regulators are concerned about.
    Did you touch upon that in your report about the--or your 
review about the follow-up enforcement, any follow-up 
enforcement, official enforcement actions, rather than informal 
discussions?
    Ms. Williams. I think we did touch on the process and the 
range of options, and the fact that with the banking 
regulators, in particular, there was a tendency not to pursue 
formal public actions, formal public enforcement actions. It 
has to do with the fact that it does become public and that can 
have an adverse impact on an open bank.
    Senator Reed. Can I--can you cite a situation, Dr. Sirri, 
where the SEC took a formal enforcement action with respect to 
the risk practices of any of the regulated entities?
    Mr. Sirri. I am not sure I can cite a public action, 
something that has happened and been closed.
    I will cite something that is public. I do not know the 
current list, but a number of months ago we stated how many 
cases we had in progress on matters related to subprime 
mortgages. Now subprime mortgages run the gamut, the cases from 
issues about origination through issues related to other things 
within large firms. It would not surprise me, and it may be 
possible, I honestly do not know, that there might be something 
related in there. But I truly do not know. And even if I did, I 
should not comment.
    Senator Reed. Mr. Polakoff?
    Mr. Polakoff. Absolutely, Senator. We took public 
enforcement action against AIG regarding some of its 
inappropriate lending.
    Senator Reed. No, I am talking about the issue of risk 
assessment, risk management, the issues that have been the 
subject of this GAO report?
    Mr. Polakoff. I cannot--I am not sure about all of the 
specifics from the GAO report, but I think Ms. Williams said 
that for some of the larger institutions the regulators were 
shy in pursuing formal enforcement action because it was 
public. And I would like to suggest that that would not be an 
accurate statement, at least from an OTS perspective.
    Senator Reed. And what actions did you take with respect to 
AIG?
    Mr. Polakoff. It was a cease and desist order. We took a 
cease and desist order against a large institution on the West 
Coast for BSA-related problems. And these are all formal and 
public. I do not think any of the banking regulators would shy 
away from taking formal enforcement action because it is 
public. We do not shy away because it is public. We do not shy 
away even when an institution is trying to raise capital. We 
have to do the right thing from an enforcement action 
perspective.
    Senator Reed. Mr. Long, your view?
    Mr. Long. Congressman, we have taken both formal and 
informal enforcement actions, and we use them regularly.
    But let me clarify something because I think it is 
important to this point. Congress specifically gave the banking 
regulators specific authority to either do a series of informal 
actions or a series of formal actions. And you know, in some 
cases, we choose to go informal and we go non-public.
    I want to assure you that that is no less rigorous than 
formal action. I have been in the boardroom for the signings of 
many informal documents throughout my career and recently. And 
I can assure you that the environment in that room in the 
signing of the informal documents can be a career-altering 
experience for the management of that firm.
    The fact that it is informal does not mean that it is not 
serious and not taken seriously.
    Senator Reed. I am not suggesting that these are not 
serious actions and you are not serious about your actions. It 
is just that many times an action which is publicized gets the 
attention of more people than just the people in the boardroom. 
And behaviors change not just within that boardroom of that 
organization but throughout the system.
    Mr. Long. Senator, that is a good point and we look at 
every action that we take and we weigh the pros and cons. We 
feel like we use both effectively. But we do utilize both and 
we do it regularly.
    Senator Reed. Mr. Cole?
    Mr. Cole. Yes, with regard to the BSA situation that I 
mentioned earlier, that was a formal public action. I would 
tend to agree very much with Mr. Long in terms of figuring out 
what the most effective approach is given the management 
situation. And if we can effect change by going directly to the 
management and accomplishing that, that is what we would tend 
to do rather than taking the next step of going to a formal 
action.
    Senator Reed. Well, I do not think there is a--this is so 
specific of a situation that you have to have some deference to 
regulators. But going to the core issue we have had of just the 
perception, I think, that was growing throughout the community 
of regulators that risk systems, risk compliance, attention to 
risk was not being emphasized enough, and then trying to deal 
with it on a case-by-case quietly, did not seem to work. I 
think that might be one of the conclusions we draw. Not to say 
you did not have the authority to do it or your judgment was--
but it just did not seem to work.
    I want to thank you. I want to thank, again, Ms. Williams 
and her colleagues for, I think, a very good report. I want to 
thank you for questions and we will continue to probe all of 
these issues as we go forward.
    Thank you very much. The hearing is adjourned.
    [Whereupon, at 5:09 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
follow:]

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                  PREPARED STATEMENT OF ROGER T. COLE
        Director, Division of Banking Supervision and Regulation
            Board of Governors of the Federal Reserve System
                             March 18, 2009
    Chairman Reed, Ranking Member Bunning and members of the 
Subcommittee, it is my pleasure to appear today to discuss the state of 
risk management in the banking industry and steps taken by Federal 
Reserve supervisors to address risk management shortcomings at banking 
organizations.
    In my testimony, I will describe the vigorous and concerted steps 
the Federal Reserve has taken and is taking to rectify the risk 
management weaknesses revealed by the current financial crisis. I will 
also describe actions we are taking internally to improve supervisory 
practices and apply supervisory lessons learned. This includes a 
process spearheaded by Federal Reserve Vice Chairman Donald Kohn to 
systematically identify key lessons revealed by recent events and to 
implement corresponding recommendations. Because this crisis is 
ongoing, our review is ongoing.
Background
    The Federal Reserve has supervisory and regulatory authority over a 
range of financial institutions and activities. It works with other 
Federal and State supervisory authorities to ensure the safety and 
soundness of the banking industry, foster the stability of the 
financial system, and provide for fair and equitable treatment of 
consumers in their financial transactions. The Federal Reserve is not 
the primary Federal supervisor for the majority of commercial bank 
assets. Rather, it is the consolidated supervisor of bank holding 
companies, including financial holding companies, and conducts 
inspections of all of those institutions. As I describe below, we have 
recently enhanced our supervisory processes on consolidated supervision 
to make them more effective and efficient.
    The primary purpose of inspections is to ensure that the holding 
company and its nonbank subsidiaries do not pose a threat to the 
soundness of the company's depository institutions. In fulfilling this 
role, the Federal Reserve is required to rely to the fullest extent 
possible on information and analysis provided by the appropriate 
supervisory authority of the company's bank, securities, or insurance 
subsidiaries. The Federal Reserve is also the primary Federal 
supervisor of State-member banks, sharing supervisory responsibilities 
with State supervisory agencies. In this role, Federal Reserve 
supervisory staff regularly conduct onsite examinations and offsite 
monitoring to ensure the soundness of supervised State member banks.
    The Federal Reserve is involved in both regulation--establishing 
the rules within which banking organizations must operate--and 
supervision--ensuring that banking organizations abide by those rules 
and remain, overall, in safe and sound condition. A key aspect of the 
supervisory process is evaluating risk management practices, in 
addition to assessing the financial condition of supervised 
institutions. Since rules and regulations in many cases cannot 
reasonably prescribe the exact practices each individual bank should 
use for risk management, supervisors design policies and guidance that 
expand upon requirements set in rules and regulations and establish 
expectations for the range of acceptable practices. Supervisors rely 
extensively on these policies and guidance as they conduct examinations 
and to assign supervisory ratings.
    We are all aware that the U.S. financial system is experiencing 
unprecedented disruptions that have emerged with unusual speed. The 
principal cause of the current financial crisis and economic slowdown 
was the collapse of the global credit boom and the ensuing problems at 
financial institutions, triggered by the end of the housing expansion 
in the United States and other countries. Financial institutions have 
been adversely affected by the financial crisis itself, as well as by 
the ensuing economic downturn.
    In the period leading up to the crisis, the Federal Reserve and 
other U.S. banking supervisors took several important steps to improve 
the safety and soundness of banking organizations and the resilience of 
the financial system. For example, following the September 11, 2001, 
terrorist attacks, we took steps to improve clearing and settlement 
processes, business continuity for critical financial market 
activities, and compliance with Bank Secrecy Act, anti-money 
laundering, and sanctions requirements. Other areas of focus pertained 
to credit card subprime lending, the growth in leveraged lending, 
credit risk management practices for home equity lending, counterparty 
credit risk related to hedge funds, and effective accounting controls 
after the fall of Enron. These are examples in which the Federal 
Reserve took aggressive action with a number of financial institutions, 
demonstrating that effective supervision can bring about material 
improvements in risk management and compliance practices at supervised 
institutions.
    In addition, the Federal Reserve, working with the other U.S. 
banking agencies, issued several pieces of supervisory guidance before 
the onset of the recent crisis--taking action on nontraditional 
mortgages, commercial real estate, home equity lending, complex 
structured financial transactions, and subprime lending--to highlight 
emerging risks and point bankers to prudential risk management 
practices they should follow. Moreover, we identified a number of 
potential issues and concerns and communicated those concerns to the 
industry through the guidance and through our supervisory activities.
Supervisory Actions to Improve Risk Management Practices
    In testimony last June, Vice Chairman Kohn outlined the immediate 
supervisory actions taken by the Federal Reserve to identify risk 
management deficiencies at supervised firms related to the current 
crisis and bring about the necessary corrective steps. We are 
continuing and expanding those actions. While additional work is 
necessary, we are seeing progress at supervised institutions toward 
rectifying issues identified amid the ongoing turmoil in the financial 
markets. We are also devoting considerable effort to requiring bankers 
to look not just at risks from the past but also to have a good 
understanding of their risks going forward.
    The Federal Reserve has been actively engaged in a number of 
efforts to understand and document the risk management lapses and 
shortcomings at major financial institutions revealed during the 
current crisis. In fact, the Federal Reserve Bank of New York organized 
and leads the Senior Supervisors Group (SSG), which published a report 
last March on risk management practices at major international 
firms.\1\ I do not plan to summarize the findings of the SSG report and 
similar public reports, since others from the Federal Reserve have 
already done so.\2\ But I would like to describe some of the next steps 
being taken by the SSG.
---------------------------------------------------------------------------
    \1\ 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. 
    \2\ 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. 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.
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    A key initiative of the Federal Reserve and other supervisors since 
the issuance of the March 2008 SSG report has been to assess the 
response of the industry to the observations and recommendations on the 
need to enhance key risk management practices. The work of the SSG has 
been helpful, both in complementing our evaluation of risk management 
practices at individual firms and in our discussions with bankers and 
their directors. It is also providing perspective on how each 
individual firm's risk management performance compares with that of a 
broad cross-section of global financial services firms.
    The continuation of the SSG process requires key firms to conduct 
self-assessments that are to be shared with the organization's board of 
directors and serve to highlight progress in addressing gaps in risk 
management practices and identify areas where additional efforts are 
still needed. Our supervisory staff is currently in the process of 
reviewing the firms' self assessments, but we note thus far that in 
many areas progress has been made to improve risk management practices. 
We plan to incorporate the results of these reviews into our future 
examination work to validate management assertions.
    The next portion of my remarks describes the supervisory actions we 
have been taking in the areas of liquidity risk management, capital 
planning and capital adequacy, firm-wide risk identification, 
residential lending, counterparty credit risk, and commercial real 
estate. In all of these areas we are moving vigorously to address the 
weaknesses at financial institutions that have been revealed by the 
crisis.
Liquidity risk management
    Since the beginning of the crisis, we have been working diligently 
to bring about needed improvements in institutions' liquidity risk 
management practices. One lesson learned in this crisis is that several 
key sources of liquidity may not be available in a crisis. For example, 
Bear Stearns collapsed in part because it could not obtain liquidity 
even on a basis fully secured by high-quality collateral, such as U.S. 
Government securities. Others have found that back-up lines of credit 
are not made available for use when most needed by the borrower.
    These lessons have heightened our concern about liquidity and 
improved our approach to evaluating liquidity plans of banking 
organizations. Along with our U.S. supervisory colleagues, we are 
monitoring the major firms' liquidity positions on a daily basis, and 
are discussing key market developments and our supervisory views with 
the firms' senior management. We also are conducting additional 
analysis of firms' liquidity positions to examine the impact various 
scenarios may have on their liquidity and funding profiles. We use this 
ongoing analysis along with findings from examinations to ensure that 
liquidity and funding risk management and contingency funding plans are 
sufficiently robust and that the institutions are prepared to address 
various stress scenarios. We are aggressively challenging those 
assumptions in firms' contingency funding plans that may be 
unrealistic.
    Our supervisory efforts require firms to consider the potential 
impact of both disruptions in the overall funding markets and 
idiosyncratic funding difficulties. We are also requiring more rigor in 
the assessment of all expected and unexpected funding uses and needs. 
Firms are also being required to consider the respective risks of 
reliance on wholesale funding and retail funding, as well as the risks 
associated with off-balance sheet contingencies. These efforts include 
steps to require banks to consider the potential impact on liquidity 
that arises from firms' actions to protect their reputation, such as an 
unplanned increase in assets requiring funding that would arise with 
support given to money market funds and other financial vehicles where 
no contractual obligation exists. These efforts also pertain to steps 
banks must take to prepare for situations in which even collateralized 
funding may not be readily available because of market disruptions or 
concern about the health of a borrowing institution. As a result of 
these efforts, supervised institutions have significantly improved 
their liquidity risk management practices, and have taken steps to 
stabilize and improve their funding sources as market conditions 
permit.
    In conducting work on liquidity risk management, we have used 
established supervisory guidance on liquidity risk management as well 
as updated guidelines on liquidity risk management issued by the Basel 
Committee on Banking Supervision last September--a process in which the 
Federal Reserve played a lead role. So that supervisory expectations 
for U.S. depository institutions are aligned with these international 
principles, the U.S. banking agencies plan to update their own 
interagency guidance on liquidity risk management practices in the near 
future. The new guidance will emphasize the need for institutions of 
all sizes to conduct meaningful cash-flow forecasts of their funding 
needs in both normal and stressed conditions and to ensure that they 
have an adequately diversified funding base and a cushion of liquid 
assets to mitigate stressful market conditions. Our supervisory efforts 
at individual institutions and the issuance of new liquidity risk 
management guidance come on top of broader Federal Reserve efforts 
outside of the supervision function to improve liquidity in financial 
markets, such as introduction of the Term Auction Facility and the Term 
Asset-Backed Securities Loan Facility.
Capital planning and capital adequacy
    Our supervisory activities for capital planning and capital 
adequacy are similar to those for liquidity. We have been closely 
monitoring firms' capital levels relative to their risk exposures, in 
conjunction with reviewing projections for earnings and asset quality 
and discussing our evaluations with senior management. We have been 
engaged in our own analysis of loss scenarios to anticipate 
institutions' future capital needs, analysis that includes the 
potential for losses from a range of sources as well as assumption of 
assets currently held off balance sheet. We have been discussing our 
analysis with bankers and requiring their own internal analyses to 
reflect a broad range of scenarios and to capture stress environments 
that could impair solvency. As a result, banking organizations have 
taken a number of steps to strengthen their capital positions, 
including raising substantial amounts of capital from private sources 
in 2007 and 2008.
    We have stepped up our efforts to evaluate firms' capital planning 
and to bring about improvements where they are needed. For instance, we 
recently issued guidance to our examination staff--which was also 
distributed to supervised institutions--on the declaration and payment 
of dividends, capital repurchases, and capital redemptions in the 
context of capital planning processes. We are forcefully requiring 
institutions to retain strong capital buffers-above the levels 
prescribed by minimum regulatory requirements--not only to weather the 
immediate environment but also to remain viable over the medium and 
long term.
    Our efforts related to capital planning and capital adequacy are 
embodied in the interagency supervisory capital assessment process, 
which began in February. We are conducting assessments of selected 
banking institutions' capital adequacy, based on certain macroeconomic 
scenarios. For this assessment, we are carefully evaluating the 
forecasts submitted by each financial institution to ensure they are 
appropriate, consistent with the firm's underlying portfolio 
performance, and reflective of each entity's particular business 
activities and risk profile. The assessment of capital under the two 
macroeconomic scenarios being used in the capital assessment program 
will permit supervisors to ascertain whether institutions' capital 
buffers over the regulatory capital minimum are appropriate under more 
severe but plausible scenarios.
    Federal Reserve supervisors have been engaged over the past few 
years in evaluating firms' internal processes to assess overall capital 
adequacy as set forth in existing Federal Reserve supervisory guidance. 
A portion of that work has focused on how firms use economic capital 
practices to assess overall capital needs. We have communicated our 
findings to firms individually, which included their need to improve 
some key practices, and demanded corrective actions. We also presented 
our overall findings to a broad portion of the financial industry at a 
System-sponsored outreach meeting last fall that served to underscore 
the importance of our message.
Firm-wide risk identification and compliance risk management
    One of the most important aspects of good risk management is risk 
identification. This is a particularly challenging exercise because 
some practices, each of which appears to present low risk on its own, 
may combine to create unexpectedly high risk. For example, in the 
current crisis, practices in mortgage lending--which historically has 
been seen as a very low-risk activity--have become distorted and, 
consequently riskier, as they have been fueled by another activity that 
was designed to reduce risk to lenders--the sale of mortgage assets to 
investors outside the financial industry.
    Since the onset of the crisis, we have been working with supervised 
institutions to improve their risk identification practices where 
needed, such as by helping identify interconnected risks. These 
improvements include a better understanding of risks facing the entire 
organization, such as interdependencies among risks and concentrations 
of exposures. One of the key lessons learned has been the need for 
timely and effective communication about risks, and many of our 
previously mentioned efforts pertaining to capital and liquidity are 
designed to ensure that management and boards of directors understand 
the linkages within the firm and how various events might impact the 
balance sheet and funding of an organization. We have demanded that 
institutions address more serious risk management deficiencies so that 
risk management is appropriately independent, that incentives are 
properly aligned, and that management information systems (MIS) produce 
comprehensive, accurate, and timely information.
    In our 2006 guidance on nontraditional mortgage products, we 
recognized that poor risk management practices related to retail 
products and services could have serious effects on the profitability 
of financial institutions and the economy; in other words, there could 
be a relationship between consumer protection and financial soundness. 
For example, consumer abuses in the subprime mortgage lending market 
were a contributing cause to the current mortgage market problems. 
Here, too, we are requiring improvements. The Federal Reserve issued 
guidance on compliance risk management programs to emphasize the need 
for effective firm-wide compliance risk management and oversight at 
large, complex banking organizations. This guidance is particularly 
applicable to compliance risks, including its application to consumer 
protection, that transcend business lines, legal entities, and 
jurisdictions of operation.
Residential lending
    Financial institutions are still facing significant challenges in 
the residential mortgage market, particularly given the rising level of 
defaults and foreclosures and the lack of liquidity for private label 
mortgage-backed securities. Therefore, we will continue to focus on the 
adequacy of institutions' risk management practices, including their 
underwriting standards, and re-emphasize the importance of a lender's 
assessment of a borrower's ability to repay the loan. Toward that end, 
we are requiring institutions to maintain risk management practices 
that more effectively identify, monitor, and control the risks 
associated with their mortgage lending activity and that more 
adequately address lessons learned from recent events.
    In addition to efforts on the safety and soundness front, last year 
we finalized amendments to the rules under the Home Ownership and 
Equity Protection Act (HOEPA). These amendments establish sweeping new 
regulatory protections for consumers in the residential mortgage 
market. Our goal throughout this process has been to protect borrowers 
from practices that are unfair or deceptive and to preserve the 
availability of credit from responsible mortgage lenders. The Board 
believes that these regulations, which apply to all mortgage lenders, 
not just banks, will better protect consumers from a range of unfair or 
deceptive mortgage lending and advertising practices that have been the 
source of considerable concern and criticism.
    Given escalating mortgage foreclosures, we have urged regulated 
institutions to establish systematic, proactive, and streamlined 
mortgage loan modification protocols and to review troubled loans using 
these protocols. We expect an institution (acting either in the role of 
lender or servicer) to determine, before proceeding to foreclosure, 
whether a loan modification will enhance the net present value of the 
loan, and whether loans currently in foreclosure have been subject to 
such analysis. Such practices are not only consistent with sound risk 
management but are also in the long-term interests of borrowers, 
lenders, investors, and servicers. We are encouraging regulated 
institutions, through government programs, to pursue modifications that 
result in mortgages that borrowers will be able to sustain over the 
remaining maturity of their loan. In this regard, just recently the 
Federal Reserve joined with other financial supervisors to encourage 
all of the institutions we supervise to participate in the Treasury 
Department's Home Affordable loan modification program, which was 
established under the Troubled Assets Relief Program.\3\ Our examiners 
are closely monitoring loan modification efforts of institutions we 
supervise.
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    \3\ See http://www.Federalreserve.gov/newsevents/press/bcreg/
20090304a.htm.
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Counterparty credit risk
    The Federal Reserve has been concerned about counterparty credit 
risk for some time, and has focused on requiring the industry to have 
effective risk management practices in place to deal with risks 
associated with transacting with hedge funds, for example, and other 
key counterparties. This focus includes assessing the overall quality 
of MIS for counterparty credit risk and ensuring that limits are 
complied with and exceptions appropriately reviewed. As the crisis has 
unfolded, we have intensified our monitoring of counterparty credit 
risk. Supervisors are analyzing management reports and, in some cases, 
are having daily conversations with management about ongoing issues and 
important developments. This process has allowed us to understand key 
linkages and exposures across the financial system as specific 
counterparties experience stress during the current market environment. 
Federal Reserve supervisors now collect information on the counterparty 
credit exposures of major institutions on a weekly and monthly basis, 
and have enhanced their methods of assessing this exposure.
     Within counterparty credit risk, issues surrounding the credit 
default swap (CDS) market have been particularly pertinent. As various 
Federal Reserve officials have noted in past testimony to congressional 
committees and in other public statements, regulators have, for several 
years, been addressing issues surrounding the over-the-counter (OTC) 
derivatives market in general and the CDS market in particular. Since 
September 2005, an international group of supervisors, under the 
leadership of the Federal Reserve Bank of New York, has been working 
with dealers and other market participants to strengthen arrangements 
for processing, clearing, and settling OTC derivatives. An early focus 
of this process was on CDS. This emphasis includes promoting such steps 
as greater use of electronic-confirmation platforms, adoption of a 
protocol that requires participants to request counterparty consent 
before assigning trades to a third party, and creation of a contract 
repository that maintains an electronic record of CDS trades.
    More recently, and in response to the recommendations of the 
President's Working Group on Financial Markets and the Financial 
Stability Forum, supervisors are working to bring about further 
improvements to the OTC derivatives market infrastructure. With respect 
to credit derivatives, this agenda includes: (1) further increasing 
standardization and automation; (2) incorporating an auction-based cash 
settlement mechanism into standard documentation; (3) reducing the 
volume of outstanding CDS contracts; and (4) developing well-designed 
central counterparty services to reduce systemic risks.
    The most important potential change in the infrastructure for 
credit derivatives is the creation of one or more central 
counterparties (CCPs) for CDS. The Federal Reserve supports CCP 
clearing of CDS because, if properly designed and managed, CCPs can 
reduce risks to market participants and to the financial system. In 
addition to clearing CDS through CCPs, the Federal Reserve believes 
that exchange trading of sufficiently standardized contracts by banks 
and other market participants can increase market liquidity and 
transparency, and thus should be encouraged. In a major step toward 
achieving that goal, the Federal Reserve Board, on March 4, 2009, 
approved the application by ICE US Trust LLC (ICE Trust) to become a 
member of the Federal Reserve System. ICE Trust intends to provide 
central counterparty services for certain credit default swap 
contracts.
Commercial real estate
    For some time, the Federal Reserve has been focused on commercial 
real estate (CRE) exposures. For background, as part of our onsite 
supervision of banking organizations in the early 2000s, we began to 
observe rising CRE concentrations. Given the central role that CRE 
lending played in the banking problems of the late 1980s and early 
1990s, we led an interagency effort to issue supervisory guidance on 
CRE concentrations. In the 2006 guidance on CRE, we emphasized our 
concern that some institutions' strategic- and capital-planning 
processes did not adequately acknowledge the risks from their CRE 
concentrations. We stated that stress testing and similar exercises 
were necessary for institutions to identify the impact of potential CRE 
shocks on earnings and capital, especially the impact from credit 
concentrations.
    Because weaker housing markets and deteriorating economic 
conditions have clearly impaired the quality of CRE loans at supervised 
banking organizations, we have redoubled our supervisory efforts in 
regard to this segment. These efforts include monitoring carefully the 
impact that declining collateral values may have on CRE exposures as 
well as assessing the extent to which banks have been complying with 
the interagency CRE guidance. We found, through horizontal reviews and 
other examinations, that some institutions would benefit from 
additional and better stress testing and could improve their 
understanding of how concentrations--both single-name and sectoral/
geographical concentrations--can impact capital levels during shocks. 
We have also implemented additional examiner training so that our 
supervisory staff is equipped to deal with more serious CRE problems at 
banking organizations as they arise, and have enhanced our outreach to 
key real estate market participants and obtained additional market data 
sources to help support our supervisory activities. As a result of our 
supervisory work, risk management practices related to CRE are 
improving, including risk identification and measurement.
    To sum up our efforts to improve banks' risk management, we are 
looking at all of the areas mentioned above--both on an individual and 
collective basis--as well as other areas to ensure that all 
institutions have their risk management practices at satisfactory 
levels. More generally, where we have not seen appropriate progress, we 
are aggressively downgrading supervisory ratings and using our 
enforcement tools.
Supervisory Lessons Learned
    Having just described many of the steps being taken by Federal 
Reserve supervisors to address risk management deficiencies in the 
banking industry, I would now like to turn briefly to our internal 
efforts to improve our own supervisory practices. The current crisis 
has helped us to recognize areas in which we, like the banking 
industry, can improve.
    Since last year, Vice Chairman Kohn has led a System-wide effort to 
identify lessons learned and to develop recommendations for potential 
improvements to supervisory practices. To benefit from multiple 
perspectives in these efforts, this internal process is drawing on 
staff from around the System. For example, we have formed System-wide 
groups, led by Board members and Reserve Bank Presidents, to address 
the identified issues in areas such as policies and guidance, the 
execution of supervisory responsibilities, and structure and 
governance. Each group is reviewing identified lessons learned, 
assessing the effectiveness of recent initiatives to rectify issues, 
and developing additional recommendations. We will leverage these group 
recommendations to arrive at an overall set of enhancements that will 
be implemented in concert. As you know, we are also meeting with 
Members of the Congress and other government bodies, including the 
Government Accountability Office, to consult on lessons learned and to 
hear additional suggestions for improving our practices.
    One immediate example of enhancements relates to System-wide 
efforts for forward-looking risk identification efforts. Building on 
previous System-wide efforts to provide perspectives on existing and 
emerging risks, the Federal Reserve has recently augmented its process 
to disseminate risk information to all the Reserve Banks. That process 
is one way we are ensuring that risks are identified in a consistent 
manner across the System by leveraging the collective insights of 
Federal Reserve supervisory staff. We are also using our internal risk 
reporting to help establish supervisory priorities, contribute to 
examination planning and scoping, and track issues for proper 
correction. Additionally, we are reviewing staffing levels and 
expertise so that we have the appropriate resources, including for 
proper risk identification, to address not just the challenges of the 
current environment but also those over the longer term.
    We have concluded that there is opportunity to improve our 
communication of supervisory and regulatory policies, guidance, and 
expectations to those we regulate. This includes more frequently 
updating our rules and regulations and more quickly issuing guidance as 
new risks and concerns are identified. For instance, we are reviewing 
the area of capital adequacy, including treatment of market risk 
exposures as well as exposures related to securitizations and 
counterparty credit risk. We are taking extra steps to ensure that as 
potential areas of risk are identified or new issues emerge, policies 
and guidance address those areas in an appropriate and timely manner. 
And we will increase our efforts to ensure that, for global banks, our 
policy and guidance responses are coordinated, to the extent possible, 
with those developed in other countries.
    One of the Federal Reserve's latest enhancements related to 
guidance, a project begun before the onset of the crisis, was the 
issuance of supervisory guidance on consolidated supervision. This 
guidance is intended to assist our examination staff as they carry out 
supervision of banking institutions, particularly large, complex firms 
with multiple legal entities, and to provide some clarity to bankers 
about our areas of supervisory focus. Importantly, the guidance is 
designed to calibrate supervisory objectives and activities to the 
systemic significance of the institutions and the complexity of their 
regulatory structures. The guidance provides more explicit expectations 
for supervisory staff on the importance of understanding and validating 
the effectiveness of the banking organization's corporate governance, 
risk management, and internal controls that are in place to oversee and 
manage risks across the organization. Our assessment of nonbank 
activities is an important part of our supervisory process to 
understand the linkages between depository and nondepository 
subsidiaries, and their effects on the overall risks of the 
organization.
    In addition to issues related to general risk management at nonbank 
subsidiaries, the consolidated supervision guidance addresses potential 
issues related to consumer compliance. In this regard, in 2007 and 2008 
the Board collaborated with other U.S. and State government agencies to 
launch a cooperative pilot project aimed at expanding consumer 
protection compliance reviews at selected nondepository lenders with 
significant subprime mortgage operations. This interagency initiative 
has clarified jurisdictional issues and improved information-sharing 
among the participating agencies, along with furthering its overarching 
goal of preventing abusive and fraudulent lending while ensuring that 
consumers retain access to beneficial credit.
    As stated earlier, there were numerous cases in which the U.S. 
banking agencies 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. It is important that regulatory policies and 
guidance continue to be applied to firms in ways that allow for 
different business models and that do not squelch innovation. However, 
when bankers 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, we must have even firmer resolve to 
hold firms accountable for prudent risk management practices. It is 
particularly important, in such cases, that our supervisory 
communications are very forceful and clear, directed at senior 
management and boards of directors so that matters are given proper 
attention and resolved to our satisfaction.
    With respect to consumer protection matters, we have an even 
greater understanding that reviews of consumer compliance records of 
nonbank subsidiaries of bank holding companies can aid in confirming 
the level of risk that these entities assume, and that they assist in 
identifying appropriate supervisory action. Our consumer compliance 
division is currently developing a program to further the work that was 
begun in the interagency pilot discussed earlier. In addition to these 
points, it is important to note that we have learned lessons and taken 
action on important aspects of our consumer protection program, which I 
believe others from the Federal Reserve have discussed with the 
Congress.
    In addition, we must further enhance our ability to develop clear 
and timely analysis of the interconnections among both regulated and 
unregulated institutions, and among institutions and markets, and the 
potential for these linkages and interrelationships to adversely affect 
banking organizations and the financial system. In many ways, the 
Federal Reserve is well positioned to meet this challenge. In this 
regard, the current crisis has, in our view, demonstrated the ways in 
which the Federal Reserve's consolidated supervision role closely 
complements our other central bank responsibilities, including the 
objectives of fostering financial stability and deterring or managing 
financial crises.
    The information, expertise, and powers derived from our supervisory 
authority enhance the Federal Reserve's ability to help reduce the 
likelihood of financial crises, and to work with the Treasury 
Department and other U.S. and foreign authorities to manage such crises 
should they occur. Indeed, the enhanced consolidated supervision 
guidance that the Federal Reserve issued in 2008 explicitly outlines 
the process by which we will use information obtained in the course of 
supervising financial institutions--as well as information and analysis 
obtained through relationships with other supervisors and other 
sources--to identify potential vulnerabilities across financial 
institutions. It will also help us identify areas of supervisory focus 
that might further the Federal Reserve's knowledge of markets and 
counterparties and their linkages to banking organizations and the 
potential implications for financial stability.
    A final supervisory lesson applies to the structure of the U.S. 
regulatory system, an issue that the Congress, the Federal Reserve, and 
others have already raised. While we have strong, cooperative 
relationships with other relevant bank supervisors and functional 
regulators, there are obvious gaps and operational challenges in the 
regulation and supervision of the overall U.S. financial system. This 
is an issue that the Federal Reserve has been studying for some time, 
and we look forward to providing support to the Congress and the 
Administration as they consider regulatory reform. In a recent speech, 
Chairman Bernanke introduced some ideas to improve the oversight of the 
U.S. financial system, including the oversight of nonbank entities. He 
stated that no matter what the future regulatory structure in the 
United States, there should be strong consolidated supervision of all 
systemically important banking and nonbanking financial institutions.
    Finally, Mr. Chairman, I would like to thank you and the 
Subcommittee for holding this second hearing on risk management--a 
crucially important issue in understanding the failures that have 
contributed to the current crisis. Our actions, with the support of the 
Congress, will help strengthen institutions' risk management practices 
and the supervisory and regulatory process itself--which should, in 
turn, greatly strengthen the banking system and the broader economy as 
we recover from the current difficulties.
    I look forward to answering your questions.
                                 ______
                                 
                 PREPARED STATEMENT OF TIMOTHY W. LONG
         Senior Deputy Comptroller, Bank Supervision Policy and
                      Chief National Bank Examiner
                             March 18, 2009
Introduction
    Chairman Reed, Ranking Member Bunning, and members of the 
Subcommittee, my name is Timothy Long and I am the Senior Deputy 
Comptroller for Bank Supervision Policy and Chief National Bank 
Examiner at the Office of the Comptroller of the Currency (OCC). I 
welcome this opportunity to discuss the OCC's perspective on the recent 
lessons learned regarding risk management, as well as the steps we have 
taken to strengthen our supervision and examination processes in this 
critical area, and how we supervise the risk management activities at 
the largest national banking companies.
    Your letter of invitation also requested our response to the 
findings of the GAO regarding the OCC's oversight of bank risk 
management. Because we only received the GAO's summary statement of 
facts on Friday night, we have not had an opportunity to thoroughly 
review and assess their full report and findings. Therefore, I will 
only provide some brief observations on their initial findings. We take 
findings and recommendations from the GAO very seriously and will be 
happy to provide Subcommittee members a written response to the GAO's 
findings once we have had the opportunity to carefully review their 
report.
Role of Risk Management
    The unprecedented disruption that we have seen in the global 
financial markets over the last eighteen months, and the events and 
conditions leading up to this disruption, have underscored the critical 
need for effective and comprehensive risk management processes and 
systems. As I will discuss in my testimony, these events have revealed 
a number of weaknesses in banks' risk management processes that we and 
the industry must address. Because these problems are global in nature, 
many of the actions we are taking are in coordination with other 
supervisors around the world.
    More fundamentally, recent events have served as a dramatic 
reminder that risk management is, and must be, more than simply a 
collection of policies, procedures, limits and models. Effective risk 
management requires a strong corporate culture and corporate risk 
governance. As noted in the March 2008 Senior Supervisors Group report 
on ``Observations on Risk Management Practices During the Recent Market 
Turmoil,'' companies that fostered a strong risk management culture and 
encouraged firm-wide identification and control of risk, were less 
vulnerable to significant losses, even when engaged in higher risk 
activities.\1\
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    \1\ See Senior Supervisors Group Report, ``Observations on Risk 
Management Practices,'' at http://www.newyorkfed.org/newsevents/news/
banking/2008/SSG_Risk_Mgt_doc_final.pdf.
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    While current economic conditions have brought renewed attention to 
risk management, it is during periods of expansionary economic growth 
when risk management can be most critical and challenging both for 
bankers and supervisors. Financial innovation and expansion of credit 
are important drivers of our economy. Banks must be able to respond to 
customer and investor demand for new and innovative products and 
services. They must also be able to compete with firms that may be less 
regulated and with financial service companies across the globe. 
Failure to allow this competition risks ceding the prominent role that 
U.S. financial firms have in the global marketplace.
    Banks are in the business of managing financial risk. Competing in 
the marketplace and allowing market innovation means that there will be 
times when banks lose money. There will also be times when, despite a 
less favorable risk/reward return, a bank will need to maintain a 
market presence to serve its customers and to retain its role as a key 
financial intermediary. These are not and should not be viewed as risk 
management failures. The job of risk management is not to eliminate 
losses or risk, but rather to ensure that risk exposures are fully 
identified and understood so that bank management and directors can 
make informed business decisions about the firm's level of risk.
    In this regard, 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 
mitigation actions are needed. Knowing when and how to strike this 
balance is one of the most difficult jobs that supervisors and 
examiners face. Taking action too quickly can constrain economic growth 
and impede credit to credit worthy borrowers; waiting too long can 
result in an overhang of risk becoming embedded into banks and the 
marketplace. Effective risk management systems play a critical role in 
this process.
Risk Management Lessons Learned
    It is fair to ask what the banking industry and supervisors have 
learned from the major losses that have occurred over the past 18 
months. The losses have been so significant, and the damage to the 
economy and confidence so great, that we all must take stock of what we 
missed, and what we should have done differently to make sure that we 
minimize the possibility that something like this happens again. Below 
are some of our assessments:

    Underwriting Standards Matter, Regardless of Whether Loans 
        are Held or Sold--The benign economic environment of the past 
        decade, characterized by low interest rates, strong economic 
        growth and very low rates of borrower defaults led to 
        complacency on the part of many lenders. Competitive pressures 
        drove business line managers to ease underwriting standards for 
        the origination of credit and to assume increasingly complex 
        and concentrated levels of risk. Increased investor appetite 
        for yield and products, fueled by a global abundance of 
        liquidity, led many larger banks to adopt the so-called 
        ``originate-to-distribute'' model for certain commercial and 
        leveraged loan products, whereby they originated a significant 
        volume of loans with the express purpose of packaging and 
        selling them to investors. Many of these institutional 
        investors were willing to accept increasingly liberal repayment 
        terms, reduced financial covenants, and higher borrower 
        leverage on these transactions in return for marginally higher 
        yields. Similar dynamics were occurring in the residential 
        mortgage markets, where lenders, primarily non-bank lenders, 
        were aggressively relaxing their underwriting standards.

    Given the abundance of liquidity and willing investors for these 
loans, lenders became complacent about the risks underlying the loans. 
However, in the fall of 2007 the risk appetite of investors changed 
dramatically and, at times, for reasons not directly related to the 
exposures that they held. This abrupt change in risk tolerance left 
banks with significant pipelines of loans that they needed to fund as 
the syndicated loan and securitization markets shut down. Bankers and 
supervisors underestimated the rapidity and depth of the global 
liquidity freeze. A critical lesson, which the OCC and other Federal 
banking agencies noted in their 2007 Shared National Credit results, is 
that banking organizations should ensure that underwriting standards 
are not compromised by competitive pressures. The agencies warned that 
``consistent with safe and sound banking practice, agent banks should 
underwrite funding commitments in a manner reasonably consistent with 
internal underwriting standards.''\2\
---------------------------------------------------------------------------
    \2\ See Joint Release, NR 2007-102 at: http://www.occ.treas.gov/
ftp/release/2007-102.htm.

    Risk Concentrations Can Accumulate Across Products and 
        Business Lines and Must be Controlled--Risk concentrations can 
        arise as banks seek to maximize their expertise or operational 
        efficiencies in a highly competitive business. Community banks 
        can often develop significant concentrations as their lending 
        portfolios tend to be highly concentrated in their local 
        markets. For larger institutions, a key issue has been the 
        ability to aggregate risk exposures across business and product 
        lines and to identify risks that may be highly correlated. For 
        example, many national banks underestimated their exposure to 
        subprime mortgages because they did not originate them. Indeed, 
        some senior bank management 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. Because of inadequate communication within these 
        firms, those structuring businesses were aggressively expanding 
        activity at the same time that retail lending professionals in 
        the bank were avoiding or exiting the business because of their 
        refusal to meet weak underwriting conditions prevalent in the 
        market. These failures were compounded when products, markets, 
        and geographic regions that previously were looked to as a 
        source of risk diversification became more highly correlated as 
        contagion effects spread across the globe. Additionally, 
        significant corporate acquisitions, especially if they were not 
        consistent with the bank's business strategy and corporate 
        culture, affected the institutions' financial well being, their 
        risk positions and reputations, and placed significant strains 
---------------------------------------------------------------------------
        on their risk management processes.

    Asset-Based Liquidity Provides a Critical Cushion--There is 
        always a tension of how much of a bank's balance sheet capacity 
        should be used to provide a cushion of liquid assets--assets 
        that can be readily converted to liquid funds should there be a 
        disruption in the bank's normal funding markets or in its 
        ability to access those markets. Because such assets tend to be 
        low risk and, thus, low yielding, many banks have operated with 
        very minimal cushions in recent years. These decisions 
        reflected the abundance of liquidity in the market and the ease 
        with which banks could tap alternative funding sources through 
        various capital and securitization markets. Here again, when 
        these markets became severely constrained, many banks faced 
        significant short-term funding pressures. For some firms, these 
        funding pressures, when combined with high credit exposures and 
        increased leverage, resulted in significant strains and, in 
        some cases, liquidity insolvency.

    Systemically Important Firms Require State-of-the-Art 
        Infrastructure--As noted in a number of visible cases during 
        this period of market turmoil, a large firm's ability to change 
        its risk profile or react to the changing risk tolerance of 
        others is dependent on an extremely robust supporting 
        infrastructure. The velocity with which information is 
        transmitted across financial markets and the size, volume and 
        complexity of transactions between market participants has been 
        greatly expanded through technology advancements and 
        globalization of markets. Failure to have sufficient 
        infrastructure and backroom operations resulted in failed 
        trades and increased counterparty exposures, increasing both 
        reputation and credit risks.

    Need for Robust Capital Levels and Capital Planning 
        Processes--Although we are clearly seeing strains, the national 
        banking system, as a whole, has been able to withstand the 
        events of the past 18 months due, in part, to their strong 
        levels of regulatory capital. The strong levels of capital in 
        national banks helped to stabilize the financial system. 
        National banking organizations absorbed many weaker competitors 
        (e.g., Bear Stearns, Countrywide, and WAMU). This relative 
        strength is more apparent when compared to the highly leveraged 
        position of many broker-dealers. Nonetheless, it is clear that 
        both banks' internal capital processes and our own supervisory 
        capital standards need to be strengthened to more fully 
        incorporate potential exposures from both on- and off-balance 
        sheet transactions across the entire firm. In addition, capital 
        planning and estimates of potential credit losses need to be 
        more forward looking and take account of uncertainties 
        associated with models, valuations, concentrations, and 
        correlation risks throughout an economic cycle.
    These findings are consistent with reports issued by the SSG's 
report on ``Risk Management Practices,'' the Financial Stability 
Forum's (FSF) report on ``Enhancing Market and Institutional 
Resilience,'' the Joint Forum's report on ``Cross- Sectoral Review of 
Group-wide Identification and Management of Risk Concentrations,'' and 
the Basel Committee on Banking Supervision's consultative paper on 
``Principles for Sound Stress Testing Practices and Supervision.''\3\ 
Two common themes from these reports and other studies in which the OCC 
has actively participated are the need to strengthen risk management 
practices and improve stress testing and firm-wide capital planning 
processes. The reports also note several areas where banking 
supervisors need to enhance their oversight regimes. The 
recommendations generally fall into three broad categories: 1) 
providing additional guidance to institutions with regard to the risk 
management practices and monitoring institutions' actions to implement 
those recommendations; 2) enhancing the various aspects of the Basel II 
risk-based capital framework; and 3) improving the exchange of 
supervisory information and sharing of best practices.
---------------------------------------------------------------------------
    \3\ Senior Supervisors Group Report, ``Observations on Risk 
Management Practices,'' at http://www.newyorkfed.org/newsevents/news/
banking/2008/SSG_Risk_Mgt_doc_final.pdf; Financial Stability Forum, 
``Enhancing Market and Institutional Resilience,'' at http://
www.fsforum.org/publications/FSF_ Report_to_G7_11_April.pdf; Joint 
Forum, ``Cross-sectoral review of group-wide identification and 
management of risk concentrations'' at http://www.bis.org/publ/
joint19.htm; and Basel Committee on Banking Supervision Report, ``Sound 
principles for stress testing practices and supervision,'' at http://
www.bis.org/publ/bcbs147.htm. 
---------------------------------------------------------------------------
OCC Supervisory Responses
    The OCC has been actively involved in the various work groups that 
issued these reports, and we are taking a number of steps, primarily in 
our large bank supervision program, to ensure that our supervisory 
process and the risk management practices of our institutions 
incorporate these recommendations. I will focus on the three key areas 
identified by the Subcommittee: liquidity risk management, capital 
requirements, and enterprise-wide risk management.
Liquidity Risk Management
    The sudden and complete shutdown in many traditional funding 
markets was not contemplated by most contingency funding plans. This 
period of market disruption has magnified the risks associated with 
underestimating liquidity risk exposures and improperly planning for 
periods of significant duress. The SSG report specifically noted that 
better performing firms carefully monitored their and on- and off-
balance sheet risk exposures and actively managed their contingent 
liquidity needs. In April 2008, the OCC developed a liquidity risk 
monitoring program to standardize liquidity monitoring information 
across our large bank population and provide more forward looking 
assessments. We developed a template for the monthly collection of 
information about balance sheet exposures, cash-flow sources and uses, 
and financial market risk indicators. Our resident examiners complete 
this template each month and then work with our subject matter 
specialists in the Credit and Market Risk (CMR) division in Washington 
to produce a monthly report that summarizes the liquidity risk profile, 
based on levels of risk and quality of risk management, for 15 banking 
companies in our Large and Mid-size bank programs. These risk profiles 
provide a forward looking assessment of liquidity maturity mismatches 
and capacity constraints, both of which are considered early warning 
signals of potential future problems.
    In September 2008, the Basel Committee on Banking Supervision 
(Basel Committee) issued a report on, ``Principles for Sound Liquidity 
Risk Management and Supervision.''\4\ This report represents critical 
thinking that was done by supervisors in over 15 jurisdictions on the 
fundamental principles financial institutions and supervisors must 
adopt to provide appropriate governance of liquidity risk. OCC subject 
matter specialists in our CMR division were actively involved in the 
development of this important paper on risk management expectations, 
and are now contributing to the second phase of this work which is 
focused on identifying key liquidity metrics and benchmarks that may be 
valuable for enhancing transparency about liquidity risk at financial 
institutions. We are also working with the other U.S. Federal banking 
agencies to adapt and apply these key principles more broadly to all 
U.S. banking institutions through an interagency policy statement.
---------------------------------------------------------------------------
    \4\ See Basel Committee on Banking Supervision, ``Principles for 
Sound Liquidity Management and Supervision,'' at http://www.bis.org/
publ/bcbs144.htm. 
---------------------------------------------------------------------------
    The OCC reviews bank liquidity on an ongoing basis and we have 
incorporated these valuable lessons into our evaluations. Our strategic 
bank supervision operating plan for 2009 directs examiners at our 
largest national banks to focus on banks' firm-wide assessments of 
their liquidity risk and the adequacy of their liquidity cushions 
(short-term liquid assets and collateralized borrowing capacity) to 
meet short and medium term funding needs, as well as on the 
effectiveness of their liquidity risk management, including management 
information systems and contingency funding plans.
Capital Requirements
    The market turmoil has highlighted areas where the current Basel II 
capital framework needs to be strengthened. The OCC, through its 
membership on the Basel Committee and work with the FSF, has been 
actively involved in formulating improvements to the capital framework. 
Among the refinements recommended by the Basel Committee in its January 
2009 consultative papers are higher capital requirements for re-
securitizations, such as collateralized debt obligations, which are 
themselves comprised of asset-backed securities.\5\ These structured 
securities suffered significant losses during the recent market 
turmoil. Other proposed changes to the Basel II framework would 
increase the capital requirements for certain liquidity facilities that 
support asset-backed commercial paper conduits.
---------------------------------------------------------------------------
    \5\ See: ``Proposed enhancements to the Basel II framework,'' 
``Revisions to the Basel II Market Risk Framework,'' and ``Guidelines 
for computing capital for incremental risk in the trading book,'' 
January 2009 at http://www.bis.org/press/p090116.htm. 
---------------------------------------------------------------------------
    In addition, the Basel Committee has proposed requirements for 
certain banks to incorporate default risk and credit migration risk in 
their value-at-risk models. These proposals are designed to better 
reflect the risks arising from the more complex, and less liquid, 
credit products that institutions now hold in their trading portfolios. 
The intention is also to reduce the extent of regulatory capital 
arbitrage that currently exists between the banking and trading books.
    The January consultative paper that proposed enhancements to the 
Basel II framework would also strengthen supervisory guidance regarding 
Pillar 2, or the supervisory review process of Basel II. Specifically, 
the proposed supervisory guidance would address firm-wide governance 
and risk management; capturing the risk of off-balance sheet exposures 
and securitization activities; and incentives to manage risk and 
returns over the long-term.
    More recently, following its meeting last week, the Basel Committee 
announced additional initiatives to strengthen capital in the banking 
system. These include introducing standards to promote the buildup of 
capital buffers that can be drawn down in periods of stress, as well as 
a non-risk-based capital measure like our leverage ratio.\6\ Once the 
Basel Committee finalizes these and other changes to the Basel II 
framework, the OCC and other Federal banking agencies will jointly 
consider their adoption in the U.S. through the agencies' notice and 
comment process.
---------------------------------------------------------------------------
    \6\ See ``Initiatives on capital announced by the Basel 
Committee,'' March 12, 2009 at: http://www.bis.org/press/p090312.htm. 
---------------------------------------------------------------------------
Enterprise Risk Management
    As previously noted, the recent market turmoil has highlighted the 
importance of a comprehensive firm-wide risk management program. The 
SSG report advised that striking the right balance between risk 
appetite and risk controls was a distinguishing factor among firms 
surveyed in its study. Additionally, the FSF report noted that, 
``Supervisors and regulators need to make sure that the risk management 
and control framework within financial institutions keeps pace with the 
changes in instruments, markets and business models, and that firms do 
not engage in activities without having adequate controls.''\7\
---------------------------------------------------------------------------
    \7\ See ``Report of the Financial Stability Forum on Enhancing 
Market and Institutional Resilience,'' April 2008 at: http://
www.fsforum.org/publications/r_0804.pdf.
---------------------------------------------------------------------------
    Proper risk governance was a key focus of guidance that the OCC, 
the SEC, and other Federal banking regulators issued in January 2007 on 
complex finance activities.\8\ That guidance stressed the need for 
firms to have robust internal controls and risk management processes 
for complex structured finance transactions. The guidance emphasized 
the importance of a strong corporate culture that includes and 
encourages mechanisms that allow business line and risk managers to 
elevate concerns to appropriate levels of management and to ensure the 
timely resolution of those concerns. It also stressed the need to 
ensure appropriate due diligence at the front-end, before products are 
offered, to ensure that all risks have been appropriately considered 
and can be effectively identified, managed and controlled. At the OCC, 
approval of new or novel banking activities is predicated on the bank 
having sufficient risk management controls in place.
---------------------------------------------------------------------------
    \8\ See: OCC Bulletin 2007-1, ``Complex Structured Finance 
Transactions'' at http://www.occ.gov/ftp/bulletin/2007-1.html. 
---------------------------------------------------------------------------
    Assessing management's ability to effectively identify, measure, 
monitor, and control risk across the firm and to conduct effective 
stress testing is a key focus of our examination strategies for large 
national banks this year. Stress tests are a critical tool for 
effective enterprise-wide risk assessments. Such tests can help 
identify concentrations and interconnected risks and determine the 
adequacy of capital and liquidity. As with most other issues, the 
success of a stress testing program depends importantly on the support 
and sponsorship provided by senior management. In banks where risk 
management functions did not perform well, stress testing typically was 
a mechanical exercise. Management viewed stress tests as more of a 
``requirement'' than an important risk management tool that could lead 
to internal discussions and debate about whether existing exposures 
constituted unacceptable risks.
    In addition, many stress tests failed to fully estimate the 
potential severity and duration of stress events and to identify and 
capture risks across the firm. Often, stress tests would focus on a 
single line of business and/or use only historical statistical 
relationships. When designing a stress test, particularly after a 
prolonged period of abundant liquidity, low credit spreads and low 
interest rates, it is important to probe for weaknesses in the 
portfolio that may not be evident from historically based stress 
exercises. Expert judgment can help define scenarios to address the 
likely breakdown in normal statistical relationships, as well as 
feedback loops, in a crisis. Such scenario-based stress tests, often 
dismissed as implausible by business unit personnel, allow firms to 
shock multiple market factors (e.g., interest rates credit spreads and 
commodity prices) simultaneously. Such stress tests are an important 
way to capture risks missed in traditional stress testing exercises, 
such as market liquidity risk and basis risk.
OCC's Supervision of Risk Management at Large National Banks
    Let me now turn to how we apply and incorporate our perspective on 
risk management into the supervision of large national banks. The OCC 
is responsible for supervising over 1,600 banks, including some of the 
largest in the world that offer a wide array of financial services and 
are engaged in millions of transactions every day.
    Pursuant to the provision of the Gramm Leach Bliley Act (GLBA), the 
OCC serves as the primary Federal banking regulator for activities 
conducted within the national bank charter and its subsidiaries, except 
for those activities where jurisdiction has been expressly provided to 
another functional supervisor, such as the Securities and Exchange 
Commission (SEC), for certain broker-dealer activities. Nonetheless, we 
work closely with the Federal Reserve Board, the SEC, and other 
appropriate regulators to help promote consistent and comprehensive 
supervision across the company.
    The foundation of the OCC's supervisory efforts is our continuous, 
onsite presence of examiners at each of our 14 largest banking 
companies. These 14 banking companies account for approximately 89 
percent of the assets held in all of the national banks under our 
supervision. The resident examiner teams are supplemented by subject 
matter specialists in our Policy Division and PhD economists from our 
Risk Analysis Division trained in quantitative finance.
    Our Large Bank program is organized with a national perspective. It 
is highly centralized and headquartered in Washington, and structured 
to promote consistent uniform coordination across institutions. The 
onsite teams at each or our 14 largest banks are led by an Examiner-In-
Charge (EIC), who reports directly to the Deputy Comptrollers in our 
Large Bank Supervision Office in Washington, DC. The Large Bank 
Deputies are in ongoing communication with the EICs, in addition to 
holding monthly calls and quarterly face-to-face meetings with all 
EICs. To enhance our ability to identify risks and share best practices 
across the large bank population, we have established a program of 
examiner network groups in Large Banks. There are eight main network 
groups (Commercial Credit, Retail Credit, Mortgage Banking, Capital 
Markets, Asset Management, Information Technology, Operational Risk and 
Compliance) and numerous subgroups. These groups facilitate sharing of 
information, concerns and policy application among examiners with 
specialized skills in these areas. The EICs and leadership teams of 
each of the network groups work closely with specialists in our Policy 
and Risk Analysis Divisions to promote consistent application of 
supervisory standards and coordinated responses to emerging issues.
    All of this enables the OCC to maintain an on-going program of risk 
assessment, monitoring, and communication with bank management and 
directors. Nonetheless, given the volume and complexity of bank 
transactions, it is not feasible to review every transaction in each 
bank, or for that matter, every single product line or bank activity. 
Accordingly, we focus on those products and services posing the 
greatest risk to the bank through risk-based supervision.
    Resident examiners apply risk-based supervision to a broad array of 
risks, including credit, liquidity, market, compliance and operational 
risks. Supervisory activities are based upon supervisory strategies 
that are developed for each institution that are risk-based and focused 
on the more complex banking activities. Although each strategy is 
tailored to the risk profile of the individual institution, our 
strategy development process is governed by supervisory objectives set 
forth annually in the OCC's bank supervision operating plan. Through 
this operating plan, the OCC identifies key risks and issues that cut 
across the industry and promotes consistency in areas of concerns. With 
the operating plan as a guide, EICs develop detailed strategies that 
will direct supervisory activities and resources for the coming year. 
Each strategy is reviewed by the appropriate Large Bank Deputy 
Comptroller. Our risk-based supervision is flexible, allowing 
strategies to be revised, as needed, to reflect the changing risk 
profile of the supervised institutions. We have a Quality Assurance 
group within our Large Bank program that selects strategies to review 
as part of a supervisory program review to ensure reasonableness and 
quality supervision.
    Our supervisory goal is to ensure banks have sound risk governance 
processes commensurate with the nature of their risk-taking activities. 
Risk management systems must be sufficiently comprehensive to enable 
senior management to identify and effectively manage risk throughout 
the firm. Therefore, examinations of our largest banks focus on the 
overall integrity and effectiveness of risk management systems.
    The first step in risk-based supervision is to identify the most 
significant risks and then to determine whether a bank has systems and 
controls to identify and manage those risks. Next, we assess the 
integrity and effectiveness of risk management systems, with 
appropriate validation through transaction testing. This is 
accomplished through our supervisory process which involves a 
combination of ongoing monitoring and targeted examinations. The 
purpose of our targeted examinations is to validate that risk 
management systems and processes are functioning as expected and do not 
present any significant supervisory concerns. Our supervisory 
conclusions, including any risk management deficiencies, are 
communicated directly to bank senior management. Thus, not only is 
there ongoing evaluation, but there is also a process for timely and 
effective corrective action when needed. To the extent we identify 
concerns, we ``drill down'' to test additional transactions.
    These concerns are then highlighted for management and the Board as 
``Matters Requiring Attention'' (``MRAs'') in supervisory 
communications. Often these MRAs are line of business specific, and can 
be corrected relatively easily in the normal course of business. 
However, a few MRAs address more global concerns such as enterprise 
risk management or company-wide information security. We also have a 
consolidated electronic system to monitor and report outstanding MRAs. 
Each MRA is assigned a due date and is followed-up by onsite staff at 
each bank. If these concerns are not appropriately addressed within a 
reasonable period, we have a variety of tools with which to respond, 
ranging from informal supervisory actions directing corrective 
measures, to formal enforcement actions, to referrals to other 
regulators or law enforcement.
    Our supervision program includes targeted and on-going analysis of 
corporate governance at our large national banks. This area encompasses 
a wide variety of supervisory activities including:

    Analysis and critique of materials presented to directors;

    Review of board activities and organization;

    Risk management and audit structures within the 
        organization, including the independence of these structures;

    Reviews of the charters, structure and minutes of 
        significant decisionmaking committees in the bank;

    Review of the vetting process for new and complex products 
        and the robustness of new product controls; and

    Analysis of the appropriateness and adequacy of management 
        information packages used to measure and control risk.

    It is not uncommon to find weaknesses in structure, organization, 
or management information, which we address through MRAs and other 
supervisory processes described above. But more significantly, at some 
of our institutions what appeared to be an appropriate governance 
structure was made less effective by a weak corporate culture, which 
discouraged credible challenge from risk managers and did not hold 
lines of business accountable for inappropriate actions. When the 
market disruption occurred in mid 2007, it became apparent that in some 
banks, risk management lacked support from executive management and the 
board to achieve the necessary stature within the organization, or 
otherwise did not exercise its authority to constrain business 
activities. At institutions where these issues occurred, we took strong 
supervisory actions, and we effected changes in personnel, organization 
and/or processes.
    Just as we adjust our strategies for individual banks, we also make 
adjustments to our overall supervisory processes, as needed. And of 
course we are adjusting our supervisory processes to incorporate the 
lessons we have learned during this period of extreme financial 
distress. For example, recent strategy guidance prepared by our Large 
Bank network groups and issued by Large Bank senior management 
increases our focus on:

    Risk concentrations across the enterprise;

    Refinancing risk arising from illiquidity in credit markets 
        and changes in underwriting standards that limit the ability of 
        many borrowers to refinance debt as originally intended;

    Collections, recovery and loss mitigation programs;

    Decision modeling;

    Liquidity contingency planning;

    Allowance for loan and lease loss adequacy;

    Capital buffers and stress assessments; and

    Syndication and other distribution processes and warehouse/
        pipeline controls.

    Our supervisory activities at individual banks are often 
supplemented with horizontal reviews of targeted areas across a group 
of banks. These horizontal reviews can help us to identify emerging 
risks that, while not posing a significant threat to any one 
institution could, if not corrected, pose more system-wide implications 
for the industry. For example, reviews of certain credit card account 
management practices several years ago revealed that as a result of 
competitive pressures, banks were reducing minimum payments required 
from credit card customers to the point where many consumers could 
simply continue to increase their outstanding balances over time with 
no meaningful reduction in principal. We were concerned that these 
competitive pressures could mask underlying deterioration in a 
borrower's condition and could also result in consumers becoming over-
extended. Because of the highly competitive nature of this business, we 
recognized that we needed to address this problem on a system-wide 
basis and as a result, worked with the other Federal banking agencies 
to issue the 2003 guidance on Credit Card Account Management 
Practices.\9\
---------------------------------------------------------------------------
    \9\ See OCC Bulletin 2003-1, ``Credit Card Lending: Account 
Management and Loss Allowance Guidance,'' at http://www.occ.gov/ftp/
bulletin/2003-1.doc.
---------------------------------------------------------------------------
    In addition to the aforementioned liquidity monitoring data we have 
begun collecting, we have also initiated loan level data collection 
from our major banks for residential mortgages, home equity loans, 
large corporate credits, and credit card loans. This data is being used 
to enhance our horizontal risk assessments in these key segments and 
offers a tool for examiners to benchmark their individual institution 
against the industry.
    More recently, in early 2008 we began developing a work plan to 
benchmark our largest national banks against the risk management ``best 
practices'' raised in various reports issued by the President's Working 
Group (PWG), SSG, FSF, and Basel Committee. OCC staff developed a 
template for our examining staff to collect information to conduct this 
benchmarking exercise and we shared this with our colleagues at the PWG 
and SSG. In the interest of expanding the pool of firms and expediting 
the collection of risk management information, agency principals 
elected to use the SSG as the forum for undertaking the risk management 
assessment. In December 2008, a self-assessment template was sent to 23 
globally active financial firms and the completed self-assessments are 
now in the process of being collected and shared among the 
participating agencies. These self-assessments will be supplemented 
with interviews at selected firms to discuss the status of addressing 
risk management deficiencies already identified and also probe for 
further information on emerging issues that may not yet be evident.
    To summarize, the goal of our supervision is to ensure that banks 
are managed in a safe and sound manner, to identify problems or 
weaknesses as early as possible and to obtain corrective action. 
Through our examinations and reviews, we have directed banks to be more 
realistic in assessing their credit risks; to improve their valuation 
techniques for certain complex transactions; to raise capital as market 
opportunities permit; to aggressively build loan loss reserves; and to 
correct various risk management weaknesses.
    As previously noted, we have a staff of specialists who provide on-
going technical assistance to our onsite examination teams. Our Risk 
Analysis Division includes 40 PhD economists and mathematicians who 
have strong backgrounds in statistical analysis and risk modeling. 
These individuals frequently participate in our risk management 
examinations to help evaluate the integrity and empirical soundness of 
banks' risk models and the assumptions underlying those models. Our 
policy specialists assist by keeping abreast of emerging trends and 
issues within the industry and the supervisory community. Staffs from 
our CMR, Operational Risk, and Capital Policy units have been key 
participants and contributors to the ongoing work of the SSG, FSF, PWG 
and Basel Committee.
    In 2008, we established a Financial Markets Group within the agency 
and tasked them with the build-out of a market intelligence program. 
Their mission is to look around corners, to seek out early warning 
signs of emerging and/or systemic risk issues. This team is comprised 
of highly experienced bank examiners and subject matter specialists 
hired from the industry, and they spend considerable time meeting with 
bank investors, bank counterparties, bank competitors, bank analysts, 
and other relevant stakeholders. Their work is discussed with members 
of the OCC's senior management team on a bi-weekly basis, or more 
frequently when needed, and discussed in detail with the OCC's National 
Risk Committee members, who represent all lines of bank supervision 
within the OCC, as well as our legal and economics teams.
Coordination with Other Supervisors
    Successful execution of our supervisory priorities requires an 
effective working relationship with other supervisors, both 
domestically and internationally. The events of the past 18 months 
highlight the global nature of the problems we are facing and the need 
for global responses.
    The OCC has taken a significant leadership role in the interagency 
work underway to address risk management issues raised during this 
period of market turmoil. Comptroller Dugan is an active member of the 
PWG and also serves as the Chair of the Joint Forum. In that capacity, 
he has sponsored critical work streams to address credit risk transfer, 
off-balance sheet activities and reliance on credit rating agencies. 
The Joint Forum work not only builds transparency about how large, 
financial conglomerates manage critical aspects of risk management, but 
it also serves as a vehicle for identifying risk management ``best 
practices.''
    Close coordination with our supervisory colleagues at the other 
banking agencies, as well as the securities agencies, has proven 
beneficial for all parties--firms, supervisors and policymakers. One 
example where this is evident has been the cooperative work among major 
market players and key regulators (the New York Federal Reserve Bank, 
the Federal Reserve Board, the OCC, the SEC, and other key global 
regulators) to strengthen the operational infrastructure and backroom 
processes used for various over-the-counter (OTC) derivative 
transactions. This is another example where a collective effort was 
needed to address problems where there was not a clear incentive for 
any individual firm to take corrective action. As a result of these 
efforts, we have seen material improvements in the reduction of 
unconfirmed trades across all categories of OTC derivatives, with the 
most notable reduction in the area of credit derivatives, where the 
large dealers have reduced by over 90 percent the backlog of credit 
derivatives confirmations that are outstanding by more than 30 days.
GAO Report
    As I noted in my introduction, we received the GAO's draft 
statement of findings on Friday night and, as requested, provided them 
with summary comments on those draft findings on Monday morning. Once 
we receive the GAO's final report, we will give careful consideration 
to its findings and any recommendations therein for improvement in our 
supervisory processes. We will be happy to share our conclusions and 
responses with the Subcommittee.
    As I have described in my testimony, the OCC has a strong, 
centralized program for supervising the largest national banks. But 
clearly, the unprecedented global disruptions that we have witnessed 
across the credit and capital markets have revealed risk management 
weaknesses across banking organizations that need to be fixed and we 
are taking steps to ensure this happens. In this regard, it is 
important to recognize that risk management systems are not static. 
These systems do and must evolve with changes in markets, business 
lines, and products. For example, improving and validating risk models 
is an ongoing exercise at our largest institutions. Therefore it should 
not be surprising that we routinely have outstanding MRAs that direct 
bank management to make improvements or changes to their risk models 
and risk management practices. This is an area where we continuously 
probe to look for areas of improvement and best practices. As I 
described earlier, we have systems in place to monitor and track these 
MRAs and, when we determine that the bank is not making sufficient 
progress to address our concerns, we can and do take more forceful 
action. However, unless we believe the model deficiency is so severe as 
to undermine the bank's safety and soundness, we will allow the bank to 
continue to use the model as it makes necessary refinements or 
adjustments. Given the iterative process of testing and validating risk 
models, it simply is not realistic to suggest that a bank suspend its 
operations or business whenever it needs to make enhancements to those 
processes.
    One of the GAO's major findings is that institutions failed to 
adequately test for the effects of a severe economic downturn scenario. 
As I have discussed, we agree that the events of the past 18 months 
have underscored the need for improved and more robust stress testing. 
Banks' stress tests need to more fully incorporate potential 
interconnection risks across products, business lines and markets, and 
evaluate such exposures under extreme tail-events. The OCC was actively 
involved in developing the January 2009 report issued by the Basel 
Committee cited by the GAO. Indeed, many of the findings and 
recommendations in that report were drawn from our findings and work in 
our large banking institutions. We will be working with these 
institutions to ensure that they incorporate those recommendations into 
their stress testing processes.
Conclusion
    The events of the past 18 months have highlighted and reinforced 
the need for effective risk management programs and revealed areas 
where improvements are needed. I believe the OCC and the banking 
industry are taking appropriate steps to implement needed changes. I 
also believe that these events have demonstrated the strength of the 
OCC's large bank supervision program. Throughout the recent market 
turmoil, our resident examination staffs at the largest institutions 
have had daily contact with the business and risk managers of those 
institutions' funding, trading, and lending areas to enable close 
monitoring of market conditions, deal flow and funding availability. 
Their insights and on-the-ground market intelligence have been critical 
in helping to assess appropriate policy and supervisory responses as 
market events have continued to unfold. Indeed, I believe that the 
OCC's large bank supervision program, with its centralized oversight 
from Washington D.C., and highly experienced resident teams of bank 
examiners and risk specialists, is the most effective means of 
supervising large, globally active financial firms.

Statement Required by 12 U.S.C. Sec.  250: The views expressed herein 
are those of the Office of the Comptroller of the Currency and do not 
necessarily represent the views of the President.
                                 ______
                                 
                PREPARED STATEMENT OF SCOTT M. POLAKOFF
             Acting Director, Office of Thrift Supervision
                             March 18, 2009
I. Introduction
    Good afternoon Chairman Reed, Ranking Member Bunning and members of 
the Subcommittee. Thank you for inviting me to testify on behalf of the 
Office of Thrift Supervision (OTS) on how the Federal financial 
regulators conduct oversight of risk management. I appreciate the 
opportunity to familiarize the Subcommittee with several critical risk 
management areas and how OTS has revised its supervisory oversight 
based on lessons learned. I also appreciate the opportunity to comment 
on the state of risk management in the financial services industry and 
OTS's recommendations for improving regulatory oversight and 
cooperation.
    In my testimony, I will discuss critical risk management areas that 
led to the failure or near-failure of an array of financial 
institutions. I will provide examples of the lessons learned and the 
actions that OTS has taken to revise industry and examiner guidance to 
ensure effective and efficient regulation. I will also describe risk 
management areas that warrant close supervision and provide OTS's 
perspective on how to proceed. My discussion will focus on five primary 
risk areas that played roles in the economic crisis: concentration 
risk, liquidity risk, capital adequacy, loan loss provisioning and fair 
value accounting.
II. Overview of OTS-regulated Entities
    I would like to begin with an overview of the thrift industry. At 
the end of 2008, OTS supervised 810 savings associations with total 
assets of $1.2 trillion and 463 holding company enterprises with 
approximately $6.1 trillion in U.S. domiciled consolidated assets. The 
majority of savings associations (97.2 percent) exceed well capitalized 
regulatory standards with combined assets that represent 95.3 percent 
of industry aggregate assets.
    Recent increases in problem assets have resulted primarily from the 
housing market downturn and rising unemployment. In December 2008, 
troubled assets (noncurrent loans and repossessed assets) rose to 2.52 
percent of assets, up from 1.66 percent a year ago. The current level 
of troubled assets is the highest since the early 1990s, when it 
reached 3.74 percent; however, the composition is quite different. 
While one- to four-family mortgage loans are traditionally lower-risk, 
they currently account for about 72 percent of the thrift industry's 
troubled assets. Economic problems are spreading to commercial real 
estate (nonresidential mortgage, multifamily and construction loans), 
which now account for 20 percent of the troubled assets. In contrast, 
68 percent of troubled assets in 1990 were commercial real estate 
loans. One- to four-family mortgages accounted for 23 percent of 
troubled assets.
    The prominence of residential mortgage loans among troubled assets 
requires a strong commitment to effective loan modification programs. 
OTS is collaborating with the Office of the Comptroller of the Currency 
to produce a quarterly Mortgage Metrics Report that analyzes 
performance data of first-lien residential mortgage loans serviced by 
federally regulated savings associations and national banks. The 
agencies are finalizing the report for the fourth quarter of 2008. The 
goal is to provide a comprehensive picture of mortgage servicing 
activities of the industry's largest mortgage servicers. This report 
includes data on mortgage delinquency rates, home retention actions and 
foreclosures. The fourth quarter report will include granular 
information to measure the effectiveness of loan modifications and new 
data on the affordability and sustainability of loan modifications.
    Preliminary analysis from the fourth quarter Mortgage Metrics 
Report indicates that credit quality continues to deteriorate, 
resulting in increased delinquencies and early payment defaults. 
However, home retention efforts, including loan modifications and 
payment plans, continue to increase. The fourth quarter report analyzes 
modifications based on four categories of payment modification. The two 
categories that lower the borrower's monthly payment are the most 
successful in improving affordability and sustainability. Servicers 
have increased use of these types of loan modifications, which is 
leading to fewer foreclosures.
    The number of problem thrifts has risen over the past year. OTS 
defines problem institutions as those with the two lowest composite 
safety-and-soundness exam ratings of ``4'' or ``5.'' There were 26 
problem thrifts representing 3.2 percent of all thrifts at the end of 
the year. This is more than double from year-end 2007, when OTS 
reported 11 problem institutions. One common measurement of capital 
strength in an unstable economic period is the ratio of tangible common 
equity capital to tangible assets. The ratio is stable for savings 
associations, measuring 7.61 percent at the end of 2008. This 
measurement remains close to the 9-year average of 7.70 percent.
    Focusing attention on core earnings is another method to assess the 
strength of insured depository institutions while eliminating volatile 
items. Core earnings measures exclude one-time events such as branch 
sale gains or acquisition charges. They also exclude charges for 
provisions for loan losses, which is a major reason for the losses by 
savings associations. The thrift industry's operating earnings remained 
stable and measured 1.39 percent of average assets in 2008. This is 
consistent with operating earnings of 1.37 percent and 1.34 percent for 
2007 and 2006, respectively. Although a focus remains on problem banks 
and the deteriorating mortgage market, the vast majority of insured 
financial institutions maintain solid capital, sufficient loan loss 
reserves, stable operating earnings and effective risk management.
III. Critical Risk Areas
    OTS has learned multiple lessons during this economic cycle and has 
used this knowledge to refine and improve its regulatory program. The 
agency conducts independent internal failed bank reviews for savings 
associations placed in receivership and generates a series of 
recommended actions to supplement and improve its regulatory oversight. 
Upon finalizing each review, senior managers distribute internal 
guidance identifying lessons learned to improve examiners' focus on 
critical risk management areas. OTS also committed to implementing the 
recommendations derived from the Material Loss Review reports from the 
Office of the Inspector General. The agency has made substantial 
progress in implementing recommended actions to improve regulatory 
oversight.
    The OTS closely monitors--in some cases participates in--and 
responds to risk management recommendations by the Senior Supervisors 
Group report on Risk Management Practices, the Financial Stability 
Forum's report on enhancing market and institutional resilience, the 
Basel Joint Forum's report on the identification and management of risk 
concentrations, and the Government Accountability Office report on 
regulatory oversight of risk management systems. The agency reviews 
these reports and integrates their findings when revising regulatory 
guidance and examination programs. OTS participated on the Joint Forum 
working group that produced the report on risk concentrations. Several 
of the report's recommendations derive from OTS's expertise in 
supervising or regulating financial institutions ranging from community 
banks to international conglomerates. All of the Federal banking 
agencies are members of the international Basel Committee on Banking 
Supervision, which comprises banking supervisors worldwide. The Basel 
Committee on Banking Supervision provides an international forum to 
collaborate and improve the quality of bank supervision.
    Managing compliance with consumer protection laws is also a 
critical element of effective enterprise risk management and is a focus 
of OTS's supervisory oversight of risk management. OTS requires sound 
compliance risk management programs in all savings associations. 
Excessive compliance risk can harm consumers, diminish a savings 
association's reputation, reduce its franchise value and limit its 
business opportunities. It can also expose a financial institution to 
supervisory enforcement action and litigation.
    OTS expects the sophistication of a savings association's risk 
management program to be appropriate for the size and complexity of the 
financial institution. OTS places responsibility on a financial 
institution's Board of Directors for understanding, prescribing limits 
on and monitoring all risk areas. Traditionally, financial institutions 
have managed their operations by organizational unit or legal entity 
rather than from a holistic, enterprise-wide risk management 
perspective. However, financial institutions are shifting their focus 
toward enterprise-wide risk management structures. This transition from 
a silo-based risk management function to horizontal risk management 
across business lines is an appropriate evolution. One of the lessons 
of the current crisis and a key recommendation of each of the risk 
management reports mentioned above is that financial institutions must 
be aware of how risk concentrations and business activities interrelate 
throughout the organization. Regulators, in turn, must identify 
weaknesses in enterprise risk management and ensure that boards of 
directors take prompt action to correct the deficiencies.
    OTS communicates refinements in its supervisory program to 
examiners, Chief Executive Officers, Board members and industry groups 
through examination handbooks, official correspondence, outreach 
meetings, and other internal and external issuances. Based on the 
knowledge we have gained through horizontal reviews of OTS-regulated 
financial institutions, cooperation with domestic and international 
financial regulators, routine examination and supervision of savings 
associations and their holding companies, and failed bank reviews, the 
agency has identified several key risk management areas for discussion.
Concentration Risk
    Poorly managed concentration risk contributed significantly to the 
deterioration in performance of several OTS-regulated problem banks. 
Concentrations are groups of assets or liabilities that have similar 
characteristics and expose a financial institution to one or more 
closely related risks. OTS defines a concentration as an asset, 
liability, or off-balance sheet exposure that exceeds 25 percent of the 
association's core capital, plus allowances for loan and lease losses. 
The agency encourages its examiners to use discretion in identifying 
higher-risk assets or liabilities that may not meet this threshold, but 
still pose a concentration risk. OTS also encourages financial 
institutions' Boards of Directors to approve limits and monitor 
concentrations based on their exposure relative to Tier 1 capital and 
allowances for loan and lease losses.
    Concentrations pose risk because the same economic, political, 
geographic, or other factors can negatively affect the entire group of 
assets or liabilities. The financial industry and the regulatory 
community have learned a valuable lesson about the risk exposure of 
asset, liability and off-balance sheet concentrations. Institutions 
with concentrations need to manage the risk of individual assets or 
liabilities, as well as the risk of the whole group. For example, an 
institution may have a portfolio of prudently underwritten loans 
located in a single geographic location. The geographic concentration 
exposes otherwise prudent loans to the risk of loss because a single 
regional economic event can expose the entire portfolio to losses. If 
the institution does not appropriately manage its geographic lending 
activity through size, sector and counterparty limits, then it has 
heightened risk exposure. Management should regularly evaluate the 
degree of correlation between related assets or liabilities, and 
establish internal guidelines and concentration limits that control the 
institution's risk exposure.
    The Basel Committee on Banking Supervision Joint Forum's paper on 
concentration risk surveyed and summarized concentration risk 
management among financial conglomerates. While its focus was on 
financial conglomerates, the principles of concentration risk it 
identified are applicable to all financial institutions. It suggests 
that concentration risk has three elements. The first element of 
concentration risk is materiality. Financial institutions must identify 
whether the risk concentration can produce losses that threaten their 
health or ability to maintain their core operations. They must also 
determine whether an interruption in the concentrated business activity 
would lead to a material change in their risk profile. The second 
element is the identification of single, or closely related, drivers of 
risk that may affect each part of the institution differently. 
Effective risk management requires that the impact of these drivers be 
integrated into any analysis to assess the overall risk exposure of the 
institution. The third element is that risk concentrations arise not 
just in assets, but also in liabilities, off-balance sheet items, or 
through the execution or processing of transactions.
    OTS captures each of these elements in its supervisory program and 
requires examiners to document concentrations of assets, liabilities 
and off-balance sheet activity in each comprehensive examination 
report. The agency is acutely aware of the risk that a concentration 
can pose to an institution, whether the concentration arises from a 
business strategy, a product type, or a funding program. OTS guidelines 
recommend establishing limits based on a ratio of the asset, liability, 
or off-balance sheet item to core capital and allowances for loan and 
lease losses. In many cases, OTS places limitations on the amount of 
assets, liabilities, or other activities that expose the institution to 
concentration risk. Firms should also have additional capital as a 
buffer against the larger loss potential that a concentration can 
present. The agency also has expectations that savings associations 
with high concentration risk establish robust risk management practices 
to identify, measure, monitor and control the risk.
    A key concentration risk that OTS identified in the current crisis 
is the risk exposure of warehouse and pipeline loans in financial 
institutions that engage in an originate-to-sell business model during 
stressful market events. In response, OTS updated its one- to four-
family real estate lending examination handbook in September 2008. The 
agency also distributed a letter to Chief Executive Officers outlining 
revised recommendations for monitoring and managing the level of 
pipeline, warehouse and credit-enhancing repurchase exposure for 
mortgage loans originated for sale to nongovernment sponsored 
purchasers. In the letter, OTS states that any concentration that 
exceeds 100 percent of Tier 1 capital will receive closer supervisory 
review. This revised guidance was in response to the lessons learned 
from recent bank failures and a horizontal review of all OTS 
institutions to assess the examination and supervision of mortgage 
banking activity.
    Another example of the regulatory expectations for concentration 
risk management is the 2006 guidance on managing commercial real estate 
concentration risk. The guidance applied to savings associations 
actively engaged in commercial real estate (CRE) lending, especially 
those that are entering or rapidly expanding CRE lending. The guidance 
states that institutions should perform a self-assessment of exposure 
to concentration risk. They should continually monitor potential risk 
exposure and report identified concentration risk to senior management 
and the board of directors. The guidance also recommends implementing 
risk management policies and procedures to monitor and manage 
concentration risk based on the size of the portfolio and the level and 
nature of concentrations.
    The OTS expects savings associations to continually assess and 
manage concentration risk. OTS conducts quarterly monitoring of savings 
associations' investments to determine compliance with portfolio 
limitations and to assess each association's exposure to concentration 
risk. An institution should hold capital commensurate with the level 
and nature of its risk exposure. Accordingly, savings associations with 
mortgage banking or commercial real estate concentration exposure 
should assess the credit risk, operational risk and concentration risk 
of those business activities. In assessing the adequacy of an 
institution's capital, OTS also considers management expertise, 
historical performance, underwriting standards, risk management 
practices and market conditions.
    By the nature of the thrift charter, savings associations are 
required to hold a concentration in real estate mortgage or consumer 
lending-related assets. OTS-regulated savings associations are subject 
to two distinct statutory restrictions on their assets, which 
contribute to this inherent concentration in mortgage lending. The 
first is a requirement that thrifts hold 65 percent of their assets in 
qualified thrift investments. This ensures that thrifts maintain a 
focus on mortgage and retail consumer lending activities. The second 
set of restrictions includes limitations on the ability of savings 
associations to engage in specific lending activities, including 
consumer, commercial and small business lending.
    Although there is merit for maintaining restrictions to ensure that 
savings associations focus on mortgage and retail consumer and 
community lending activities consistent with the purpose of the thrift 
charter, certain asset restrictions contradict the purpose of the 
charter and compromise safety and soundness. For example, savings 
associations have no limits on credit card lending, an unsecured 
lending activity, but are limited to 35 percent of their assets in 
secured consumer lending activities. This has the clearly unintended 
effect of promoting unsecured consumer lending activities over secured 
consumer lending. Similarly, the existing 20 percent of assets limit on 
small business lending discourages thrifts from pursuing business 
activities that could diversify their lending operations and credit 
risk.
    The OTS has offered several legislative proposals to address these 
shortcomings, while maintaining the thrift charter's focus on consumer 
and community lending. These increases would strengthen OTS-regulated 
institutions by further diversifying their business lines and would 
increase the availability of credit in local communities. Small 
business lending is a key to economic growth and recovery, particularly 
in low- and moderate-income areas.
Liquidity Risk
    Another risk management area that requires additional focus is 
liquidity risk. OTS and the other U.S. banking agencies published 
interagency guidance that required institutions to develop a 
comprehensive liquidity risk management program. As articulated in this 
interagency guidance, a sound liquidity risk management program 
includes clearly written policies, well-defined responsibilities, 
strong management information systems, sound forecasting and analysis, 
thoughtful contingency planning, scenario analyses, and diversification 
and management of funding sources.
    Recent events illustrate that liquidity risk management at many 
insured depository institutions needs improvement to comply with this 
guidance. Deficiencies include insufficient holdings of liquid assets, 
funding risky or illiquid asset portfolios with potentially volatile 
short-term liabilities, insufficient cash-flow projections and a lack 
of viable contingency funding plans. The current crisis also identified 
areas where it is necessary to strengthen supervisory guidance and 
oversight. In mid 2007, the secondary mortgage markets began showing 
signs of stress as investor appetite for non-conforming mortgages 
greatly diminished. Many large institutions that relied on the 
originate-to-distribute model were trapped by the speed and magnitude 
of market liquidity evaporation. As the size of their mortgage 
warehouse ballooned, lenders and depositors became increasingly 
concerned about the financial health and long-term viability of these 
organizations. Those institutions that had a strong contingency funding 
strategy were able to find temporary relief until they could develop 
longer-term solutions.
    OTS is working with the other U.S. banking agencies to issue 
updated interagency guidance on funding liquidity risk management. The 
revised guidance will incorporate the recent lessons learned and the 
liquidity guidance issued by the Basel Committee on Banking 
Supervision. As part of this guidance, the agencies will reiterate the 
need for diversified funding sources, stress testing and an 
unencumbered cushion of highly liquid assets that are readily available 
and are not pledged to payment systems or clearing houses. This 
increased emphasis on high-quality liquid assets is important because 
many firms had a misconception about the extent to which decreases in 
market and funding liquidity are mutually reinforcing. As market 
liquidity erodes, so does the availability of funding. The regulatory 
agencies plan to release the revised guidance with a notice for public 
comment the first half of 2009.
    OTS is also strengthening its examination and supervision of 
savings associations with high-risk business models or reliance on 
volatile funding sources. In some cases, OTS is obtaining daily 
liquidity monitoring reports from financial institutions to identify 
cash in-flows and out-flows and the availability of unpledged 
collateral. We are also stressing the need for institutions to test the 
actual availability of lines of credit and to work actively with their 
respective Federal Home Loan Banks to ensure sufficient borrowing 
capacity. OTS is also conducting a review of liquidity risk management 
to identify best practices and issue guidance to savings associations. 
The agency is using the review to develop additional liquidity metrics 
as a tool for examiners to use to identify institutions with developing 
liquidity problems.
Capital Adequacy
    OTS and the other Federal banking agencies agree that capital 
adequacy is a central component of safe and sound banking. Capital 
absorbs losses, promotes public confidence and provides protection to 
the deposit insurance fund. It provides a financial cushion for a 
financial institution to continue operating during adverse events. OTS 
has learned important lessons about how the capital adequacy rules work 
in a broad economic downturn and when financial systems are stressed 
primarily because of systemic events, including the deterioration in 
values of entire asset classes.
    This crisis underscores the critical importance of prudent 
underwriting for every loan. The risk of home loans varies depending 
upon factors, such as the loan-to-value, borrower creditworthiness, 
loan terms and other underwriting factors. Yet the risk-based capital 
requirements do not adequately address the varying levels of risk in 
different types of home loans. The existing risk-based capital rules 
treat almost all home loans as having similar risk and assign most of 
them a 50 percent risk weight, which effectively requires $4 of capital 
for every $100 dollars of asset value. A more sensitive risk-based 
capital framework with meaningful risk drivers should encourage Federal 
depositories to make fewer higher-risk mortgage loans, or to support 
higher-risk lending activity with a more realistic capital cushion.
    Among the capital tools available to a supervisor in an environment 
of financial stress is the early intervention authority under Section 
38 of the Federal Deposit Insurance Act, known as Prompt Corrective 
Action (PCA). The purpose of PCA statutory authority was to require and 
enable supervisory intervention before an institution becomes 
critically undercapitalized. PCA is triggered by an institution's 
capital category, as defined in 12 USC Sec.  1831o and 12 CFR Part 565. 
Depending on an institution's PCA capital category, the statute 
automatically imposes certain restrictions and actions. The 
restrictions begin once an institution falls below the well-capitalized 
category. In addition to the automatic restrictions, there are other 
discretionary PCA actions. The expectation is that banking agencies 
must apply progressively significant restrictions on operations as an 
institution's capital category declines.
    To be effective, supervisory intervention must be timely when an 
institution is experiencing a rapid and severe deterioration in its 
financial condition. However, because PCA is linked to declining 
capital categories, we have learned that its utility is limited in a 
liquidity crisis, particularly when the crisis is widespread. We have 
witnessed severe and rapid declines in the financial condition of well 
or adequately capitalized institutions that were precipitated by an 
inability to meet rapid, sustained deposit outflows or other cash and 
collateral demands. In the current crisis, PCA has not been an 
effective supervisory tool because its triggers for supervisory action 
are capital-driven. Extraordinary liquidity demands typically do not 
produce the gradual erosion of capital envisioned by PCA. It is 
possible to modernize the PCA framework to link the PCA system to other 
risk areas.
    Liquidity and funding problems can stem from a lack of investor 
confidence in an institution's financial condition. In the current 
environment, this may also stem from a lack of confidence in balance 
sheets of financial institutions and a belief that there is 
insufficient transparency. While institutions report well-capitalized 
ratios, investors are questioning the value of those ratios under 
extreme financial stress when it is difficult to value assets. Some 
have also questioned the quantity and quality of capital and the 
validity of capital buffers in stressful periods. The economic crisis 
demonstrates the interrelationship of portfolio risk, liquidity, risk-
based capital rules and PCA. The Agencies will continue to review our 
rules in light of these lessons learned.
    OTS and the other Federal banking agencies finalized the Basel II 
advanced capital adequacy rules, which establish a capital requirement 
that increases proportionally with loan risk. The advanced rules are 
mandatory only for the largest financial institutions in the United 
States, in part due to the complexity of measuring risk and assigning 
commensurate capital requirements, often requiring a models-based 
approach. Due to this complexity, implementation of the advanced Basel 
II rules will take several years.
    The Agencies have also developed a proposal for a standardized 
risk-based capital adequacy framework that is simpler than the advanced 
rule, yet more risk sensitive than the existing framework for home 
mortgages. If this voluntary framework is finalized in its current 
form, no one knows how many institutions would adopt it, but most of 
the banking industry would likely not choose it. The Agencies proposed 
these new standardized rules in 2008, but based on recent lessons 
learned, the proposal needs further improvement. OTS supports expanding 
the risk-based capital refinements in the proposed rule and extending 
capital modernization to all Federal depositories.
    In designing the Basel II capital adequacy framework, the Basel 
Committee intended for Basel II to be a ``living framework.'' As part 
of its strategic response to address weaknesses revealed by the 
financial market crisis, the Basel Committee has reviewed the Basel II 
capital adequacy framework and has developed and published for comment 
a series of proposed enhancements to strengthen the framework. The 
Basel Committee has also just announced it is developing a combination 
of measures to strengthen the level of capital in the banking system to 
increase resilience to future episodes of economic stress. It plans to 
introduce standards to increase capital buffers for stress events and 
to strengthen the quality of bank capital. The Committee also announced 
that it would review the regulatory minimum level of capital to arrive 
at a higher level than the current Basel II framework. OTS and the 
other Agencies continue our work with other Basel Committee members to 
evaluate the financial crisis and refine our rules.
Loan Loss Provision
    Another area that deserves attention because of the rapid 
deterioration in credit quality is the adequacy of allowances for loan 
and lease losses (ALLL). Economic weakness and uncertainty of the 
timing of the economic recovery require elevated levels of loan loss 
reserves. Savings associations responded to this environment and 
outlook by significantly bolstering their ALLL. In the fourth quarter, 
savings associations added $8.7 billion to loan loss provisions, 
bringing the total additions to a record $38.7 billion for the year. 
These substantial loan loss provisions increased the ratio of loss 
reserves to total loans and leases 63 percent, from 1.10 percent 1 year 
ago to 1.79 percent at the end of 2008.
    Because financial institutions build loan loss reserves through 
charges to earnings, these substantial loss provision expenses are 
driving industry net losses. The large provision for losses in the 
fourth quarter resulted in a net loss of $3 billion, or an annualized 
return on average assets (ROA) of negative 1.02 percent. The record 
annual provision drove the industry's loss to a record for all of 2008 
of $13.4 billion, or an ROA of negative 1.00 percent. Loss provisioning 
will continue to dampen industry earnings until home prices stabilize, 
job market losses slow and the employment outlook improves.
    On September 30, 2008, OTS issued guidance to its examiners and 
other supervision staff members about the allowance for loan losses. 
The purpose of the guidance was to highlight best practices for savings 
associations. This guidance discussed inflection points, or periods of 
increasing or decreasing losses, the use of lagging data when loss 
rates change quickly, and validation methods that rely on leading data 
rather than historical loss experience.
    Institutions rely on the 2006 interagency guidance, ``Interagency 
Policy Statement on the Allowance for Loan and Lease Losses and 
supplemental Questions and Answers on Accounting for Loan and Lease 
Losses,'' to manage loan loss provisions. This guidance uses the 
Generally Accepted Accounting Principles' incurred loss model for 
assessing losses and establishing reserves. When there is a significant 
economic downturn following an extended period of positive economic 
performance, the incurred loss model may result in insufficient loan 
loss allowances and the need for substantial increases. OTS supports 
refining the current accounting model to one based on expected credit 
losses for the life of the loan. An expected loss model will result in 
more robust allowances throughout the credit cycle to absorb all 
expected charge-offs as they occur over the life of the loan, without 
regard to the economic environment. The expected loss model would not 
eliminate pro-cyclicality, but it would allow for earlier recognition 
of loan losses.
Fair Value Accounting
    Many have blamed the current economic crisis on the use of ``mark-
to-market'' accounting. Some assert that this accounting model 
contributes to pro-cyclicality or 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. In order to increase regulatory capital ratios, 
those institutions de-leverage by selling assets into stressed, 
illiquid markets. This triggers a cycle of additional sales at 
depressed prices and results in further write-downs by institutions 
holding similar assets.
    The term ``mark-to-market'' can be misleading. Thrifts carry less 
than 5 percent of their assets at market value, with gains and losses 
recognized in earnings and regulatory capital. These include trading 
assets, derivatives and financial instruments for which the thrift has 
voluntarily elected the fair-value option. We believe it is appropriate 
to report these assets at fair value because financial institutions 
manage them, or should manage them, on a fair-value basis.
    Fair value accounting requires the recognition in earnings and 
regulatory capital of significant declines in the fair value of 
investment securities, including mortgage backed securities. Fair value 
determinations are more challenging when the markets are illiquid. 
Financial institutions find it difficult to determine fair value 
because there is a lack of trades of identical or similar securities. 
The result is that institutions must rely on models and assumptions to 
estimate fair value. The OTS supports disclosure of the assumptions 
used to estimate fair value. Increased transparency would improve 
confidence in the fair value adjustment.
    The Securities and Exchange Commission (SEC), in its Report and 
Recommendations Pursuant to Section 133 of the Emergency Economic 
Stabilization Act of 2008: Study on Mark-To-Market Accounting, stated 
that fair value accounting did not play a meaningful role in bank 
failures in 2008. The SEC staff concluded that U.S. bank failures 
resulted from growing probable credit losses, concerns about asset 
quality and, in certain cases, eroding lender and investor confidence. 
The report also concluded that for the failed banks that did recognize 
sizable fair-value losses, the reporting of these losses was not the 
reason the bank failed.
    OTS believes that refining fair value accounting is a better 
approach than suspending it. It is possible to improve the accounting 
standards to respond to both those who insist fair value accounting 
should continue and those that call for its suspension.
    The most significant fair value issue facing savings associations 
relates to nontrading investment securities. Non-trading investment 
securities are those the institution designates as available-for-sale 
or held-to-maturity. The concept of ``other-than-temporary impairment'' 
(or OTTI) is the primary area of concern. Accounting standards call for 
different impairment (loss) recognition models, based on whether an 
asset is a loan or a security. Loan impairment reflects only credit 
losses. The measure of impairment of debt securities is fair value. In 
the current market, fair value can include recognition of significant 
additional losses because of illiquidity and other non-credit losses 
that may be temporary. This discrepancy, although largely overlooked in 
the past, is at the center of the debate about fair value accounting 
because the non-credit components of fair value losses in some cases 
represent the majority of the loss amount.
    OTS supports an alternative to the current mark-to-market 
accounting model that is gaining recognition through recent roundtable 
discussions on accounting standards. The Center for Audit Quality 
recommended this alternative approach to the SEC in its November 13, 
2008 letter responding to the SEC's study of mark-to-market accounting. 
The proposed alternative would identify and clarify the components of 
fair value and improve the application and practice of the fair value 
accounting standards. Fair value estimates incorporate numerous 
observable data, such as the credit worthiness and paying capacity of 
the debtor, changes in interest rates and the volume of market 
liquidity.
    Under the proposed alternative accounting treatment, financial 
institutions would continue to report impaired investment securities at 
fair value. They would separate impairment losses into two components: 
credit and non-credit. They would continue to report the credit 
component as a reduction of earnings, but they would report the 
noncredit component as a direct reduction of equity. The significant 
result of this alternative accounting treatment is that only the credit 
loss portion would immediately reduce regulatory capital. It would also 
mitigate the effects of temporary market volatility on earnings. The 
non-credit component would result in a direct reduction in equity, but 
would not reduce earnings or regulatory capital unless the institution 
sells the security and realizes the loss. The credit component consists 
of probable declines in expected cash-flows. These declines represent a 
loss of contractual or estimated cash-flows anticipated by an investor, 
and should reduce earnings and regulatory capital immediately.
    OTS believes that this recommendation to recognize the credit loss 
component of the OTTI impairment through earnings improves the 
application of the fair value accounting standards. This improvement in 
the accounting standards will align the recognition of impairment for 
loans and securities more closely. Financial institutions already 
record an allowance for loan loss based only on the credit impairment. 
Because many investment securities held by financial institutions are 
mortgage- or asset-backed securities, it is reasonable to use a similar 
model to recognize losses on debt securities.
    Investor panic to sell certain investments immediately rather than 
take a longer-term view of their underlying value has exacerbated 
current market conditions. The desire to stop the decline in fair value 
fuels these sales because of the current OTTI accounting requirements. 
Bifurcation of the fair value components will permit investors to take 
a longer-term view of investments, by only recognizing declines in 
expected cash-flows in earnings. Other components of fair value 
adjustments will be reported in a separate section of equity. When 
markets return to normalized activity, financial institutions can 
recover these components.
IV. Regulatory Restructuring
    Lessons learned on risk management are helping to guide OTS's 
position on regulatory restructuring. The events of the past several 
years have reinforced the need for a review of the framework for the 
regulatory oversight of financial services firms of all types. The 
importance of ensuring consistent regulation for similar products 
regardless of the issuer or originator has become evident, whether the 
product is a mortgage loan or a complex commercial instrument. One of 
the goals of creating a new framework should be to ensure scrutiny of 
all bank products, services and activities. There should be consistent 
regulation and supervision of every entity that provides bank-like 
products, services and activities, whether or not it is an insured 
depository institution. The ``shadow bank system,'' where bank or bank-
like products are offered by nonbanks, should be subject to the same 
rigorous standards as banks.
    As one element of regulatory modernization, OTS recommends 
subjecting unevenly regulated or under-regulated mortgage brokers and 
independent mortgage companies to the same regulatory, supervisory and 
enforcement regime as insured institutions offering the same products.
    Another important element in regulatory modernization is 
establishing a systemic risk regulator. 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. 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.
V. Conclusion
    Effective enterprise risk management, commensurate with the size 
and complexity of a financial institution's operations, is paramount. 
The lessons learned from this economic cycle support this conclusion. A 
holistic approach to identifying, assessing and managing risk is 
relevant not only for financial institutions, but also for the 
regulatory environment. The interdependency of each risk area warrants 
a comprehensive solution from financial institutions and the agencies 
that regulate them.
    Thank you, Mr. Chairman, Ranking Member Bunning and members of the 
Subcommittee for the opportunity to testify on risk management and the 
steps that OTS is taking to adjust its examinations based on the 
lessons learned during the economic crisis.
    Concentration risk, liquidity risk, capital adequacy, allowances 
for loan and lease losses and fair value accounting are critical areas 
where risk management deficiencies contributed to the recent turmoil. 
OTS is committed to refining and improving its oversight to ensure that 
financial institutions adopt stronger risk management programs.
                                 ______
                                 
                    PREPARED STATEMENT OF ERIK SIRRI
               Director, Division of Trading and Markets,
                   Securities and Exchange Commission
                             March 18, 2009
    Chairman Reed, Ranking Member Bunning, and Members of the 
Subcommittee:

    I am pleased to have the opportunity today to testify concerning 
the insights gained from the SEC's long history of regulating the 
financial responsibility of broker-dealers and protecting customer 
funds and securities.
    The turmoil in the global financial system is unprecedented and has 
tested not only the resiliency of financial institutions, but also the 
assumptions underpinning many financial regulatory programs. I have 
testified previously that the deterioration in mortgages spread to the 
capital markets through securitization, and to related derivative and 
insurance products. The knock-on effects broadened and deepened beyond 
those entities that deal in mortgages and mortgage-related financial 
products, including investment and commercial banks, insurance 
companies, and government sponsored enterprises, and finally to 
operating companies.
    Market participants relied on the thriving securitization process 
to disperse risk and provide more private capital raising and investing 
opportunities for investors, but as we have learned that process did 
not eliminate or, in many cases, even reduce risk. Ultimately, the 
growing size and dispersion of risk, combined with deteriorating 
markets, has made clear to regulators the need for greater transparency 
and stronger risk management controls for financial institutions of all 
kinds. I believe, however, that hearings such as this one, where 
supervisors reflect on and share their experiences from this past year 
will enhance our collective efforts to continue to improve the risk 
management oversight of complex financial institutions.
The CSE Program and BD Financial Responsibility
    Some changes in the capital markets and the broader economy have 
presented new challenges that are rightly the subject of Congressional 
review, notwithstanding the current regulatory system's long record of 
accomplishment. The point is, we don't need to start from scratch. 
Instead, we should build on and strengthen what has worked, while 
taking lessons from what hasn't worked in order to adjust the current 
system to update our regulatory system to fit modern market practices, 
products, and conditions.
    Beginning in 2004, the SEC supervised five entities with large U.S. 
securities firms as subsidiaries on a consolidated basis, specifically, 
Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers and Bear 
Stearns. For such firms, known as consolidated supervised entities or 
``CSEs,'' the Commission oversaw not only the U.S. registered broker-
dealer, but also the holding company and all affiliates on a 
consolidated basis. The registered broker-dealers that were the core 
regulated entities within the CSE groups were supervised by staff both 
at the SEC and at the primary self-regulatory organization (SRO), 
FINRA--a system akin to bank supervision at the depository institution 
level as well as the holding company level. It should be noted that the 
U.S. broker-dealer subsidiaries of the CSE firms at all times during 
this credit crisis remained solvent and adequately capitalized.
     The CSE program was designed to be broadly consistent with Federal 
Reserve oversight of bank holding companies. Of note, the use of the 
Basel Standard to regulate holding companies of the broker dealer did 
not result in a diminution of capital at the broker-dealer. First, 
broker-dealers had to maintain a minimum of $5 billion tentative net 
capital to qualify for the calculation. Although phrased as an early 
warning level, the ``5 billion'' was and remained a hard limit. No firm 
fell below this requirement. The CSE regime was also tailored to 
reflect two fundamental differences between investment bank and 
commercial bank holding companies. First, the CSE regime reflected the 
reliance of securities firms on fair value, and where possible, mark-
to-market accounting as a critical risk and governance control.\1\ 
Second, the CSE program requirements as to liquidity are explained 
below. Whereas commercial banks may use insured deposits to fund their 
businesses and have access to the Federal Reserve as a backstop 
liquidity provider, the CSE firms were prohibited, under SEC rules, 
from financing their investment bank activities with customer funds or 
fully paid securities held in a broker-dealer. Moreover, the SEC had no 
ability to provide a liquidity backstop to CSEs.
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    \1\ Hereafter the terms ``fair value'' and ``mark-to-market'' are 
used interchangeably.
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     The CSE program had five principal components: First, CSE holding 
companies were required to maintain and document a system of internal 
controls that had to be approved by the Commission at the time of 
initial application. Second, before approval and on an ongoing basis, 
the Commission staff examined the implementation of these controls. 
Third, CSEs were monitored for financial and operational weakness that 
might place regulated entities within the group or the broader 
financial system at risk. Fourth, CSEs were required to compute a 
capital adequacy measure at the holding company level that is 
consistent with standards set forth by the Basel Committee on Banking 
Supervision (Basel Committee). Finally, CSEs were required to perform 
stress tests on the liquidity computation and maintain significant 
liquidity pools at the holding company, for use in any regulated or 
unregulated entity within the group without regulatory restriction.
     To monitor the implementation of firms' internal controls, the CSE 
program leveraged the firms' internal audit functions, among other 
things. Our staff met regularly with internal auditors to review and 
explore issues identified by their risk assessment and audit program. 
The Commission's rules for CSEs required internal auditors to review 
the functioning of major governance committees and all internal risk 
control functions and represent in writing to the SEC annually that 
this work has been done, with the results presented to the external 
auditor and the audit committee of the Board of Directors. Also, as 
circumstances required, or as risk management issues arose, senior 
officers of the SEC met with CEOs, CFOs, and other members of the 
firm's senior management to raise issues for focus and resolution.
    The CSE program also included examination of and monitoring for key 
risk control areas, in particular market, credit, liquidity, and 
operational risk. The holding company was required to provide the 
Commission on a periodic basis with extensive information regarding its 
capital and risk exposures, including market, credit, and liquidity 
risk. SEC staff met monthly with CSE firm risk managers and other 
personnel to review and discuss this information.
    Two fundamental components of the CSE program deserve special 
attention: capital and liquidity. In electing to operate under the CSE 
program, the holding company was required, among other things, to 
compute on a monthly basis its group-wide capital in accordance with 
the Basel standards. CSEs were expected to maintain an overall Basel 
capital ratio at the consolidated level of not less than the Federal 
Reserve Bank's 10 percent ``well-capitalized'' standard for bank 
holding companies. CSEs were also required to file an ``early warning'' 
notice with the SEC in the event that certain minimum thresholds, 
including the 10 percent capital ratio, were breached or were likely to 
be breached. Commission rules for CSEs permitted the parent holding 
company to calculate its capital adequacy using an approach consistent 
with either of the two Basel standards, adopted by the Basel Committee.
    Investment banks relied on the ongoing secured and unsecured credit 
markets for funding, rather than customer deposits; therefore liquidity 
and liquidity risk management were of critical importance. In 
particular, the Commission's rules required CSEs to maintain funding 
procedures designed to ensure that the holding company had sufficient 
stand-alone liquidity to withstand the complete loss of all sources of 
unsecured funding for at least 1 year. In addition, with respect to 
secured funding, these procedures incorporated a stress test that 
estimated what a prudent lender would lend on an asset under stressed 
market conditions (e.g., a haircut). Another premise of this liquidity 
planning was that any assets held in a regulated entity were 
unavailable for use outside of the entity to deal with weaknesses 
elsewhere in the holding company structure, based on the assumption 
that during the stress event, including a tightening of market 
liquidity, regulators in the U.S. and relevant foreign jurisdictions 
would not permit a withdrawal of capital. Thus, the liquidity pool at 
the holding company was comprised of unencumbered liquid assets.
    Beginning immediately in the wake of the Bear Stearns sale to 
JPMorgan Chase, the SEC broadly strengthened liquidity requirements for 
CSE firms. The Division of Trading and Markets, working with the 
Federal Reserve, implemented substantially more rigorous approaches to 
supervision of liquidity levels and liquidity risk management. We 
developed scenarios that were much more severe, including denial of 
access to short-term unsecured funding. Those more stringent scenarios 
assumed limited access to the Fed's discount window or other liquidity 
facilities, although in fact such facilities became available to the 
major investment banks. As a matter of prudence, the investment banks 
were urged to maintain capital and liquidity at levels far above what 
would be required under the standards themselves.
    The SEC scrutinized the secured funding activities of each CSE 
firm, and advised the establishment of additional term funding 
arrangements and a reduction of dependency on ``open'' and 
``overnight'' transactions. We also focused on the so-called matched 
book, a significant focus of secured funding activities within 
investment banks. We monitored closely potential mismatches between the 
``asset side,'' where positions are financed for customers, and the 
``liability side'' of the matched book, where positions are financed by 
other financial institutions and investors. Also, we discussed with CSE 
senior management their longer-term funding plans, including plans for 
raising new capital by accessing the equity and long-term debt markets.
Observations and Lessons
    The Bear Stearns and Lehman Brothers' experience as well as the 
continuing financial distress and government support of commercial 
banks and insurance companies has challenged a number of assumptions 
held by the SEC. We are working with other regulators to ensure that 
the proper lessons are derived from these experiences, and changes will 
continue to be made to the relevant regulatory processes to reflect 
those lessons. Long before the CSE program existed, the SEC's 
supervision of investment banks recognized that capital is not 
synonymous with liquidity that a firm could be highly capitalized--that 
is, it can have far more assets than liabilities--while also having 
liquidity problems. While the ability of a securities firm to withstand 
market, credit, and other types of stress events is linked to the 
amount of its capital, the firm also needs sufficient liquid assets--
cash, and high-quality instruments such as U.S. Treasury securities 
that can be used as collateral to meet its financial obligations as 
they arise.
    The CSE program built on this concept and required stress testing 
and substantial liquidity pools at the holding company to allow firms 
to continue to operate normally in stressed market environments. But 
what neither the CSE regulatory approach nor most existing regulatory 
models have taken into account was the possibility that secured 
funding, even that backed by high-quality collateral such as U.S. 
Treasury and agency securities, could become unavailable. The existing 
models for both commercial and investment banks are premised on the 
expectation that secured funding, would be available in any market 
environment, albeit perhaps on less favorable terms than normal.
    Thus, one lesson from the SEC's oversight of CSEs--Bear Stearns in 
particular--is that no parent company liquidity pool can withstand a 
``run on the bank.'' Supervisors simply did not anticipate that a run-
on-the-bank was indeed a real possibility for a well-capitalized 
securities firm with high quality assets to fund. Given that the 
liquidity pool was sized for the loss of unsecured funding for a year, 
such a liquidity pool would not suffice in an extended financial crisis 
of the magnitude we are now experiencing, where firms are taking 
significant writedowns on what have become illiquid assets over several 
quarters while the economy contracts. These liquidity constraints are 
exacerbated when clearing agencies seize sizable amounts of collateral 
or clearing deposits to protect themselves against intraday exposures 
to the firm. Thus, for financial institutions that rely on secured and 
unsecured funding for their business model, some modification, such as 
government backstop emergency liquidity support, may well be necessary 
to plug a liquidity gap on an interim basis, to guarantee assets over 
the longer term, or to provide a capital infusion. Indeed, as we have 
seen, such facilities can be necessary even for deposit-taking 
institutions. The role of the government in providing any such backstop 
liquidity should be carefully circumscribed, and the effects on 
incentives considered.
    Another lesson relates to the need for supervisory focus on the 
concentration of illiquid assets held by financial firms, particularly 
in entities other than a U.S. registered broker-dealer. Such monitoring 
is relatively straightforward with U.S. registered broker-dealers, 
which must disclose illiquid assets on a monthly basis in financial 
reports filed with their regulators. Also, registered U.S. broker-
dealers must take capital charges on illiquid assets when computing net 
capital. As a result, illiquid assets often are held outside the 
registered U.S. broker-dealer in other legal entities within the 
consolidated entity. So, for the consolidated entity, supervisors must 
be well acquainted with the quality of assets on a group wide basis, 
monitor the amount of illiquid assets, and drill down on the relative 
quality of such illiquid assets.
    We currently inquire, through FINRA, about the amount of Level 3 
assets at broker-dealers, but such information must be known with 
specificity about affiliates in the group as well. A thorough 
understanding of illiquid assets would be a more useful measure of 
financial health than a leverage metric that is broadly applied across 
a complex financial institution. The SEC has noted on numerous 
occasions that leverage tests are not accurate measures of financial 
strength, especially in firms with a sizable matched book or 
derivatives business. Leverage ratios do not account for the risk or 
liquidity of the underlying assets or associated hedging positions. 
Therefore, leverage ratios can overstate or understate actual risk due 
to leverage. For example: a 10-1 leverage ratio involving Treasury 
bills involves little risk of loss; however, the same 10-1 leverage 
ratio applied to uncollateralized loans would be extremely risky, and 
would not be prudent in a broker-dealer. The same could be said of repo 
transactions involving treasuries versus mortgages. Rather than rely on 
such overly simplistic measures of risk, regulators of financial firms 
have gone to great lengths to develop capital rules that are risk 
sensitive and act as limiters on the amount of risk that can be taken 
on by a firm.
    While the SEC knew the importance of supervisory focus on illiquid 
assets, I do not believe any regulator truly understood that market 
perception of the integrity of the financial statements, which involves 
both the amount of illiquid assets and the valuation of such assets, 
could erode so precipitously and ignite a run on a securities firm. 
This brings me to a related point--and lesson.
    A knowledge of illiquid assets also requires supervisors to review 
valuation thoroughly, and understand how mark-to-market (MTM) is 
executed within the firm--with a particular focus on the strength of 
control processes, the independence of the price verification function, 
and the disclosures made by the firm on its valuation processes. The 
challenges of valuing illiquid or complex structured products should 
not cast doubt on the process of marking-to-market, however. In fact, 
marking-to-market is part of the solution. This is another lesson from 
the events of 2008.
    MTM informs investment bank senior managers of trading performance 
and asset price and risk factor volatilities, supports profit and loss 
(p/l) processes and hedge performance analyses, facilitates the 
generation and validation of risk metrics, and enables a controlled 
environment for risk-taking In short, the MTM process helps ensure 
consistency between p/l reporting, hedging, and risk measurement. 
Without this, discipline across these activities would be more 
difficult to maintain and risk management would be significantly 
weaker. The act of marking-to-market provides necessary information and 
can impose discipline on risk-taking and risk management.
    At securities firms and elsewhere, to protect the accuracy and 
integrity of the financial institution's books and records and to 
support the CFO's attestation concerning the fair value of the firm's 
inventory as of a certain date, an independent group of financial 
controllers verifies monthly that traders' marks are accurate and 
unbiased. Once the price verification is completed, summary mark review 
reports are provided to senior managers at investment banks which 
provides insight into the composition of the portfolio, as different 
methods signal different degrees of liquidity, complexity or model 
risk. Internally, one of the primary aims of the control function 
performed by price verification is to reduce the risk of a position or 
portfolio being mis-marked. Obviously, this risk rises with the degree 
of subjectivity that may be applied to a given mark or position (and 
gets multiplied by the exposure). Given its critical contribution to 
the integrity of valuation and books and records, supervisors must 
engage fully in understanding the price verification controls at 
financial institutions, ensure that it is well-resourced, has 
independent authority to push back on the business line valuations, and 
is in ready communication with and has the active support and 
involvement of firm senior management.
    Recent events have proven the limitations of certain risk metrics 
such as Value-at-Risk (VaR) and the necessity of rigorous stress 
testing of financial models. VaR, among other things, assumes certain 
historical correlations, which may be inapplicable during times of 
extreme stress. In addition, VaR does not measure liquidity or 
concentration risk. Therefore, a lesson learned is while VaR and other 
risk metrics may be useful during normal market conditions, risk 
managers and supervisors must recognize their imbedded limitations and 
assumptions and plan accordingly. That is, supervisors and risk 
managers must supplement their usage with stress testing that 
incorporates not only likely economic scenarios, but also low 
probability, extreme events. In addition, the market-wide failure to 
appreciate and measure the market risk of mortgage-related assets, 
including structured credit products, has shown that the Basel market 
risk standards as then in force were not adequate. Each is in need of 
serious improvement.
    Another important lesson is that critical financial and risk 
management controls cannot just exist on paper. They must be staffed 
appropriately and well-resourced. Whether a supervisory program 
maintains staff onsite at regulated entities, or engages in frequent 
in-person meetings, the quality of the program must combine an ability 
to focus and follow up on risk management issues as they develop with 
an ability to gain the attention of senior management of the firm. 
Within the firm, senior management must engage with firm risk managers 
and support them as an independent function. Firm boards of directors 
must participate actively in setting the risk appetite of the firm, 
hold senior management accountable for following the board's direction 
on risk taking, and force management to take action, as appropriate. 
For instance, risk managers should have some degree of authority over 
trading decisions, and any decision by senior management to deviate 
from their recommendations should be documented and reviewed by the 
board.
    One final observation relates to the challenges any single 
regulator has in overseeing an entity--in the SEC's case, sizable 
broker-dealers--that reside within a complex institution with multiple 
material affiliates, regulated or not, in numerous countries. Any 
regulator must have an ability to get information about the holding 
company and other affiliates, particularly about issues and 
transactions that could impact capital and liquidity. For instance, 
whether directed by a holding company supervisor here or abroad, a 
poorly capitalized and not very liquid affiliate could require 
infusions from the parent and become the source of financial weakness 
for the entire organization. This could occur while the registered U.S. 
broker-dealer is well-capitalized and liquid. As was true in the case 
of Lehman Brothers, the bankruptcy filing of a material affiliate has a 
cascading effect that can bring down the other entities in the group. 
Also, in some instances, affiliates try to involve the well-capitalized 
broker-dealer in their business in a manner that is not prudent. For 
these reasons, and to protect the broker-dealer and its customer 
assets, the SEC would want, not only to be consulted before any such 
liquidity drain occurs at the parent, but to have a say, likely in 
coordination with other interested regulators, in the capital and 
liquidity standards the holding company must maintain. Our experience 
last year with the failure of Lehman's UK broker-dealer, and the fact 
that the U.S. registered broker-dealers were well-capitalized and 
liquid throughout the turmoil, has redoubled our belief that we must 
rely on and protect going forward the soundness of the regulatory 
regime of the principal subsidiaries. Nothing in any future regulatory 
regime, or systemic regulator, should operate to weaken the regulatory 
standards of these subsidiaries.
    Having learned all of these lessons, we at the SEC are focusing on 
how best to deploy our broker-dealer expertise in a new regulatory 
paradigm. As Congress considers the financial services regulatory 
structure, we believe that regulatory expertise should be recognized 
and deployed efficiently. For a certain set of large broker-dealer 
holding companies that are not affiliated with banks, the SEC supports 
a program that would permit us to also set capital standards at the 
holding company level (perhaps, in consultation with a holding company 
supervisor, if any), and to obtain financial information about, and 
examine, the holding company and material affiliates. Such broker-
dealer holding companies may also have an emergency liquidity provider 
(not the SEC). The SEC would determine the universe of broker-dealer 
holding companies that would be subject to parent company capital 
standards. The remaining broker-dealer holding companies not affiliated 
with banks would be subject to material affiliate reporting 
requirements, similar to the reporting regime under Section 17(h) of 
the Exchange Act.
    Given the recent dialog about systemic regulation, I must note that 
our experience with the bankruptcy filing of a foreign affiliate of 
Lehman Brothers has demonstrated the innate difficulties of any 
multijurisdictional approach to regulation. While cross border 
coordination and dialog is important, jurisdictions nonetheless have 
unique bankruptcy and financial regulatory regimes--and creditors 
wherever they are located shall always act in their own interest during 
a crisis. Thus, a U.S. liquidity provider might be faced with the 
difficult choice of guaranteeing the assets of the holding company 
globally, or else risk creditors exercising their rights against 
foreign affiliates or foreign supervisors acting to protect the 
regulated subsidiaries in their jurisdictions, either of which could 
trigger bankruptcy of the holding company. These are thorny issues that 
Congress should consider carefully.
GAO Review of Regulators' Oversight of Risk Management Systems
    I want, finally, to mention that, recently, we were provided a copy 
of the GAO's draft Review of Regulators' Oversight of Risk Management 
Systems. Based on our review of that draft, I can make a few personal 
observations. First, I appreciate the work that GAO did to review the 
supervision of financial institutions' risk management programs across 
the various regulators and find GAO's observations about those programs 
helpful. I can also make a few comments about the draft of GAO's review 
of regulators' oversight of risk management systems at various 
financial institutions. Staff of the Division of Trading and Markets 
has discussed these and other comments on the draft directly with GAO 
staff.
    The GAO draft states that banking regulators (the Federal Reserve, 
OCC, and OTS) use a combination of supervisory activities, including 
informal tools and examination-related activities to assess the quality 
of institutional risk management systems. It then describes the 
securities regulators' approach as revolving around regularly scheduled 
target examinations. This is not, however, an apt description of the 
SEC's CSE risk management supervisory program. We believe it is 
important to stress that SEC's supervision included continuous 
monitoring throughout the year of the CSEs for which we were the 
consolidated supervisor. While SEC staff conducted formal meetings with 
firms on a regular schedule (e.g., monthly risk meetings), SEC staff 
had continuous contact with the firm. These formal meetings were 
supplemented by additional follow-up meetings to discuss issues 
further. This often led to further monitoring by staff and, if 
warranted, included cross-firm reviews conducted by SEC monitoring 
staff and later SEC inspection staff for CSEs. We also received regular 
risk, financial, and liquidity reporting from the CSE firms, including 
some information on a daily basis. Particularly with respect to the 
liquidity reporting, we had frequent discussions, often daily or 
weekly, with the firms' treasurers during much of 2007 and 2008. In 
addition, during times of extreme market stress we had on-site coverage 
as well. While not continuously onsite, the SEC's approach was one of 
continuous supervision, a point not evident in the draft GAO report.
    SEC staff's continuous supervision was directly aimed at addressing 
risk management weaknesses. While we fully understand that SEC's 
process for ensuring that firms take corrective action was not as 
formal as some of the banking regulators, the substance was the same. 
There have been many instances in which, based on our supervisory 
approach, firms made changes to their risk management to address 
weaknesses that the SEC highlighted.
    We concur in the GAO's observation that although financial 
institutions manage risks on an enterprise basis or by business lines 
that cut across legal entities, functional regulators may oversee risk 
management at the legal entity level, resulting in a view of risk 
management that is limited or in overlap in efforts by regulators. 
Under the CSE program, the SEC continued its focus on the functionally 
regulated entity--the broker-dealer--but also assessed risk management 
wherever implemented within the holding company structure. This is 
necessary in order to gain an accurate assessment of the effectiveness 
of these risk management controls.
    Thank you again for this opportunity to discuss these important 
issues. I am happy to take your questions.
 RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM ROGER T. 
                              COLE

Q.1. How many banks have asked to return TARP funds officially? 
Unofficially?

A.1. As of April 22, 2009, the Federal Reserve had been 
informed by Treasury Department staff of 16 companies that had 
formally asked to return TARP funds.

Q.2. Have you told any banks that they cannot return TARP 
funds?

A.2. The Federal Reserve has established a uniform process to 
analyze and respond to requests to redeem TARP funds by bank 
holding companies and State member banks. This process includes 
consideration of the following elements:

    Whether the redemption request raises any question 
        about the company's ability to maintain appropriate 
        capital levels over the next one to two years, even 
        assuming worsening economic conditions.

    Whether the holding company will still be able to 
        serve as a source of financial and managerial strength 
        to its subsidiary bank(s) after the redemption.

    The level and composition of capital, earnings, 
        asset quality, the allowance for loan and lease losses 
        (ALLL), and liquidity, among other factors.

    Whether management's capital planning projections 
        are appropriate given the current financial condition 
        and risk profile of the organization.

    Expectations for communication with management and/
        or the Federal banking regulator of the subsidiary 
        bank(s) as needed.

    At this time, the Federal Reserve has not denied the 
request of any banking organization to return TARP funds. 
However, there have been some informal inquiries from 
organizations involved in the Supervisory Capital Assessment 
Program (CAP) stress test regarding returning funds they 
received from the TARP Capital Purchase Program. We have 
communicated to these institutions that such requests will not 
be considered, and should not be formally submitted, until the 
CAP stress test process has been completed.

Q.3. What is the process to return TARP funds? Do they just 
mail it back to Secretary Geithner?

A.3. Institutions must formally notify the Treasury of their 
intention to return TARP funds. Treasury staff then notifies 
the appropriate banking agency of the request and the agency 
then completes an analysis of the request (as detailed above) 
and indicates to Treasury whether they object to the repayment 
Treasury staff has asked that this analysis process be 
completed within two weeks, if possible. If the appropriate 
Federal banking agency notifies Treasury staff that it has no 
objection to the repayment, the Treasury Department immediately 
contacts the requesting company and coordinates the details and 
scheduling of the redemption with the issuer. This includes 
coordinating the exchange of both cash and securities, as well 
as the redemption of warrants, if applicable.

Q.4. If a bank asked to return TARP funds, why would they be 
denied?

A.4. As detailed in the responses to questions 2 and 5, those 
supervisory agencies may object to a request to repay the TARP 
funds if such repayment would raise questions about the 
adequacy of capital at a supervised institution and its ability 
to operate in a safe and sound manner.

Q.5. What provision of law would justify a regulator or 
treasury denying a bank's request to return TARP funds?

A.5. Capital plays a critical role in ensuring the safety and 
soundness of a banking organization. For this reason, Federal 
banking laws and regulations have long provided the Federal 
banking agencies several important tools to ensure that banking 
organizations maintain strong capital levels and that an 
organization's capital is not depleted through redemptions or 
similar transactions in a manner or amount that would have 
materially adverse consequences on the organization's financial 
condition or resources. For example, under the ``prompt 
corrective action'' provisions of the Federal Deposit Insurance 
Act (12 U.S.C. 1831o) (FDI Act), all insured depository 
institutions are prohibited without their Federal banking 
agency permission from redeeming capital if the institution 
would be undercapitalized as a result of the redemption. The 
Federal banking laws, also expressly require that an insured 
bank obtain the approval of its Federal banking regulator to 
redeem its equity capital,\1\ such as the preferred equity 
generally issued by banks in exchange for TARP funds.
---------------------------------------------------------------------------
    \1\ 12 U.S.C. 56 and 59 (national banks and extended to State 
member banks by 12 U.S.C. 324); 12 U.S.C. 1828(i)(l) (State nonmember 
banks).
---------------------------------------------------------------------------
    The risk-based capital rules applicable to bank holding 
companies (BHCs) directs BHCs to consult with the Federal 
Reserve before redeeming any equity or other capital instrument 
included as certain components of regulatory capital prior to 
stated maturity, if such redemption could have a material 
effect on the level or composition of the organization's 
capital base.\2\ Certain BHCs also must provide the Federal 
Reserve with notice prior to making a redemption that would 
reduce a BHC's consolidated net worth by 10 percent or more.\3\
---------------------------------------------------------------------------
    \2\ See 12 CFR part 225, Appendix A, section II, (iii).
    \3\ 12 CFR 225.4(b)(1). See Board SR Letter 09-04. ``Applying 
Supervisory Guidance and Regulations on the Payment of Dividends, Stock 
Redemptions, and Stock Repurchases at Bank Holding Companies'' for a 
description of the standards applied by the Federal Reserve in 
evaluating a BHC's capital position.
---------------------------------------------------------------------------
    In addition, Federal law provides the Federal banking 
agencies important enforcement tools to ensure that banking 
organizations remain safe and sound, including by maintaining 
adequate capital. For example, under section 8 of the FDI Act, 
a Federal banking agency may impose a cease-and-desist order on 
a banking institution requiring the institution to take 
corrective actions if the institution engages in an unsafe or 
unsound practice.\4\ The International Lending Supervision Act 
also provides that a Federal banking agency may issue a 
directive to a banking institution that fails to maintain 
capital at or above the level required by its Federal banking 
regulator, which may require the institution to submit and 
adhere to plan acceptable to the agency describing the 
institution's plan for restoring its capital.
---------------------------------------------------------------------------
    \4\ See 12 U.S.C. 1818(b).

Q.6. What changes, if any, to the law would have to be made to 
---------------------------------------------------------------------------
prevent a regulator from forcing a bank to keep TARP funds?

A.6. As discussed above, Congress has provided the Federal 
banking agencies several important tools to ensure that 
redemptions of capital by a banking organizations do not 
materially weaken a banking organization or cause it to be in 
an unsafe or unsound condition. To prevent a regulator from 
taking steps to prevent a banking organization from redeeming 
TARP capital when necessary to protect the financial health of 
the organization, Congress would have to provide that the 
safety and soundness laws and regulations discussed in question 
1 shall not prevent or restrict a banking organization from 
redeeming TARP capital. Moreover, Congress would need to adopt 
a law that specifically prevents the Federal banking agencies 
from taking any action under section 8 of the FDI Act to 
prevent a bank from making redemptions even if the redemption 
is determined to be an unsafe or unsound practice or would 
result in the institution being undercapitalized in violation 
of law.

Q.7. What would be possible negative implications of allowing 
any bank/company to give back TARP funds at their discretion?

A.7. As discussed above, depending on the current and projected 
condition of a TARP recipient, the immediate repayment of TARP 
funds could result in capital levels that are inadequate to 
support the risk of loss at the banking institution and result 
in an unsafe and unsound condition.

Q.8. Do the regulators have the necessary authority to deal 
with the consequences of TARP funds being returned over 
regulator objections?

A.8. If a banking organization were to redeem the capital 
instruments issued to the TARP over a regulator's objections, 
and such action constituted an unsafe or unsound practice or 
violated any law or regulation, the appropriate Federal banking 
agency would have a range of options under the FDI Act to 
address the infraction.\5\ For example, the banking 
organization's Federal banking regulator could impose a cease-
and-desist order on the organization under section 8 of the FPI 
Act. Such an order could require the bank to take steps to 
correct or remedy the acts or practices giving rise to the 
order. The regulator also could impose civil money penalties on 
the organization if it violated a law or regulation, failed to 
comply with a cease and desist order imposed by the regulator, 
or engaged in a recklessly unsafe or unsound practice.
---------------------------------------------------------------------------
    \5\ See 12 U.S.C. 1818.

    The ``prompt corrective action'' provisions also require 
the appropriate Federal banking agency to take prompt 
correction action to resolve capital issues at insured 
depository institutions. The statute requires the Federal 
banking agencies to establish capital requirements for the 
institutions they regulate together with measures of when the 
institution would be considered well-capitalized, adequately 
capitalized, undercapitalized, or significantly 
undercapitalized under those standards. If an insured 
depository institution is undercapitalized, the statute lays 
out the steps that must be taken by the institution and the 
relevant agency to address the capital deficiency. Moreover, 
the statue provides that if the appropriate Federal banking 
agency determines that an insured depository institution is in 
an unsafe or unsound condition or is engaging in an unsafe or 
unsound practice, the agency may reclassify the institution's 
capitalization status to the next lower category and impose 
requirements on that institution in accordance with its revised 
capitalization status. For example, if a bank were considered 
adequately capitalized and is engaged in an unsafe or unsound 
practice, the bank's Federal banking regulator could reclassify 
the bank as undercapitalized. As a result the bank, among other 
things, would not be allowed to redeem equity securities, would 
have to submit an acceptable capital restoration plan to its 
regulator, and could be subject to restrictions on its asset 
growth.\6\
---------------------------------------------------------------------------
    \6\ See 12 U.S.C. 1831o.

    A bank that is significantly undercapitalized or is 
undercapitalized and fails to submit a satisfactory capital 
restoration plan also could be subject to a range of 
requirements or restrictions under the prompt corrective action 
provisions of the FDI Act, such as a recapitalization plan 
imposed by its regulator or restrictions on activities, 
transactions with affiliates, interest rates paid, or asset 
growth, or other similar restrictions that address the bank's 
---------------------------------------------------------------------------
capital situation.

Q.9. Are you requiring banks to hold capital above the 
statutory definition of well capitalized, and if so why? 
Anecdotal reports indicate that examiners are requiring an 
additional 200 basis points of capital on top of the well 
capitalized requirements--is that true, if so why?

A.9. It has been longstanding policy that banking institutions 
are expected to hold capital commensurate with their overall 
risk profiles. Regulatory capital requirements are designed to 
establish a minimum level of capital that is relatively 
comparable across institutions, and are limited in their 
ability to reflect an institution's full risk profile. 
Accordingly, all banking institutions need to understand their 
risks and hold capital commensurate with those risks--at levels 
above regulatory minimums--to ensure overall capital adequacy.
    With respect to the composition of capital, supervisory 
expectations are outlined in the BHC Supervision Manual:

        The Board's long-standing view is that common equity (that is, 
        common stock and surplus and retained earnings) should be the 
        dominant component of a banking organization's capital 
        structure and that organizations should avoid undue reliance on 
        capital elements that do not form common equity. Common equity 
        allows an organization to absorb losses on an ongoing basis and 
        is permanently available for this purpose. Further, this 
        element of capital best allows organizations to conserve 
        resources when they are under stress because it provides full 
        discretion as to the amount and timing of dividends and other 
        distributions. Consequently, common equity is the basis on 
        which most market judgments of capital adequacy are made.

Q.10. What are you communicating to the examination force on 
these issues of TARP repayment and capital requirements? Please 
provide any relevant documents or training materials related to 
how your agency is instructing examiners to treat capital. In 
H.R. 1, Congress has said the TARP money can be repaid, please 
provide information which documents how your agency is getting 
that legal change out into the field.

A.10. The Federal Reserve has developed written guidelines for 
Reserve Bank staff to follow and a Redemption Request Decision 
Memo for Reserve Banks to complete when processing and 
analyzing redemption requests. The guidelines require Reserve 
Bank staff to analyze the sufficiency of an institution's 
capital planning process and capital levels and ensure that any 
approvals that may be required under Federal or State law or 
regulation are received before the redemption can proceed. The 
guidelines and Redemption Request Decision Memo were provided 
to the Reserve Bank TARP CPP contacts on March 13, 2009, and 
have been modified as appropriate as experience has been gained 
with the redemption process. The redemption analysis guidelines 
are consistent with longstanding Federal Reserve policies 
addressing the assessment of capital adequacy and the 
redemption of material amounts of capital and direct examiners 
to consider the factors outlined in SR letter 09-4, Applying 
Supervisory Guidance and Regulations on the Payment of 
Dividends, Stock Redemptions, and Stock Repurchases at Bank 
Holding Companies, when evaluating redemption requests.
                                ------                                


RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM TIMOTHY W. 
                              LONG

Q.1. How many banks have asked to return TARP funds officially? 
Unofficially?

A.1. As of April 23, 2009, six national banks have officially 
asked to return their CPP TARP funds. Four of those banks, Old 
National Bancorp, Sun Bancorp, First Merit Corporation, and TCF 
Financial Corporation have repaid their funds. We do not have a 
mechanism to track banks that may be considering or asking 
unofficially to return TARP funds. However, based on inquiries 
we have received from national banks about the process for 
returning TARP funds, we estimate that the total number, as of 
April 23, is probably fewer than 15. We would caution, however, 
that participation and interest in the TARP CPP program has 
become very fluid in the past month as an increasing number of 
banks have withdrawn their CPP applications either before or 
after they received preliminary approval from Treasury to 
receive TARP funding. Based on these trends, a greater number 
of banks could ultimately decide to attempt to return their 
TARP funding.

Q.2. Have you told any banks that they cannot return TARP 
funds?

A.2. As of April 23, we have not told any national banks who 
have inquired that they cannot repay their TARP CPP funds. Any 
requests that we would receive from the largest TARP recipients 
(those with assets over $100 billion) that are currently 
undergoing a comprehensive forward looking assessment (stress 
tests) would be considered after the completion of the 
assessment analysis.

Q.3. What is the process to return TARP funds? Do they just 
mail it back to Secretary Geithner?

A.3. Banks wishing to repay their TARP CPP funds have been 
instructed to notify Treasury at [email protected] and 
their primary Federal regulator of their desire to redeem their 
securities. Banks will need to follow their primary Federal 
banking regulators' existing guidelines governing reductions of 
capital. Once the appropriate Federal banking regulator 
notifies Treasury that the regulator has no objection, Treasury 
will work with the bank to schedule the bank's repayment. It is 
our understanding that Treasury is executing repayment requests 
on a weekly basis.
    For national banks that have a holding company, the Federal 
Reserve Board will be the regulator that formally provides 
consent to Treasury. This is because the TARP securities were 
issued and funds injected at the holding company level. The OCC 
and Federal Reserve, however, are closely coordinating on any 
such requests.
    In cases where TARP CPP funds have been down-streamed to a 
national bank, OCC approval will likely be needed to allow the 
bank to reduce capital, pursuant to 12 CFR 5.46 and 12 USC 59, 
or to pay a dividend in excess of the amount allowed under 12 
USC 60(b).

Q.4. If a bank asked to return TARP funds, why would they be 
denied?

A.4. This determination will be made based on the condition of 
the bank and the amount of capital it has in relation to the 
risks it confronts. For example, there could be cases where a 
bank's condition has deteriorated significantly since its 
receipt of TARP CPP funds and where repayment of those funds 
could impair the bank's safety and soundness or would trigger 
the capital provisions of the Prompt Corrective Action regime 
(12 CFR 6, 12 USC 1831o).

Q.5. What provision of law would justify a regulator or 
treasury denying a bank's request to return TARP funds?

A.5. As noted above, under Prompt Corrective Action, the 
banking agencies are required to take increasingly severe 
supervisory actions should a bank's capital levels fall below 
specified regulatory minimums. Those requirements are specified 
in section 38 of the Federal Deposit Insurance Act, 12 USC 
1831o, and OCC implementing regulations, 12 CFR 6. In such 
cases, the agencies may deny a bank's request to return TARP 
funds until and unless it developed and implemented an 
effective capital restoration plan. More generally, if 
repayment would result in capital levels that are inconsistent 
with the bank's overall risk profile or with other OCC 
directives to the bank, such as an individual minimum capital 
requirement under 12 CFR 3.15 due to the bank's risk profile, 
or the terms of a cease and desist order under 12 USC 1818(b), 
the OCC may require additional actions or commitments from bank 
management before repayment would be allowed.

Q.6. What challenges, if any, to the law would have to be made 
to prevent a regulator from forcing a bank to keep TARP funds?

A.6. As described in our answers above, if the OCC objected to 
a bank's repayment of TARP funds, our objection would be based 
on supervisory concerns about capital adequacy or safety and 
soundness. To override those concerns, Congress would have to 
provide in statute that the OCC could not exercise the safety 
and soundness authorities the law currently provides (including 
the statutes mentioned in our answers to Questions 3 and 5) to 
preclude the repayment of TARP funds, regardless of the effect 
that repayment would have on the bank's ability to meet its 
capital requirements, on its financial condition, or on its 
safety and soundness. The clear downside of such an approach is 
that it would deprive the OCC of the tools it currently has to 
ensure that repayment of TARP funds does not welcome a national 
bank's condition or adversely affect its safety and soundness.

Q.7. What would be possible negative implications of allowing 
any bank/company to give back TARP funds at their discretion?

A.7. We would be concerned about cases in which a TARP 
repayment would cause a bank to become undercapitalized or 
otherwise reduce capital to a level that is inconsistent with 
its risk profile, thus threatening its on-going viability and 
its ability to meet the credit needs of its community.

Q.8. Do the regulators have the necessary authority to deal 
with the consequences of TARP funds being returned over 
regulator objections?

A.8. We do not anticipate this will be an issue as Treasury 
will be requesting a ``no objection'' from the appropriate 
Federal banking agency before allowing an institution to repay 
its TARP CPP funds.

Q.9. Are you requiring banks to hold capital above the 
statutory definition of well capitalized, and if so why? 
Anecdotal reports indicate that examiners are requiring an 
additional 200 basis points of capital on top of the well 
capitalized requirements--is that true, if so why?

A.9. The OCC and other Federal banking agencies have long 
stressed that the regulatory risk-based and leverage capital 
ratios (12 CFR 3) are minimums and that banks are expected to 
hold capital commensurate with the level and nature of all 
risks. As noted in 12 CFR 3, Appendix A, section 1(b)(1), `` . 
. . since this measure [risk-based capital ratio] addresses 
only credit risk, the 8 percent minimum ratio should not be 
viewed as the level to be targeted, but rather as a floor. The 
final supervisory judgment on a bank's capital adequacy is 
based on an individualized assessment of numerous factors, 
including those listed in 12 CFR 3.10.'' Among the factors 
listed in 12 CFR 3.10 are: banks with significant exposures due 
to the risks from concentrations of credit; banks exposed to a 
high volume or, particularly severe, problem loans; banks that 
are growing rapidly, either internally, or through 
acquisitions; or banks exposed to a high degree of asset 
depreciation.
    Many banks currently have substantial concentrations in 
various commercial real estate segments, have been involved in 
recent mergers, or have experienced recent asset depreciation 
that warrant capital levels above the risk-based capital 
regulatory minimums.

Q.10. What are you communicating to the examination force on 
these issues of TARP repayment and capital requirements? Please 
provide any relevant documents or training materials related to 
how your agency is instructing examiners to treat capital. In 
H.R. 1, Congress has said the TARP money can be repaid, please 
provide information which documents how your agency is getting 
that legal change out into the field.

A.10. We issued internal guidance to our examiners on the TARP 
program, including requests for repayment of TARP funds, on 
March 26, 2009. A copy of those materials is attached.
    Our general guidance to examiners on capital and dividends 
can be found in:

   LThe Interagency ``Uniform Financial Institutions 
        Rating System,'' where capital adequacy is one of the 
        component ``CAMELS'' rating assigned to every financial 
        institution. (See Appendix A in ``Bank Supervision 
        Process'' booklet of the Comptroller's Handbook (http:/
        /www.occ.gov/handbook/banksup.pdf).) and

   LThe ``Large Bank Supervision,'' ``Community Bank 
        Supervision,'' and ``Capital Accounts and Dividends'' 
        booklets of the Comptroller's Handbook. Copies can be 
        found at: http://www.occ.gov/handbook/lbs.pdf; http://
        www.occ.gov/handbook/cbsh2003intro.pdf; and http://
        www.occ.gov/handbook/Capital.pdf.
                                ------                                


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM SCOTT 
                            POLAKOFF

Q.1. How many banks have asked to return TARP funds officially? 
Unofficially?

A.1. As of May 5 2009, OTS has received official requests by 
five institutions \1\ to return TARP funds received as part of 
the Capital Purchase Program (CPP). Also as of May 5, 2009, OTS 
has received one unofficial notice from an institution that may 
return its CPP funds.
---------------------------------------------------------------------------
    \1\ The word institutions as used in this letter may refer to both 
thrifts and thrift holding companies.

Q.2. Have you told any banks that they cannot return TARP 
---------------------------------------------------------------------------
funds?

A.2. No. OTS, as of May 5, has not informed any institutions 
under its supervision that they cannot return TARP funds.

Q.3. What is the process to return TARP funds? Do they just 
mail it back to Secretary Geithner?

A.3. An institution that would like to redeem its CPP 
investment will notify its primary regulator of its desire to 
redeem. The institution also notifies Treasury at 
[email protected]. After receiving the institution's 
notice, Treasury and the institution's primary regulator will 
consult about the request. When all consultations have been 
completed, Treasury will contact the institution to discuss the 
redemption request. Details of the redemption and completion of 
all necessary documentation will be handled by the 
institution's original Treasury counsel.
    Please refer to the link below for the Treasury's listing 
of Frequently Asked Questions (FAQs) addressing Capital 
Purchase Program (CPP) redemptions. The linked-to document is 
also included with this letter as an attachment. http://
www.treasury.gov/press/releases/reports/CPP-FAQs.pdf.

Q.4. If a bank asked to return TARP funds, why would they be 
denied?

A.4. An institution's request to return TARP CPP funds may be 
denied by its primary regulator if the repayment of the TARP 
CPP funds would result in insufficient capital and/or liquidity 
to support the operations of a thrift holding company or in an 
unsafe and unsound financial condition for its subsidiary 
thrift.

Q.5. What provision of law would justify a regulator or 
treasury denying a bank's request to return TARP funds?

A.5. The OTS's primary statutory authority is the Home Owners' 
Loan Act (HOLA). HOLA provided the OTS with authority to impose 
capital requirements on thrifts as well as supervisory and 
enforcement authority to contain and resolve problem 
institutions. The OTS may deny a TARP repayment request if it 
determines that the repayment would result in an insufficient 
level of capital and/or liquidity necessary to support the 
operations of either the thrift holding company or its 
subsidiary thrift.

Q.6. What changes, if any, to the law would have to be made to 
prevent a regulator from forcing a bank to keep TARP funds?

A.6. The Home Owners' Loan Act includes a specific section, 
section 10(f), that requires notice to OTS before a savings 
association subsidiary of a savings and loan holding company 
may pay a dividend to its holding company. There is also a 
specific restriction on dividends under the prompt corrective 
action statute in the Federal Deposit Insurance Act (generally, 
a dividend may not be paid if it causes a savings association 
to become undercapitalized). In addition, OTS has consistently 
taken the position that it has the authority to object to a 
dividend by a savings association based on safety and soundness 
grounds. In order to ensure that the agency could not object on 
any basis to a dividend by a savings association in connection 
with a redemption TARP securities, the HOLA would need to be 
amended to provide ``The Director, notwithstanding any safety 
and soundness concerns regarding a savings association, and 
notwithstanding any other provision of law, may not object to a 
dividend by a savings association to the extent the dividend is 
declared in connection with a redemption of TARP securities.''

Q.7. What would be possible negative implications of allowing 
any bank/company to give back TARP funds at their discretion?

A.7. If an institution is allowed to return TARP funds at its 
discretion, without obtaining its primary regulator's approval, 
the possible negative implications could include a resulting 
insufficient level of capital and/or liquidity necessary to 
support the operations of either the thrift holding company or 
its subsidiary thrift.

Q.8. Do the regulators have the necessary authority to deal 
with the consequences of TARP funds being returned over 
regulator objections?

A.8. We consider this to be a hypothetical question because an 
OTS-supervised institution may not presently return TARP funds 
over the objection of the OTS. Institutions supervised by the 
other Federal banking regulatory agencies are likewise subject 
to the approval of their relevant primary regulator for 
returning TARP funds.
    If an institution is allowed to return TARP funds over the 
objection of its primary regulator, the possible negative 
implications could include a resulting insufficient level of 
capital and/or liquidity necessary to support the operations of 
either the thrift holding company or its subsidiary thrift. In 
the event of such an undesired outcome, the OTS has the 
supervisory authority to direct the institution to address its 
resulting weakened condition and to correct it.

Q.9. Are you requiring banks to hold capital above the 
statutory definition of well capitalized, and if so why? 
Anecdotal reports indicate that examiners are requiring an 
additional 200 basis points of capital on top of the well 
capitalized requirements--is that true, if so why?

A.9. The OTS expects its supervised thrifts to maintain capital 
buffers above the minimum defined amount necessary to be well-
capitalized, and also expects its supervised holding companies 
to maintain prudent levels of capital necessary to support 
their operations. The OTS does not direct its examiners to 
require institutions to maintain a ``one-size-fits-all'' amount 
of additional capital above the minimum defined amount 
necessary to be well-capitalized.

Q.10. What are you communicating to the examination force on 
these issues of TARP repayment and capital requirements? Please 
provide any relevant documents or training materials related to 
how your agency is instructing examiners to treat capital. In 
H.R. 1, Congress has said the TARP money can be repaid, please 
provide information which documents how your agency is getting 
that legal change out into the field.

A.10. The OTS's Regional Supervisory Staff reviews each 
institution's request to repay its CPP investment and 
recommends approval or denial of the request to OTS Washington. 
OTS Washington makes the final decision to approve or deny each 
institution's request and then informs Treasury of its 
decision.
    The process that the OTS follows in its decision to approve 
or deny an institution's CPP repayment request is completed 
outside of the OTS's examination process. Regardless of the 
OTS's decision on the repayment request, examiners follow 
required review procedures that are necessary to determine the 
capital adequacy of the institution. Please refer to the 
website link below for the OTS's Examination Handbook section 
on Capital. The linked-to document is also included with this 
letter as an attachment. http://files.ots.treas.gov/422319.pdf.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                                ------                                


   RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM ERIK 
             SIRRI, AS ANSWERED BY DANIEL GALLAGHER

Q.1. How many banks have asked to return TARP funds officially? 
Unofficially?

Q.2. Have you told any banks that they cannot return TARP 
funds?

Q.3. What is the process to return TARP funds? Do they just 
mail it back to Secretary Geithner?

Q.4. If a bank asked to return TARP funds, why would they be 
denied?

Q.5. What provision of law would justify a regulator or 
treasury denying a bank's request to return TARP funds?

Q.6. What changes, if any, to the law would have to be made to 
prevent a regulator from forcing a bank to keep TARP funds?

Q.7. What would be possible negative implications of allowing 
any bank/company to give back TARP funds at their discretion?

Q.8. Do the regulators have the necessary authority to deal 
with the consequences of TARP funds being returned over 
regulator objections?

Q.9. Are you requiring banks to hold capital above the 
statutory definition of well capitalized, and if so why? 
Anecdotal reports indicate that examiners are requiring an 
additional 200 basis points of capital on top of the well 
capitalized requirements--is that true, if so why?

Q.10. What are you communicating to the examination force on 
these issues of TARP repayment and capital requirements? Please 
provide any relevant documents or training materials related to 
how your agency is instructing examiners to treat capital. In 
H.R. 1, Congress has said the TARP money can be repaid, please 
provide information which documents how your agency is getting 
that legal change out into the field.

A.1-A.10. Thank you for the opportunity to respond to questions 
for the Hearing concerning ``Lessons Learned in Risk Management 
Oversight at Federal Financial Regulators,'' held March 18, 
2009. To better explain our role in the context of TARP 
activities, it may be helpful to first describe the SEC's 
jurisdiction in the current regulatory system.
    As you know, several statutes, primary among them, the 
Securities Act of 1933, Securities Exchange Act of 1934, 
Investment Advisers Act of 1940, and the Investment Company Act 
of 1940, grant the SEC authority to regulate, among other 
things, public disclosure to investors, governance and 
accounting standards, securities exchanges, securities broker-
dealers, municipal securities dealers, clearing agencies, 
investment companies, and investment advisers. To promote fair 
markets and to protect against fraud, the SEC conducts 
examinations through its Office of Compliance, Inspections, and 
Examinations (OCIE) and investigations of misconduct through 
its Division of Enforcement.
    The Exchange Act is the primary statute governing broker-
dealers and covers a wide range of issues, including broker-
dealer registration, sales practices, trading practices, and 
financial responsibility. In addition, the Exchange Act confers 
legal status upon self-regulatory organizations (SRO), such as 
the Financial Industry Regulatory Association (FINRA), to 
enforce compliance by their broker-dealer members with SRO as 
well as Exchange Act rules, subject to SEC oversight. The SEC 
has long promulgated and administered financial responsibility 
rules for broker-dealers, including the Net Capital Rule, 
Hypothecation Rule, Customer Protection Rule, the Commission's 
books and records rules, reporting requirements, and the early 
warning rule for broker-dealers regarding their capital levels.
    The Consolidated Supervised Entity (CSE) regime and 
Appendix E of the Net Capital Rule that were largely the 
subject of Dr. Sirri's testimony stem from the SEC's authority 
to regulate the financial responsibility of broker-dealers. The 
SEC was prompted to establish the CSE regime in 2004 by the 
perceived need for group-wide risk monitoring. The firms were 
concerned about the requirements of the European Union's 
Financial Conglomerates Directive, which essentially requires 
non-EU financial institutions doing business in Europe to be 
supervised on a consolidated basis. As discussed in Dr. Sirri's 
testimony, Goldman Sachs, Merrill Lynch, Lehman Brothers, 
Morgan Stanley, and Bear Stearns consented to consolidated 
supervision at the holding company level by the SEC as a 
condition of the use by their U.S. registered broker-dealers of 
the alternative net capital (ANC) computation under Appendix E. 
Of note, the Commission has not otherwise altered the net 
capital rule for broker-dealers.
    As a result of the unprecedented level of distress in the 
financial markets that began in the Summer of 2007 and has 
continued through the present, each of the remaining investment 
banks (other than Lehman) that had been part of the CSE program 
have been reconstituted within a bank holding company and are 
now all subject to statutory supervision at the holding company 
level by the Federal Reserve Board. Under the Bank Holding 
Company Act, the Federal Reserve Board has statutory authority 
to impose and enforce supervisory requirements on those 
entities.
    The SEC continues to work closely with the Federal Reserve 
Board and other banking regulators concerning risk management 
oversight of these large financial conglomerates, but focuses 
on our statutory obligation to regulate their broker-dealer 
subsidiaries. Since the SEC no longer oversees the holding 
company as a consolidated supervisor, the SEC typically would 
defer to the relevant consolidated supervisor on matters 
concerning the holding company, such as holding company 
capital, liquidity, leverage, risk models and methodologies, 
stress testing, and contingency funding. The receipt, use, 
handling, and repayment of TARP funds generally would fall 
under this category.
    In addition, as you know, the TARP was created pursuant to 
authority granted to the Secretary of the Treasury under the 
Emergency Economic Stabilization Act of 2008. Since then, a 
number of programs have been developed under the TARP with the 
goal of stabilizing the financial system and restoring the flow 
of credit to consumers and businesses. As administrator of the 
TARP, Treasury has the authority to determine eligibility and 
allocations for interested parties and sets terms and 
conditions for participants in TARP programs. I understand that 
this is done in consultation with the appropriate Federal 
banking supervisors. Further, on June 9, 2009, Treasury 
announced that 10 of the largest U.S. financial institutions 
participating in the Capital Purchase Program (CPP) had met the 
requirements for repayment established by the primary Federal 
banking supervisors, and that Treasury had notified the 
institutions that they are now eligible to complete the 
repayment process. Many of these institutions have now made 
their repayment.
    Under Section 104(e) of the EESA, the Chairman of the 
Commission is one of five members of the Financial Stability 
Oversight Board, which is responsible for reviewing the 
exercise of Treasury's authority with regard to the lending 
program and making recommendations to Treasury regarding the 
use of that authority. The Commission, however, has no direct 
authority over the terms of the lending program and does not 
functionally oversee any of the fund recipients. The SEC 
continues to monitor and take interest in activities of the 
holding company or other affiliates that would materially 
impact the financial stability of the broker-dealer.
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