[Senate Hearing 111-297]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-297


         ESTABLISHING A FRAMEWORK FOR SYSTEMIC RISK REGULATION

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

                                HEARING

                               before the

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

           EXAMINING A FRAMEWORK FOR SYSTEMIC RISK REGULATION

                               __________

                             JULY 23, 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

                    Edward Silverman, Staff Director

              William D. Duhnke, Republican Staff Director

                      Amy S. Friend, Chief Counsel

                     Dean Shahinian, Senior Counsel

                          Charles Yi, Counsel

                Julie Chon, Senior International Adviser

                Mark Oesterle, Republican Chief Counsel

                Andrew J. Olmem, Jr., Republican Counsel

                 Chad Davis, Professional Staff Member

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)













                            C O N T E N T S

                              ----------                              

                        THURSDAY, JULY 23, 2009

                                                                   Page

Opening statement of Chairman Dodd...............................     1
    Prepared statement...........................................    59

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     3
        Prepared statement.......................................    59
    Senator Johnson
        Prepared statement.......................................    60
    Senator Reed
        Prepared statement.......................................    61
    Senator Bunning
        Prepared statement.......................................    61

                               WITNESSES

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation..     5
    Prepared statement...........................................    62
    Responses to written questions of:
        Senator Shelby...........................................    98
        Senator Reed.............................................   101
        Senator Menendez.........................................   105
        Senator Bunning..........................................   106
        Senator Crapo............................................   108
        Senator Vitter...........................................   110
Mary L. Schapiro, Chairman, Securities and Exchange Commission...     7
    Prepared statement...........................................    69
    Responses to written questions of:
        Senator Shelby...........................................   112
        Senator Reed.............................................   118
        Senator Bunning..........................................   121
        Senator Crapo............................................   124
        Senator Vitter...........................................   125
Daniel K. Tarullo, Member, Board of Governors of the Federal 
  Reserve
  System.........................................................     9
    Prepared statement...........................................    74
    Responses to written questions of:
        Senator Shelby...........................................   125
Vincent R. Reinhart, Resident Scholar, American Enterprise 
  Institute......................................................    47
    Prepared statement...........................................    80
    Responses to written questions of:
        Senator Shelby...........................................   128
        Senator Bunning..........................................   129
Paul Schott Stevens, President and CEO, Investment Company 
  Institute......................................................    48
    Prepared statement...........................................    83
    Responses to written questions of:
        Senator Shelby...........................................   131
Alice M. Rivlin, Senior Fellow, Economic Studies, Brookings 
  Institution....................................................    49
    Prepared statement...........................................    89
    Responses to written questions of:
        Senator Shelby...........................................   135
        Senator Bunning..........................................   136

                                 (iii)

Allan H. Meltzer, Professor of Political Economy, Tepper School 
  of Business, Carnegie Mellon University........................    50
    Prepared statement...........................................    94
    Responses to written questions of:
        Senator Shelby...........................................   137
        Senator Bunning..........................................  137&

 
         ESTABLISHING A FRAMEWORK FOR SYSTEMIC RISK REGULATION

                              ----------                              


                        THURSDAY, JULY 23, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 9:37 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. I will make some opening comments, turn to 
Senator Shelby for his, and then we will invite our very 
distinguished witnesses to join us at the witness table, and I 
will in advance apologize to them if we interrupt your 
testimony once the 12th Member arrives here, to go back into 
executive calendar to deal with this legislation.
    So let us shift gears, if we can now, to the hearing, and 
that is, as I mentioned earlier, a hearing to establish a 
framework for systemic risk regulation. Let me just share some 
thoughts, if I can. And, again, we have had a lot of discussion 
about this subject matter over the last number of months. We 
have had some 40 hearings in this Committee since January, not 
all of it on this subject matter, but the bulk of the hearings 
have been on this whole issue of how do we modernize our 
financial regulatory structure not only to address the problems 
that have brought us to this point, but also how do we create 
that architecture for the 21st century that will allow us to 
move forward with innovation and creativity that has been the 
hallmark of our financial services sector, and yet once again 
restore that credibility of safety and soundness that has been 
the hallmark, I think, of our financial services sector for so 
many years, and yet collapsed, in the views of many, over the 
last number of years, resulting in the economic problems that 
so many of our fellow citizens are facing, with joblessness, 
with house foreclosures, retirement accounts being wiped out, 
and all of the ancillary problems that our economy is suffering 
through.
    Systemic risk is going to be an important factor in all of 
this, and I cannot begin to express my gratitude to my fellow 
Members here because, unlike other matters that the Congress is 
dealing with, my sense is on this subject matter this is not 
one that has any ideology, that I can sense, to it at all. What 
all of us want is to figure out what works best, what makes 
sense for us here--not that we are going to solve every future 
problem. I think we make a mistake if we are sort of promising 
what we cannot deliver on. There will be future problems, and 
we are not going to solve every one of them. But if we look 
back a bit and see where the gaps have been, either, one, where 
there was no authority or, two, where there was authority but 
it was not being exercised, then how we fill those gaps in a 
way that makes sense I think will be a major contribution.
    And I want to particularly thank Senator Shelby, the former 
Chairman of this Committee, the Ranking Member now. We have had 
a lot of conversations together. We do not have a bill ready at 
all. There has been a lot of talk at this point. But I get a 
sense among my colleagues, as I have discussed the subject 
matter with them, that we share a lot of common views about 
this, and that is a good place to begin. It does not mean we 
are going to agree on every answer we have, but I sense that 
the overwhelming majority of us here are committed to that goal 
of establishing what makes sound and solid regulatory process.
    The economic crisis introduced a new term in our national 
vocabulary: ``systemic risk.'' Not words we use much. I do not 
recall using those words at all back over the years. It is the 
idea that in an interconnected global economy, it is easy for 
some people's problems to become everybody's problems, and that 
is what systemic risk is. The failures that destroyed some of 
our Nation's most prestigious financial institutions also 
devastated the economic security of millions of working 
Americans who did nothing wrong and never heard of these 
institutions that collapsed and put them at great risk. Jobs, 
homes, and retirement security were gone in a flash because 
Wall Street greed in some cases, regulatory neglect in others, 
resulted in these problems.
    After years of focusing on short-term profits while 
ignoring long-term risk, a number of companies, giants of the 
financial industry, found themselves in very serious trouble. 
Some, as we know, tragically, failed. Some were sold under 
duress. And an untold number only survived because of 
Government intervention--loans, guarantees, direct injections 
of capital.
    Taxpayers had no choice but to step in--and that is my 
strong view--assuming billions of risk and saved companies 
because our system was not set up to withstand their failure. 
Their efforts saved our economy from catastrophe, but real 
damage remains, as we all are painfully aware. Investors who 
lost billions were scared to invest. Credit markets dried up, 
with no one willing to make loans. Businesses could not make 
payrolls. Employees were laid off and families could not get 
mortgages or loans to buy an automobile, even.
    Wall Street's failures have hit Main Street, as we all 
know, across our Nation, and it will take years, perhaps 
decades, to undo the damage that a stronger regulatory system I 
think could have prevented. And while many Americans understand 
why we had to take extraordinary measures this time, it does 
not mean that they are not angry, because they are. It does not 
mean they are not worried, and they certainly are that. And it 
does not mean they do not expect us to fix the problems that 
allowed this to happen.
    First and foremost, we need someone looking at the whole 
economy for the next big problem with the authority to do 
something about it. The Administration has a bold proposal to 
modernize our financial regulatory system. It would give the 
Federal Reserve new authority to identify, regulate, and 
supervise all financial companies considered to be systemically 
important. It would establish a council of regulators to serve 
in a sole advisory role. And it would provide a framework for 
companies to fail, if they must fail, in a way that does not 
jeopardize the entire financial system.
    It is a thoughtful proposal, but the devil, obviously, we 
all know, is in the details, and I expect changes to be made in 
this proposal.
    I share my colleagues' concerns about giving the Fed 
additional authority to regulate systemic risk. The Fed has not 
done a perfect job, to put it mildly, with the responsibilities 
it already has. This new authority could compromise the 
independence the Fed needs to carry out effective monetary 
policy. Additionally, systemic risk regulation involves too 
broad of a range of issues, in my view, for any one regulator 
to be able to oversee. And so I am especially interested to 
hear from our witnesses this morning on your ideas and how we 
might get this right.
    Many of you have suggested a council with real authority 
that would effectively use the combined knowledge of all of the 
regulatory agencies. As President Obama has said, when we 
rebuild our economy, we must ensure that its foundation rests 
on a rock, not on sand. And today we continue our work to lay 
the cornerstones of that foundation--strong, smart, effective 
regulation that protects working families without hindering 
growth, innovation, and creativity that has been, again, the 
hallmark, as I said earlier, of our financial services sector.
    With that, let me turn to Senator Shelby, and then I will 
introduce our first panel.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    At the core of the Administration's financial regulatory 
reform proposal is the concept of systemic risk. The President 
believes that it can be regulated and that the Fed should be 
the regulator. But as we begin to consider how to address 
systemic risk, my main concern is that while there appears to 
be a growing consensus on the need for a systemic risk 
regulator, there is no agreement on how to define systemic 
risk, let alone how to manage it.
    I believe that it would be legislative malfeasance to 
simply tell a particular regulator to manage all financial risk 
without having reached some consensus on what systemic risk is 
and whether it can be regulated at all. Should we reach such a 
consensus, I believe we then must be very careful not to give 
our markets a false sense of security that could actually 
exacerbate our ``too-big-to-fail'' problem. If market 
participants believe that they no longer have to closely 
monitor risk presented by financial institutions, the stage 
will be set for our next economic crisis.
    If we can decide what systemic risk is and that it is 
something that should and can be regulated, I believe our next 
question should be: Who should regulate it?
    Unfortunately, I believe the Administration's proposal 
largely places the Federal Reserve in charge of regulating 
systemic risk. It would grant the Fed, as I understand the 
white paper, authority to regulate any bank, securities firm, 
insurer, investment fund, or any other type of financial 
institution that the Fed deems a systemic risk. The Fed would 
be able to regulate any aspect of these firms, even over the 
objections of other regulators. In effect, the Fed would become 
a regulator giant of unprecedented size and scope.
    I believe that expanding the Fed's power in this manner 
could be very dangerous. The mixing of monetary policy and bank 
regulation has proven to be a formula for taxpayer-funded 
bailouts and poor monetary policy decisions. Giving the Fed 
ultimate responsibility for the regulation of systemically 
important firms will provide further incentives for the Fed to 
hide its regulatory failures by bailing out troubled firms.
    Rather than undertaking the politically painful task of 
resolving failed institutions, the Fed could take the easy way 
out and rescue them by using its lender-of-last-resort 
facilities or open market operations. Even worse, it could 
undertake these bailouts without having to obtain the approval 
of the Congress.
    In our system of Government, elected officials should make 
decisions about fiscal policy and the use of taxpayers' 
dollars, not unelected central bankers. Handing over the public 
purse to an enhanced Fed is simply inconsistent with the 
principles of democratic Government.
    Augmenting the Federal Reserve's authority also risks 
burdening it with more responsibility than one institution can 
reasonably be expected to handle. In fact, the Federal Reserve 
is already overburdened with its responsibility for monetary 
policy, the payment system, consumer protection, and bank 
supervision. I believe anointing the Fed as the systemic risk 
regulator will make what has proven to be a bad bank regulator 
even worse.
    Let us not forget that it was the Fed that pushed for the 
adoption of the flawed Basel II Capital Accords right here in 
this Committee which would have drained our banking system of 
capital. It was the Fed that failed to adequately supervise 
Citigroup and Bank of America, setting the stage for bailouts 
in excess of $400 billion there. It was the Fed that failed to 
adopt mortgage underwriting guidelines until well after this 
crisis was underway.
    Yes, it was the Fed that said there was no need to regulate 
derivatives right here in this Committee. It was also the Fed 
that lobbied to become the regulator of financial holding 
companies as part of Gramm-Leach-Bliley. The Fed won that fight 
and got the additional authority it sought. Ten years later, 
however, it is clear that the Fed has proven that it is 
incapable of handling that responsibility.
    Ultimately, I believe if we are able to reach some sort of 
agreement on systemic risk and whether it can be managed, I 
strongly believe that we should consider every possible 
alternative to the Fed as a systemic risk regulator.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator, and we are 
still missing one, I think. Is it one? One. We need 12. If I 
have a colleague that can count 12, I am willing to move ahead 
on that.
    [Laughter.]
    Chairman Dodd. After all, this is Washington, you know. We 
will wait for the 12th to arrive.
    Let me invite Sheila Bair and Mary Schapiro and Dan Tarullo 
to join us at the witness table, and let me briefly introduce 
the people who hardly need an introduction. They have been 
before this Committee on numerous occasions, and we thank them.
    Sheila Bair, as we all know, is our Chair of the Federal 
Deposit Insurance Corporation, served as Assistant Secretary at 
the Treasury, has an extensive background in banking finance, 
and, of course, many of us up here have known her over the 
years when she was legal counsel to Bob Dole and did a great 
job in that capacity as well, so very familiar with the Senate 
as an institution.
    Mary Schapiro is the new Chair of the Securities and 
Exchange Commission, and prior to her appointment this year, 
she served as the CEO of the Financial Industry Regulatory 
Authority, or FINRA, also served as a Commissioner of the SEC 
during Ronald Reagan's administration, President Bush 41, and 
the Clinton administration.
    Dan Tarullo--I will finish this and then turn to our 
executive session--is the new member of the Board of Governors 
of the Federal Reserve System and, again, a familiar figure to 
many of us up here, having served in public life on numerous 
occasions in the past, including Assistant Secretary of State 
for Economic and Business Affairs, before he served as Chief 
Counsel for Employment Policy on the staff of our good friend 
Senator Ted Kennedy as well, and taught at Georgetown 
University Law Center, worked in the Clinton administration. So 
we thank you, Dan for your service, as we do yours, Mary, and 
Sheila Bair.
    [Whereupon, at 9:49 a.m., the Committee proceeded to other 
business and reconvened at 9:52 a.m.]
    Chairman Dodd. We will now go back to our witnesses. You 
have been introduced, and, Sheila, we will begin with you. All 
statements, supporting data, materials, and the like that you 
think would be valuable for our Committee as we consider 
modernization of the Federal regulatory structure, of course, 
will be included in the record. That is also true, of course, 
of all of our colleagues here as well.
    We would like you, if you could, to try to keep those 
remarks to 5 or 7 minutes so we can get to the questions as 
quickly as possible. Thank you for joining us.

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

    Ms. Bair. Chairman Dodd, Ranking Member Shelby, and Members 
of the Committee, I appreciate you holding this hearing. The 
issues under discussion today approach in importance those 
before the Congress in the wake of the Great Depression. We are 
emerging from a credit crisis that has wreaked havoc on our 
economy. Homes have been lost; jobs have been lost. Retirement 
and investment accounts have plummeted in value.
    The proposals put forth by the Administration to address 
the causes of this crisis are thoughtful and comprehensive. 
However, these are very complex issues that can be addressed in 
a number of different ways.
    It is clear that one of the causes of our current economic 
crisis is significant regulatory gaps within the financial 
system. Differences in the regulation of capital, leverage, 
complex financial instruments, and consumer protection provided 
an environment in which regulatory arbitrage became rampant. 
Reforms are urgently needed to close these regulatory gaps.
    At the same time, we must recognize that much of the risk 
in the system involved financial firms that were already 
subject to extensive regulation. One of the lessons of the past 
several years is that regulation alone is not sufficient to 
control risk taking within a dynamic and complex financial 
system. Robust and credible mechanisms to ensure that market 
participants will actively monitor and control risk taking must 
be in place.
    We must find ways to impose greater market discipline on 
systemically important institutions. In a properly functioning 
market economy, there will be winners and losers, and when 
firms--through their own mismanagement and excessive risk 
taking--are no longer viable, they should fail. Actions that 
prevent firms from failing ultimately distort market 
mechanisms, including the incentive to monitor the actions of 
similarly situated firms and allocate resources to the most 
efficient providers. Unfortunately, the actions taken during 
the past year have reinforced the idea that some financial 
organizations are too-big-to-fail.
    The notion of ``too-big-to-fail'' creates a vicious circle 
that needs to be broken. Large firms are able to raise huge 
amounts of debt and equity and are given access to the credit 
markets at favorable terms without sufficient consideration of 
the firms' risk profile. Investors and creditors believe their 
exposure is minimal since they also believe the Government will 
not allow these firms to fail. The large firms leverage these 
funds and become even larger, which makes investors and 
creditors more complacent and more likely to extend credit and 
funds without fear of losses. ``Too-big-to-fail'' must end.
    Today, shareholders and creditors of large financial firms 
rationally have every incentive to take excessive risk. They 
enjoy all the upside. But their downside is capped at their 
investment, and with ``too-big-to-fail,'' the Government even 
backstops that.
    For senior managers, the incentives are even more skewed. 
Paid in large part through stock options, senior managers have 
an even bigger economic stake in going for broke because their 
upside is so much bigger than any possible loss. And, once 
again, with ``too-big-to-fail'' the Government takes the 
downside.
    To end ``too-big-to-fail,'' we need a solution that uses a 
practical, effective, and highly credible mechanism for the 
orderly resolution of these institutions similar to that which 
exists for the FDIC-insured banks. When the FDIC closes a bank, 
shareholders and creditors take the first loss. When we call 
for a resolution mechanism, we are not talking about propping 
up the failed firm and its management. We are talking about a 
process where the failed bank is closed, where the shareholders 
and creditors typically suffer severe losses, and where 
management is replaced and the assets of the failed institution 
are sold off. This process is harsh, but it quickly reallocates 
assets back into the private sector and into the hands of 
better management. It also sends a strong message to the market 
that investors and creditors will face losses when an 
institution fails.
    So-called ``open bank assistance,'' which puts the 
interests of shareholders and creditors before that of the 
Government, should be prohibited. Make no mistake. I support 
the actions the regulators have collectively taken to stabilize 
the financial system. Lacking an effective resolution 
mechanism, we did what we had to do. But going forward, open 
bank assistance by any Government entity should be allowed only 
upon invoking the extraordinary systemic risk procedures, and 
even then, the standards should be tightened to prohibit 
assistance to prop up any individual firm.
    Moreover, whatever systemwide support is provided should be 
based on a specific finding that such support would be least 
costly to the Government as a whole. In addition, potentially 
systemic institutions should be subject to assessments that 
provide disincentives for complexity and high-risk behavior. I 
am very pleased that yesterday the President expressed support 
for the idea of an assessment. Funds raised through this 
assessment should be kept in reserve to provide working capital 
for the resolution of large financial organizations to further 
insulate taxpayers from loss.
    Without a new comprehensive resolution regime, we will be 
forced to repeat the costly ad hoc responses of the past year. 
In addition to a credible resolution process, there is a need 
to improve the structure for the supervision of systemically 
important institutions and create a framework that proactively 
identifies issues that pose risk to the financial system.
    The new structure, featuring a strong oversight council, 
should address such issues as the industry's excessive 
leverage, inadequate capital, and overreliance on short-term 
funding. A council of regulators will provide the necessary 
perspective and expertise to view our financial system 
holistically. A wide range of views makes it more likely we 
will capture the next problems before they happen. As with the 
FDIC Board, a systemic risk council can act quickly and 
efficiently in a crisis.
    The combination of the unequivocal prospect of an orderly 
closing, a stronger supervisory structure, and a council that 
anticipates and mitigates risks that are developing both within 
and outside the regulated financial sector will go a long way 
to assuring that the problems of the last several years are not 
repeated and that any problems that do arise can be handled 
without cost to the taxpayer.
    Thank you very much.
    Chairman Dodd. Thank you very much, Chairman Bair.
    Chairman Schapiro.

    STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN, SECURITIES AND 
                      EXCHANGE COMMISSION

    Ms. Schapiro. Thank you. Chairman Dodd, Ranking Member 
Shelby, and Members of the Committee, I am very pleased to be 
here today with my colleagues from the Fed and FDIC.
    There are many lessons to be learned from the recent 
financial crisis, and a key one is that we as regulators need 
to identify, monitor, and reduce systemic risk before they 
threaten the stability of the financial system.
    However, in our efforts to minimize the potential for 
institutional failures to threaten the system, we must take 
care not to unintentionally facilitate the growth of large, 
interconnected institutions whose failure might later pose even 
greater systemic risk.
    To best address these risks, I believe we must rely on two 
lines of defense. First, there is traditional oversight and 
regulation. This includes enhancing existing regulations, 
filling gaps, increasing transparency, and strengthening 
enforcement to prevent systemic risks from developing. And, 
second, we should establish a workable macroprudential 
regulatory framework and resolution regime that can identify, 
reduce, and unwind systemic risks if they do develop.
    Closing regulatory gaps is an important part of reducing 
systemic risk. If financial participants realize they can 
achieve the same economic ends with fewer costs by flocking to 
a regulatory gap, they will do so quickly, often with size and 
leverage. We have seen this time and again, most recently with 
over-the-counter derivatives, instruments through which major 
institutions engage in enormous, virtually unregulated trading 
in synthetic versions of other, often highly regulated 
financial products. We can do much to reduce systemic risk if 
we close these gaps and ensure that similar products are 
regulated similarly.
    In addition to filling gaps, we need to ensure greater 
transparency of risk. Transparency helps reduce systemic risk 
by enabling market participants to better allocate capital and 
giving regulators more information about risks that are 
building in the financial system. Transparency has been utterly 
lacking in the world of unregulated over-the-counter 
derivatives, hedge funds, and dark pools. Additionally, we need 
to recognize the importance that vigorous enforcement plays in 
sending a strong message to market participants.
    As a second line of defense, I believe there is a need to 
establish a framework for macroprudential oversight, a key 
element of the Administration's financial regulatory plan. 
Within that framework, I believe the most appropriate approach 
consists of a single systemic risk regulator and a very strong 
council.
    In terms of a systemic risk regulator, I agree there needs 
to be a governmental entity responsible for monitoring our 
financial markets for systemwide risks. This role could be 
performed by the Federal Reserve or by a new entity 
specifically designed for this task. The systemic risk 
regulator should have access to information across the 
financial markets about institutions that pose significant 
risk. And it should be able to monitor whether institutions are 
maintaining appropriate capital levels, and it should have 
clear delegated authority from the council to respond quickly 
in extraordinary circumstances. Most importantly, the systemic 
risk regulator should serve as a second set of eyes upon those 
institutions whose failure might put the system at risk.
    At the same time, I agree with the Administration that the 
systemic risk regulator must be combined with a newly created 
council, but I believe that any council must be strengthened 
well beyond the framework set forth in the Administration's 
white paper. The council should have authority to identify 
institutions, practices, and markets that create potential 
systemic risks and to set standards for liquidity, capital, and 
other risk management practices at systemically important 
institutions. This hybrid approach can help minimize systemic 
risk in a number of ways.
    First, a council would bring different perspectives to the 
identification of risks that individual regulators might miss 
or consider too small to warrant attention.
    Second, the members on the council would have experience 
regulating different types and sizes of institutions so that 
the council would be more likely to ensure that risk-based 
capital and leverage requirements do not unintentionally foster 
greater systemic risk.
    And, third, the council would include multiple agencies, 
thereby significantly reducing potential conflicts of interest 
and regulatory capture.
    Finally, the council would monitor the growth and 
development of financial institutions to prevent the creation 
of institutions that are either too-big-to-fail or too-big-to-
succeed.
    At most times, I would expect the council and systemic risk 
regulator to work with and through primary regulators who are 
experts on the products and activities of their regulated 
entities. The systemic risk regulator, however, can provide a 
second layer of review over the activities, capital, and risk 
management procedures of systemically important institutions as 
a backstop to ensure that no red flags are missed.
    To ensure that authority is checked and decisions are not 
arbitrary, the council would remain the place where general 
policy is set, and if differences remain between the council 
and the primary regulator, the more stringent standards should 
apply.
    For example, on questions of capital, the new systemic risk 
framework should only be in a position to raise standards for 
regulatory capital for these institutions, not lower them. This 
will reduce the ability of any single regulator to compete with 
other regulators by lowering standards, driving a race to the 
bottom.
    And, finally, the Government needs a credible resolution 
mechanism for unwinding systemically important institutions. 
Currently, banks and broker-dealers are subject to resolution 
processes, but no corresponding resolution process exists for 
the holding companies of systemically significant financial 
institutions.
    I believe we have an opportunity to create a regulatory 
framework that will help prevent the type of systemic risk that 
created havoc in our financial system, and I believe we can 
create a credible regulatory regime that will help restore 
investor confidence.
    I look forward to working with you to address these issues 
and doing all we can to foster a safer, dynamic, and more 
nimble financial system. Thank you.
    Chairman Dodd. Thank you very much, Chairwoman Schapiro.
    Dan Tarullo, welcome to the Committee once again.

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

    Mr. Tarullo. Thank you, Mr. Chairman, Senator Shelby, and 
Members of the Committee. My prepared statement sets forth in 
some detail the positions of the Federal Reserve on a number of 
the proposals that have been brought before you, so I thought I 
would use these introductory remarks to offer a few more 
general points.
    First, I think the title you have given this hearing 
captures the task well, ``Establishing a Framework for Systemic 
Risk Regulation.'' The task is not to enact one piece of 
legislation or to establish one overarching systemic risk 
regulator and then to move on. The shortcomings of our 
regulatory system were too widespread, the failure of risk 
management at financial firms too pervasive, and the absence of 
market discipline too apparent to believe that there was a 
single cause of, much less a single solution for, the financial 
crisis. We need a broad agenda of basic changes at our 
regulatory agencies and in financial firms, and a sustained 
effort to embed market discipline in financial markets.
    Second, the ``too-big-to-fail'' problem looms large on the 
agenda. Therein lies the importance of proposals to ensure that 
the systemically important institutions are subject to 
supervision, to promote capital and other kinds of rules that 
will apply more stringently because the systemic importance of 
an institution increases, and to establish a resolution 
mechanism that makes the prospect of losses for creditors real, 
even at the largest of financial institutions.
    But ``too-big-to-fail,'' for all its importance, was not 
the only problem left unaddressed for too long. The 
increasingly tightly wound connection between lending and 
capital markets, including the explosive growth of the shadow 
banking system, was not dealt with as leverage built up 
throughout the financial system. That is why there are also 
proposals before you pertaining to derivatives, money market 
funds, ratings agencies, mortgage products, procyclical 
regulations, and a host of other issues involving every 
financial regulator.
    Third, in keeping with my first point on a broad agenda for 
change, let me say a few words about the Federal Reserve. Even 
before my confirmation, I had begun conversations with many of 
you on the question of how to ensure that the shortcomings of 
the past would be rectified and the right institutional 
structure for rigorous and efficient regulation put in place, 
particularly in light of the need for a new emphasis on 
systemic risk. This colloquy has continued through the prior 
hearing your Committee conducted and in subsequent 
conversations that I have had with many of you.
    My colleagues and I have thought a good deal about this 
question and are moving forward with a series of changes to 
achieve these ends. For example, we are instituting closer 
coordination and supervision of the largest holding companies, 
with an emphasis on horizontal reviews that simultaneously 
examine multiple institutions.
    In addition, building on our experience with the SCAP 
process that drew so successfully upon the analytic and 
financial capacities of the nonsupervisory divisions of the 
Board, we will create a quantitative surveillance program that 
will use a variety of data sources to identify developing 
strains and imbalances affecting individual firms and large 
institutions as a group. This program will be distinct from the 
activities of the on-site examiners, so as to provide an 
independent perspective on the financial condition of the 
institutions.
    Fourth and finally, I would note that there are many 
possible ways to organize or to reorganize the financial 
regulatory structure. Many are plausible, but as experience 
around the world suggests, none is perfect. There will be 
disadvantages, as well as advantages, to even good ideas.
    One criterion, though, that I suggest you keep in mind as 
you consider various institutional alternatives is the basic 
principle of accountability. Collective bodies of regulators 
can serve many useful purposes: examining latent problems, 
coordinating a response to new problems, recommending new 
action to plug regulatory gaps, and scrutinizing proposals for 
significant regulatory initiatives from all participating 
agencies.
    When it comes to specific regulations or programs or 
implementation, though, collective bodies often diffuse 
responsibility and attenuate the lines of accountability, to 
which I know this Committee has paid so much attention. 
Achieving an effective mix of collective process and agency 
responsibility with an eye toward relevant institutional 
incentives will be critical to successful reform.
    Thank you very much, Mr. Chairman. I would be happy to 
answer any questions.
    Chairman Dodd. Thank you very much, Dan. We appreciate your 
testimony and your involvement with the Committee, as well.
    I will ask the Clerk to put on--why don't you put on 6 
minutes and try and keep an eye on that. We have got a lot of 
participation here this morning and I want to make sure we get 
around to people. I have asked the staff to make sure you give 
me a very accurate account of the arrival of Members in terms 
of the order in which they will be asked to address the 
questions to our panel.
    Let me begin with you, Governor Tarullo, if I can. I 
suspect a lot of the questions I am going to raise for you, you 
are going to hear variations of these same kind of questions, I 
suspect that sort of a theme will emerge here.
    You testified that the Administration's proposal to give 
the Fed systemic risk supervision is incremental. It builds on 
the robust authority which you already have under the Bank 
Holding Company Act, and you also detail your plan for a new 
surveillance program, which you mentioned here, for large 
complex financial organizations that will look at emerging 
risks to the system as a whole.
    Now, obviously, we are not speaking about you, because 
obviously you are new to this, but given the Federal Reserve's 
history and record on this as an institution as we look back, 
why should we in this Congress have any confidence in the 
Federal Reserve, other than what is being said today, and I 
appreciate what is being said today, but given the history of 
the Federal Reserve, you can argue that this authority has 
already existed. We don't need new authority. It has been 
there. Under the Bank Holding Company Act, you have had that 
authority for a long, long time. Certainly all the powers are 
there, the personnel, the resources to do a job, and yet there 
was an abysmal failure when it came to these institutions.
    So why at this juncture, and I raise this with you, why 
should this Committee or the Congress have any heightened 
degree of confidence that the Federal Reserve, having failed in 
that function, given the authority for years, should now be 
granted expanded authority in that same area?
    Mr. Tarullo. Well, Senator, let me say a couple of things 
about that. First, as you know, in my prior capacity, I had a 
fairly broad-based set of criticisms about the Fed and the 
regulatory system as a whole. I continue to believe that when 
the final history of the financial crisis is written, there is 
going to be a lot of blame to go around to regulatory agencies 
and private institutions. This was not a single failing. This 
was a broad-based failing at home and, as we have seen, 
internationally as well. Let me be clear. I think that includes 
an inadequate or flawed approach to supervision at the banking 
agencies, including the Fed.
    Second, I will say that I think that history shifts. 
History shifts and the relative positions of agencies shift 
over time. I remember when I was in law school studying this 
set of issues that the Federal Reserve was regarded as the most 
aggressive of the regulatory agencies and the other agencies 
were regarded as somewhat more accommodating. So I think there 
is a rhythm that goes with the times, with the leadership of an 
agency, and with the general orientation of public policy.
    So, since I have gotten to the Fed--actually before that, 
since I began having conversations with you and other Members 
of the Committee--what I have been trying to determine is the 
degree to which the capacity and the resources are present to 
do what is in some sense the same job that should have been 
done better. But to be honest, in some sense, it is a different 
job because I don't think anybody actually was focused on the 
systemic part of the problem as much as they ought to have 
been. It was a more siloed approach to regulation.
    And that is why I also think some changes should be made in 
prevailing law so that it is clear that the supervisor of the 
holding companies has authority to do examinations of 
functionally regulated subsidiaries when it is necessary. Those 
sorts of things need to move forward. But, I think more 
fundamentally, what has to be done is the kind of thing I 
mentioned a moment ago, which is to put in place a system 
within the agency that has its own kind of cross-checks, 
drawing upon the substantial resources of the agency. There are 
substantial resources in the research and monetary affairs 
parts of the Board to provide exactly the kinds of information 
that will enhance supervision.
    And that is, I think, the task which someone is going to 
have to perform, Senator, and it is either going to be done by 
the Federal Reserve or another agency. It has got to be done 
somewhere. My belief is, based upon my 6 months' experience at 
the Fed, that under Chairman Bernanke's leadership, it can be 
done. But I don't think anyone should underestimate the task 
and I would just second something you said in your introductory 
remarks. I hope people are not expecting that anything that the 
Fed or the SEC or the FDIC or anybody else does is going to 
eliminate all potential for systemic risk. That is just not 
going to happen. And I think we have got to keep that in mind.
    Let me just say one final thing. The Administration's 
proposal and other proposals vary in how much authority they 
really mean to invest in a particular agency. Back at our March 
hearing, you and I talked back and forth a good bit about the 
different possible functions of a systemic risk regulator. With 
the possible exception of some of the proposals for the council 
as they have been described, most proposals don't talk about a 
systemic risk regulator. They talk about allocating a 
particular set of responsibilities to particular agencies or 
collective groups, and I think that is probably the way it 
should be.
    I really don't think you need or want so much 
responsibility, as well as authority, lodged in any one agency 
to say, you have responsibility for figuring out anywhere in 
the financial system there is a problem and you have authority 
to do whatever you think is necessary.
    Chairman Dodd. Well, let me--thank you for that. Let me, 
Sheila, quickly turn to you for two quick questions and let me 
play the devil's advocate, in a sense, in this, as well. And 
again, I am still sort of agnostic on this, although I am sort 
of leaning toward the council approach, but let me take the 
side of the argument that the Administration opposes and raise 
it with you. I will give my best shot here in giving their side 
of the argument.
    This is a new idea we are fooling around with, a council 
here, agencies that don't necessarily have the kind of 
expertise and background of the Federal Reserve. You are going 
to spread this out among a bunch of different agencies so no 
one is really in control or authority. The Federal Reserve has 
the experience. Yes, they have done a bad job of this over the 
years, but historically, they have the capacity, the knowledge, 
and so forth to do this. We know about the Fed. You are asking 
me to create something that is altogether new and it may not 
function well at all to handle the issue of systemic risk, a 
very important issue.
    Why should I take a leap of faith in something here 
creating a whole new entity that may include the Fed, but is 
going to have the problem of spreading out the responsibility 
in such a way that you will never figure out who is really 
running the shop? In a sense, systemic risk will be suffering 
terribly. Despite the fact you have given it a nice name, hired 
a bunch of nice people, it really will not make the kind of 
decisions that you need to have with a single regulator with 
the experience the Fed has to do the job. Why is that not a bad 
idea?
    Ms. Bair. Obviously, we disagree with that. We think a 
council needs real teeth and rule-making authority. It needs to 
have some real authorities to be highly effective in monitoring 
for systemic risk and taking action to address it. The more 
eyes you have looking at this from different perspectives, the 
better. Clearly the FDIC has a different perspective from the 
SEC or the CFTC or the Federal Reserve. So I think bringing 
those multiple perspectives together is going to strengthen the 
entity, not weaken it.
    You are talking about tremendous regulatory power being 
invested in whatever this entity is going to be, and I think in 
terms of checks and balances, it is also helpful to have 
multiple views being expressed and coming to a consensus. We do 
a lot of this informally now, but there is no forcing 
mechanism. There are a lot of discussions now about OTC 
derivatives and trying to harmonize capital and margining 
standards. But having a formalized group with a head who is 
charged with dealing with those kinds of cross-cutting issues, 
harmonizing standards to make sure there is no regulatory 
arbitrage, and making sure risk throughout the system is being 
appropriated addressed, I think is extremely important.
    I think we have a bit of a middle ground in terms of 
institution regulation. We would not advocate the Federal 
Reserve losing its consolidated supervisory authorities now. 
They do that. They are the reservoir for that expertise. To the 
extent that there are other systemic institutions that are not 
under that prudential framework, we think the council should be 
able to make a determination regarding the consolidated 
supervision of those entities. But, it would be fine for the 
Federal Reserve to be the regulator for those systemic 
institutions.
    The kind of power that is contemplated in the U.S. Treasury 
White Paper, that we think, frankly, is needed, is much better 
vested in a council of regulators who I do believe can work 
together. The FDIC Board has three different agencies 
represented. We make decisions very quickly.
    Chairman Dodd. Thank you very much. I was going to ask 
you--I will wait for another round on the Consumer Financial 
Product Safety Agency idea. I will delay that for later.
    Let me turn to Senator Shelby.
    Senator Shelby. Thank you, Mr. Chairman.
    Governor Tarullo, in your testimony, you appear to fully 
endorse the Obama administration's regulatory reform proposal. 
I am curious to know if you arrived at this position as a 
member of the Board of Governors after conducting an 
independent assessment of the plan, which I hope is the case. 
Otherwise, it would call into question the so-called 
``independence'' of the Fed. Could you provide the Committee 
with the data and analysis that you used to make the 
determination that the Obama plan was the optimal approach?
    Mr. Tarullo. Well, Senator, I actually wouldn't say that 
the Board's position is an endorsement of the Administration's 
plan. I think what you saw in my prepared testimony which 
reflects the position of the Board, is a sense that the 
Administration is moving in the right direction on these key 
components, that there are obviously lots of details, many of 
which, by the way, we don't know and didn't know based on the 
white paper and are only beginning to find out as they send up 
legislation to you.
    Senator Shelby. What about our legislation? They want to 
send it up, but don't you think we should be preparing our own 
legislation?
    Mr. Tarullo. Absolutely. All I am saying is we couldn't 
figure out in some cases exactly what one of their proposals 
meant, which is why the testimony is phrased in such a way as 
to agree with the concept of needing to have every systemically 
important institution supervised and needing to have a 
resolution mechanism.
    As you probably saw, the Fed is certainly not endorsing the 
proposal of the Administration to create the new consumer 
agency. It is not opposing it, either.
    Senator Shelby. Let me get into that a little bit. Safety 
and soundness regulation, very important here. In your 
testimony, you state there are synergies between the monetary 
policy and systemic risk regulation. In order to capture these 
synergies, you argue that the Fed should become a systemic risk 
regulator, as I understand it. Yesterday, Chairman Bernanke 
testified that he believed there are synergies between 
prudential bank regulation and consumer protection. This argues 
in favor of establishing one consolidated bank regulator.
    Do you agree with Chairman Bernanke that there are 
synergies between prudential supervision and consumer 
protection, and if so, do you believe that the Obama 
administration's call for a separate consumer protection agency 
would undermine the safety and soundness regulation that we 
have?
    Mr. Tarullo. Senator, as I said in my introductory 
comments, there are multiple ways to organize or to reorganize 
financial services regulation. Many times you have got 
competing ideas, each of which has merits and each of which has 
some demerits.
    With respect to the consumer protection issue, the 
Administration has made a proposal which I think a lot of 
people have some sympathy with because it focuses on consumer 
protection. We say we are going to give one agency the 
exclusive authority to regulate on consumer matters and thus 
they will be 100 percent devoted to doing that.
    My testimony is meant only to suggest that there are some 
things that would be lost by doing that as well as some things 
that would be gained, and what the Chairman, I think, was 
suggesting yesterday is that there is a synergy or interaction 
between prudential regulation and consumer protection 
regulation, at least if they are both being done well. That 
synergy is both in the substance of things--that is, having 
some sense of what makes an effective consumer protection 
regulation because you know the way in which the institutions 
operate--but also in the practical sense that as you have one 
corps of examiners, there is a certain economy of scope in 
having them looking at the multiple sets of issues within the 
same organization.
    So, I definitely think there are synergies. There are some 
benefits that go back and forth. If you take consumer 
protection away and put it in another agency, you probably lose 
some of those. I guess the Administration's position would be, 
yes, but you gain some things along the way.
    Senator Shelby. Chairman Bair, the Obama administration's 
proposal, as I understand it, would have regulators designate 
certain firms as systemically important. You alluded to that 
earlier. These firms would be classified as Tier 1 Financial 
Holding Companies and would be subject to a separate regulatory 
regime.
    If some firms are designated as systemically important, 
would this signal to market participants that the Government 
will not allow these firms to fail? And if so, how would this 
worsen our ``too-big-to-fail'' problem?
    Ms. Bair. We do have concerns about formally designating 
certain institutions as a special class. At the same time, we 
recognize there may be very large interconnected financial 
entities out there that are not yet subject to Federal 
consolidated supervision. I think almost all of them already 
are subject to Federal consolidated supervision as a result of 
the crisis. But, some type of formal designation, I think, you 
would need to think hard about for just the reasons you 
expressed.
    Any recognition of an institution as being systemic, 
though, should be a stigmatizing designation, not something 
that is favorable. This is why we do feel so strongly that a 
robust resolution mechanism--for very large financial 
organizations needs to be combined with any type of new 
supervisory entity or to even recognize whether some 
institutions may be systemic.
    Senator Shelby. Governor, I want to get back on the 
consumer protection. I have just got a second. There was 
testimony here last week on that, that this would change the 
whole model from a classical approach to consumer protection to 
a behavioral approach. Have you done some work in that area? 
Have you looked at that closely yet?
    Mr. Tarullo. Senator, I have to be honest. I am not 
altogether sure what that refers to. I can only tell you--
again, based on what I have learned since I have been at the 
Fed--the way in which the division there does consumer 
protection and generates proposals is one that has a fairly 
important behavioral orientation, up to and including the fact 
that there is extensive consumer testing done before 
regulations are presented to the Board to make sure, for 
example, that if what you are trying to do is disclose terms of 
a consumer contract, that the kind of terms you are disclosing 
will actually mean something to a consumer and be useful to 
them.
    So in that sense, it is not just a top-down inquiry--how 
would the rational person think--but you actually try to 
determine how real people really do think.
    Senator Shelby. It would put a lot of power in bureaucrats, 
would it not?
    Mr. Tarullo. To create a----
    Senator Shelby. No, if we created something like they 
proposed, which I hope we won't, it would put a lot of power in 
the bureaucrats.
    Mr. Tarullo. Well, it depends, Senator. I mean, obviously, 
it depends on the mandate and the scope. That is obviously to 
be determined by all of you. I think that people at the Fed 
would agree strongly with the proposition that there needs to 
be good, solid consumer protection in the financial services 
area. Obviously, we also think that should be done in a well-
organized fashion with due process for everyone involved.
    Senator Shelby. Thank you.
    Chairman Dodd. Thank you very much, and I just point out 
that it was, as Jim Bunning has pointed out on countless 
occasions and others have, we gave the Fed the authority in 
1994 to deal with consumer protection. It took them 14 years to 
finally promulgate a single regulation in the area, so I 
appreciate the concern about consumer protection.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman. Thank you, Chairman 
Bair, Chairman Schapiro, and Governor Tarullo.
    I will start with Chairman Bair, but this is a general 
question for everyone. As I understand the proposals by the 
White House, the OTS would be eliminated, so effectively all 
Financial Holding Company regulation would be lodged under the 
Federal Reserve, that there would, in fact, be at least a 
review and perhaps the elimination of the Unitary Savings and 
Loan Holding Company Act. Those institutions would be Financial 
Holding Companies under the Federal Reserve.
    So direct regulation after this legislation by the Fed 
would comprise most of, if not all of, the systemic 
institutions, save perhaps some insurance companies that might 
be outside, and we have to deal with that, and some very large 
hedge funds or maybe not so large hedge funds but operating 
very recklessly.
    So with that framework, what does the council--how does the 
council relate now to a regulator that has full direct 
authority, and in fact in the proposal would eliminate the 
functional--the deference to functional regulators, so that the 
Fed, I think, could look through every part of the institution? 
What role does the council play there in that reality, or 
should play?
    Ms. Bair. I think there are still issues across markets. 
Even when functions within the holding company are individually 
regulated, there will still be some practices and products that 
other nonsystemic institutions may be doing. Mortgage 
originations are a prime example. You had a lot of very small 
third-party mortgage brokers originating some pretty bad 
mortgages that were being funded through multiple sources, 
including nonregulated finance companies, Wall Street firms, et 
cetera.
    So I think that there is plenty of opportunity for risk to 
be assessed across the system by any entity in terms of 
products and practices. Even within large holding companies, 
there will be reservoirs of expertise. There will be expertise 
in investment banks and broker-dealers from the SEC. There will 
be expertise regarding State-chartered and nationally chartered 
banks from the new prudential OCC-OTS regulator and the FDIC.
    I think in particular, capital standards--applying them 
across the board, making sure that there are no opportunities 
for arbitrage going forward--is a very major issue. I think OTC 
derivatives, some derivatives, are going to be traded on 
exchanges. Some are going to be traded through central 
counterparties. Others are still going to be done by OTC 
derivative market makers. Seeing how margining and capital 
across the system affects incentives, and whether we can all 
get together to incentivize more standardized trading, are all 
interagency matters that I think cry out for coordination 
across agency rule making. I actually see a lot for the council 
to do, even preserving the Fed's authority to be an 
institutional regulator for major holding companies.
    Senator Reed. Just specifically, would the council, in your 
view, designate the Tier 1 or the entities----
    Ms. Bair. That is tremendous power, to say to an 
institution, whether you want to be regulated or not, we are 
going to designate you as Tier 1. I do think that that power is 
needed, but I think it is better to be exercised by a council 
where there would be a diversity of views and some checks and 
balances.
    Senator Reed. And the council would formally begin the 
resolution process?
    Ms. Bair. I think we could discuss that. We have been 
talking about that a lot internally. I think, certainly for 
systemic institutions or institutions where the resolution 
might have systemic impact, that might be a role for the 
council. On the other hand, to the extent resolution will 
involve potential at least short-term assistance, I think the 
current approach, what we call the three keys now, the FDIC, 
the Fed, the Treasury, in consultation with the President, 
might be another model to look at. Those are the three entities 
that actually have to put the money on the table, so to speak, 
to deal with the situation. That is the way the system works 
now. If you rely on that system, though, we think the systemic 
risk exception, as I indicated in my testimony, should be 
tightened so it is harder, much harder to provide assistance, 
at least to individual institutions.
    Senator Reed. Let me ask Chairman Schapiro, and I do want 
Governor Tarullo to comment, too.
    Ms. Schapiro. Thank you. I really agree very much with what 
Sheila has said. I think a council is really critical to bring 
a diversity of views about the financial markets to the 
deliberations of all the regulators and this diversity of views 
really does need to reach across equity markets, futures and 
derivatives markets, the banking institutions, the clearance 
and settlement systems, and across a huge variety of different 
products. And if we don't bring the diverse perspectives 
together, we run the risk of any one regulator not appreciating 
a risk that is developing or not understanding the risk that 
may impact other financial institutions for which that 
regulator doesn't have direct responsibility.
    So I think both the ability to designate the institutions 
that need to be subject to additional risk-type regulation and 
establish capital standards, liquidity requirements, other risk 
management procedures for those institutions, in conjunction 
with the primary regulators, is a very important backstop.
    Senator Reed. Governor Tarullo, you have 40 seconds. This 
is the lightning round.
    [Laughter.]
    Mr. Tarullo. So, Senator, I think it depends a lot on how 
you structure things. I guess one model--maybe this is what 
Sheila and Mary are talking about--has the council basically as 
the rule-making entity for things that are systemically 
important, the designation of the Tier 1, the capital rules, I 
assume deposit insurance premiums to the degree that they are 
affecting the system, as well, and money market fund 
regulation.
    And then the question for you, for everybody, is going to 
be, do you want a system in which each major regulation that 
has systemic importance--as Chairman Schapiro said, something 
that will affect regulated entities of the other regulators--do 
you want that done formally in a council by a vote of some 
sort, or do you want it to be done through a lot of scrutiny, a 
lot of discussion, perhaps bringing in outsiders as well as--
those people outside from the Government or from the Congress 
as well as from the agencies to ask the hard questions--to 
require the agency that has responsibility and accountability 
for that regulation to defend it, to make it a better 
regulation, but then ultimately to itself have the 
responsibility to implement it.
    And I think that is the choice, and that is what I was 
alluding to earlier in terms of the tradeoff. Do you get the 
incentives right?
    Senator Reed. Thank you. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator Reed.
    Senator Corker.
    Senator Corker. Mr. Chairman, thank you, and I thank each 
of you for your testimony.
    Chairman Bair, I very much, as you know, support your 
outlook as it relates to the resolution issue, and I am 
surprised at the Administration's proposal and wanting to 
continue to support companies that fail, much like is being 
done with TARP, and I hope that that will evolve. But let me 
just ask you this: On the issue of systemic risk, if there had 
been a resolution mechanism in place, would that not have 
actually--even though there was risk in the market, would that 
not have actually reduced the risk to some degree? In other 
words, if you had the appropriate ability to deal with a Lehman 
Brothers or an AIG, would that actually have reduced the risk 
to the system in the first place?
    Ms. Bair. I think it would have, for two reasons. One, if 
it had already been in place for some time, I think we would 
have had better market discipline across the system. Second, 
when the problems hit--and we will always have cycles, 
hopefully never as severe as this one, but we will always have 
cycles--there would have been a consistent statutory mechanism 
in place that could be applied to all of these institutions 
which would have reduced market uncertainty about who was going 
to be next and who was going to win and who was going to lose.
    So I absolutely think it would have reduced risk in the 
system going into this crisis if we had had such a resolution 
mechanism in place.
    Senator Corker. I think that is really a big point. I think 
that is something that--you know, we are looking at creating 
something new, and I know we will debate that, and we may come 
up with the right solution. But the fact of the matter is if we 
had just had effective market disciplines in the first place 
where there were not entities that were too-big-to-fail, they 
could actually fail, the risk itself would have been less, and 
I think that is an important point.
    Let me ask you another question. I have served on several 
public company boards, and certainly not the size of the 
companies we are talking about here, but I have been before 
lots of them, and each of the board members typically are 
respected individuals that have a focus on their own companies, 
and I respect people in that position very much. But is there 
something we should be thinking about as it relates to boards? 
My guess is most board members show up, really do not know, 
excuse the language, squat about what is going on inside the 
company. It is a nice social event. It is just the way boards 
are set up, and most CEOs like it that way.
    Chairman Dodd. Is this an admission on your part?
    Senator Corker. No, no, no. I was very----
    [Laughter.]
    Senator Corker. I was not serving on highly social boards, 
but, you know, it is a fact. I mean, let us face it. The board 
members really, as good as they are, the respected individual, 
they have their own companies. They have their own fish to fry 
in many cases. They really do not know what is happening inside 
these companies, and the greatest regulation would just be 
knowing that people are on these boards and they actually 
understand what is happening inside the company.
    Again, I know most CEOs do not like that much, but I wonder 
if you might respond, both Mary and Sheila, to that--excuse me, 
Chairman and Chairman, to that.
    Ms. Schapiro. ``Mary'' is just fine.
    I actually think governance is an enormous issue here, and 
I do not think it is by malintention or neglect that so many of 
these institutions got into so much trouble. But I do think we 
have serious examples of boards that were not paying close 
enough attention or did not actually understand the business 
the company was in.
    I think from the perspective of the SEC, there are a couple 
things we want to do about that coming directly out of the 
financial crisis. One is we have proposed some new rules that 
require much greater disclosure in the proxy when shareholders 
get to vote about a board member's qualifications to serve on 
that particular board and a risk committee or a compensation 
committee or other committee that might require particular 
expertise. So we can encourage boards to nominate people to sit 
on their boards who actually bring that value to the company.
    I think the second big problem is with compensation 
schemes. To the extent that compensation schemes in some of 
these institutions really incentivize excessive risk taking, 
holding boards accountable through better disclosure of 
compensation schemes and the link between compensation programs 
and risk taking I think will help shareholders do a better job 
of holding the boards accountable for how they are utilizing 
compensation.
    Senator Corker. Thank you.
    Ms. Bair. Yes, I think that the direction the SEC is going 
is great and much needed. Our own focus with regulated banks, 
obviously, where our examiners identify weaknesses in 
management, we look to the bank's board of directors. We want 
to make sure the board has people who understand banking and 
can oversee management, but also really their primary 
responsibility is to make sure that the management knows how to 
run the bank and will run the bank in a safe and sound manner.
    So we have put a focus on this, and I believe the Federal 
Reserve has as well at the holding company level. We want real 
boards. We want people who are experienced, who know what is 
going on in their company, who understand the derivative 
positions and the risks they are taking and how their 
compensation structures impact risk-taking behavior.
    Senator Corker. I know the first question any board member, 
a potential board member is asked, the first question they ask 
the company is: How much insurance do you have? Right? I mean, 
you know, ``I want to be able to be on this board, but I do not 
want any liability, and if the insurance is not enough, I am 
not coming on.'' And I just think that is something that we 
ought to consider as we move ahead, again, not--without any 
disrespect to the individuals themselves.
    So I think if the resolution had been in place, the risk 
would have been less. If we had boards that somehow had some 
stake in the game or some different relationship, that would 
reduce risk. So let me move back to the notion of a systemic 
regulator, which I know we will debate, but what powers, Mr. 
Tarullo, if Company A was engaging in buying one side of a risk 
in a major way, unintelligently, what would the power of the 
systemic regulator be to stop that action?
    Mr. Tarullo. Well, Senator, again, it depends on how 
Congress would choose to define a systemic risk regulator. If 
you are asking could the Federal Reserve deal with it, it would 
depend, of course, on whether it was a supervised institution 
or not, because if it is not a supervised institution, we have 
no authority over them.
    Senator Corker. I am talking about--forget all the--just 
tell me, I mean, at the end of the day, if you are going to 
give a systemic regulator the ability to do something, if they 
saw something that was creating a risk, what power would it be 
given? I think we would all like to understand. What exactly 
would they do in that case?
    Mr. Tarullo. So, I think here it is important to draw this 
distinction. Right now, if we have a supervised institution, 
there is a set of rules and supervisory expectations. There are 
rules on leverage, rules on capital, rules on liquidity. They 
are supposed to be conforming to those, and if they are 
conforming to those, there should be a containment of the kind 
of risks you are talking about.
    The backup effort there is supervisory examination, which 
goes beyond the rules, and if that works well, it identifies 
these things, and then allows the supervisor to give guidance 
to the firm to say we think you ought to be moving away from 
this practice or it creates certain risks.
    But I think your question raises an important point, which 
is--let us just assume the Administration's proposal on Tier 1 
FHCs was enacted--there would still be a substantial universe 
of firms out there which would not be regulated by the Fed, 
which might be engaging in the kind of practices you are 
talking about. Even if no one firm is systemically important, 
in the aggregate a practice engaged in by a lot of firms can 
still create problems. So you would have to ask who would be 
able to regulate that.
    Senator Corker. My time is up. I think that answer was 
really interesting, Mr. Chairman, from this standpoint: 
Nothing--I mean, the answer is nothing. So the notion of having 
a single person, a single entity overseeing so they can act 
swiftly is not even relevant, because there would be no power. 
Again, if it is all conversation, looking, regulation, those 
things can be done by a group. And I just think that is worthy 
of hearing one of the Governors saying, no action. So----
    Mr. Tarullo. Senator, could I just--just slightly amend or 
add to what I said. It is important to look to see what those 
rules are that prevail. The rules on leverage, the rules on 
capital, the rules on liquidity are themselves supposed to be 
based upon concepts of risk, and I believe they are based upon 
concepts of risk, which should contain these kinds of risks I 
mentioned. I think that if you set the rules properly, you have 
gotten a fair way down the line to containing risks within 
those institutions.
    What I was saying before about the backup supervisory 
examination authority is there can still be practices that 
arise that somehow are evading the rules or are not falling 
under the rules, and then you need to determine whether it is 
an unsafe and unsound practice and make a judgment about that.
    So, I do not think anybody should promise to you that as 
soon as any firm starts doing anything dangerous that some 
regulator is going to see it and be able to stop it. It is 
going to have to evolve over time. If the rules are set right, 
you should be containing a good bit of that to begin with.
    Chairman Dodd. Thank you very much.
    Senator Tester.
    Senator Tester. Thank you, Mr. Chairman.
    All of you have talked about regulatory gaps and systemic 
risk in all of this. Mr. Tarullo, one of the points that you 
made was on accountability, you have got to be able--you cannot 
diffuse the responsibility. Later on, you talked about silos 
and that, and I do not want to put words in your mouth, but you 
were opposed to one agency that could determine the problem and 
determine the solution to the problem. And I may be wrong in 
what I heard in that, but that is what I thought I heard.
    You know, we are at a point where we know there are 
regulatory failures, and I think there is an opportunity to fix 
that. I think that is what the President put forth with this 
proposal. But shouldn't we push for further consolidation to 
stop the gaps, to allow ourselves to really focus and have that 
accountability that you talked in one of your main points, more 
consolidation than even here.
    Mr. Tarullo. Senator, I keep referring to my prior life, 
but it turns out to have been relevant for this job, which I 
guess is a good thing. I spent a good bit of time as an 
academic looking at the different ways in which countries 
structured their regulatory systems, and there are some 
countries--the U.K. and Japan notable among them--that have 
tried fundamentally to consolidate all financial regulation in 
a single entity.
    I do not think there is any denying that there are some 
advantages to that. You do get some of the cross-pollination of 
views. You do balance your incentives to foster the system but 
protect, for example, the deposit insurance fund. You get a lot 
of those incentives.
    I think, though, that many people in those countries would 
also say there are downsides to that as well. The advent of the 
crisis in the U.K. suggested to a lot of people that that model 
was not a fail-safe either.
    I should say the Fed does not have a position on more 
consolidation, less consolidation. But just as a kind of policy 
observation, I think there would be gains to trying to get more 
focus and consolidation so that you have some sense of who is 
accountable for what. But I think most of us--and I suspect all 
three of us at the table here--would also agree that some 
measure of redundancy is actually not a bad thing; that is, 
sometimes, you want accountability, but sometimes it is not the 
worst thing in the world to have multiple pairs of eyes, and 
even somewhat overlapping authorities.
    Senator Tester. I would agree with that, but then what 
happens with the instrument that is developed that has no 
regulation and falls in those gaps that we talked about and 
then everybody says it was----
    Mr. Tarullo. I think that is a very good point, and so I 
think the question for you will be: In the architecture that 
you all may choose to legislate, do you provide that somewhere 
there is going to be a residual or default authority to address 
the unanticipated?
    Senator Tester. OK. Chairman Bair, the Administration 
proposes factoring in a firm's size and leverage and the impact 
its failure would have on the financial system and the economy 
when determining if a firm is systemically important. It is 
kind of a two-edged sword once again, but if the firm size is--
and the metrics are developed around that--and we can talk 
about what those metrics might be, and we might if we have 
time. But wouldn't that provide--from a safety standpoint, 
wouldn't that provide a competitive advantage for those bigger 
banks versus the community banks if, in fact, their size and 
leverage determined them to be--they cannot fail, so we are 
going to make sure that they do not through the regulation?
    Ms. Bair. Well, we think any designation of ``systemic'' 
should be a bad thing, not a good thing. That is one of the 
reasons why we suggest there should be a special resolution 
regime to resolve large, interconnected firms. It is the same 
as the regime that applies to small banks. Also, they should 
have to pay assessments to prefund a reserve that could provide 
working capital if they have to be resolved.
    We are not sure you need a special Tier 1 category. We 
think the assessment, for instance, could apply to any firm 
that could be systemic, perhaps based on some dollar threshold 
or some other criteria that could be used as a means of the 
first cut of who should pay the assessment. But you are right, 
if you have any kind of systemic determination, without a 
robust resolution authority--and, again, we think assessments 
for a prefunded reserve would be helpful as well--it is going 
to be viewed as a reward. It is going to reinforce ``too-big-
to-fail,'' not end it, and you want to end it.
    Senator Tester. So I am not tracking as a consumer. How 
would you stop it from being a reward and not----
    Ms. Bair. You would need a resolution mechanism that works. 
So if they become nonviable, if they could not exist without 
Government support, the Government would not support them. They 
would close them. They would impose losses on their 
shareholders and creditors. The management would be gone, and 
they would be sold off. That is what we do with----
    Senator Tester. So too big----
    Ms. Bair. ----smaller banks.
    Senator Tester. Excuse me, but ``too-big-to-fail'' would go 
away?
    Ms. Bair. Well, I hope so. I certainly hope so. I think 
that should be the policy goal. Right now it was a doctrine 
that fed into lax market discipline that contributed to this 
crisis. I think the problem is even worse now because, lacking 
an adequate resolution mechanism, we have had to step in and 
provide a lot of open bank assistance.
    Senator Tester. And I have heard from other participants, 
and I would just like to get your perspective. They would go 
away by increased regulation----
    Ms. Bair. No. I think ``too-big-to-fail'' would be 
addressed by increased supervision combined with increased 
market discipline, which we think you can get through a 
resolution mechanism.
    Senator Tester. Thank you.
    Thank you very much.
    Senator Johnson. Senator Johanns.
    Senator Johanns. Let me just say this has been just a very, 
very interesting discussion. I appreciate you being here. I 
will tell you what I said a few weeks back, maybe a couple 
months back. I tend to favor the council. The idea of the 
Federal Reserve I think is just fraught with a lot of problems, 
so at least today that is where I am thinking about this.
    But the discussion today has really raised, I think--in my 
mind at least--some very important fundamental questions. It 
seems to me if you have a council, Chairman Bair, I would tend 
to agree with you that the council would designate who is 
classified as somebody who would fit within this. But that 
raises the issue: How broad is that power? Which probably 
brings us back to even a more fundamental question of what are 
we meaning by systemic risk.
    Is that an institution that is so entangled with the 
overall economy that if they go down, it could literally shake 
the economy or bring the economy down? Is that what we are 
thinking about here?
    Ms. Bair. I think you are, and I think it should be a very 
high standard. I also believe through more robust regulation, 
higher standards for large, complex entities, a robust 
resolution mechanism, as well as an assessment mechanism, that 
you will provide disincentives for institutions to become that 
large and complex as opposed to now where all the incentives 
are to become so big that they can basically blackmail us 
because of a disorderly resolution. This is one of the things 
that we lack, a statutory scheme that allows the Government the 
powers it needs to provide a resolution on an orderly basis. It 
rewards them for being very large and complex.
    Senator Johanns. So under that analysis, very, very clearly 
you could have a large banking operation fall within that. But 
you could also have a very large insurance company fall within 
that.
    Ms. Bair. You could. That is right.
    Senator Johanns. You could have a very large power 
generating company fall within that. What if I somehow have the 
wealth and capital access to start buying power generation, and 
all of a sudden, someday you kind of look up and I own 60 
percent of it. Now, that is a huge risk to the economy. If I go 
under, power generation is at risk. Is that what we are talking 
about?
    Ms. Bair. No. I think we are talking about financial 
intermediaries. There are things that need to be addressed with 
respect to financial intermediaries such as the reliance on 
short-term liabilities to fund themselves as well as the 
creditors, and the borrowers, who are dependent on financial 
intermediaries for continuing credit flows. So there are things 
that are different about financial intermediaries that make it 
more difficult to go through the standard bankruptcy process, 
which can be uncertain. You cannot plan for it. The Government 
cannot plan for it. They cannot control the timing for it, and 
it can be very protracted and take years. And the banking 
process is focused on maximizing returns for creditors as 
opposed to our resolution mechanism, which is designed to 
protect insured depositors, but also to make sure there is a 
seamless transition so there are no disruptions, especially for 
insured depositors, but also for borrowers. Through that 
process, through the combination of the supervisory process 
plus our legal authorities for resolution, we are able to plan 
for these failures and deal with them in advance. And I would 
assume that this would be the same situation you would have--as 
Senator Reed pointed out, with the Federal Reserve that 
virtually regulates almost every financial holding company 
already. Certainly if you do away with the thrift charter, that 
would be the case.
    I would also say that I really do not think a very large 
plain-vanilla property and casualty insurer would be systemic. 
I think AIG got into trouble because it deviated from its 
bread-and-butter property and casualty insurance and went into 
very high-risk, unregulated activities. But if you penalize 
institutions for being systemically significant, you will 
reinforce incentives to stick to your knitting, stick to more 
basic lower-risk activities as opposed to getting into the 
higher-risk endeavors that can create systemic risk for us all, 
as we have seen.
    Senator Johanns. Chairman Schapiro, do you agree with that?
    Ms. Schapiro. I do agree with that. I think if you have an 
adequate resolution mechanism that the marketplace understands 
will, in fact, be used, it can cancel out effectively the 
competitive advantage that might be perceived to exist for an 
institution that is systemically important and, therefore, the 
Government will not let it fail. If people understand in the 
marketplace the institutions will be unwound, they will be 
permitted to fail, then they should not have that competitive 
advantage that ``too-big-to-fail'' would give them.
    I also think that a council will be much better equipped to 
make an expert judgment across the many different types of 
financial institutions that we have in this country about which 
ones are systemically significant and important.
    Senator Johanns. Governor, what are your thoughts?
    Mr. Tarullo. Senator, I guess I basically agree, but maybe 
with a couple of qualifications. I think that the resolution 
mechanism is an important component of any program to address 
``too-big-to-fail.'' But as with each of the other components, 
I do not think we should look at it as a panacea. This is not 
something that we have done before. It is something we think 
needs to be done. And I agree with Senator Corker's earlier 
observation that if it had been in place before, it would have 
reduced risk. But note, he did not say eliminate the risk and 
eliminate the problem, and I agree with that.
    I think you are going to need a good, sound resolution 
mechanism. I think you are going to need other mechanisms to 
enhance market discipline as well--the capital structure of the 
firm, for example. And I think you are also going to need 
sound, transparent regulations because I do not think going 
forward we can rely on any one instrument. We are going to have 
to rely on a set of instruments to try to contain this problem.
    Senator Johanns. My time has expired, but if I could just 
offer this thought: I think the Chairman is absolutely right. I 
do not notice any political agenda here. I do not think it is a 
partisan sort of thing we are trying to come to grips with. My 
hope is that as we start working through this and putting pen 
to paper, the Administration will look at this from the 
standpoint of there are a lot of ways of dealing with this 
problem and preventing what happened and avoid locking down on 
just a single approach, like it has got to be the Federal 
Reserve or it cannot be anything, because I do think you can 
come at this from a number of different angles. But having said 
that, I will again reiterate I am hoping at some point we can 
move beyond the ``who manages this'' and resolve that issue, 
because there are some very, very important issues about who 
does this apply to. What are the unintended consequences of 
trying to define that? And I think that is where you really get 
into where the rubber meets the road here, is how you structure 
this in a way that makes sense, that deals with the problem, 
without going off on a cul-de-sac that really is not where we 
want to be today.
    Thank you, Mr. Chairman.
    Chairman Dodd. Well, let me just say--and I appreciate my 
friend and colleague's comments, because he is on track and I 
agree with him. And my sense is with the Administration as well 
that this is a dynamic process. They are sending up ideas and 
proposals to us, and that is as they should do, I suspect. But 
my sense of it is as well that I do not get a locked down view 
on this.
    So I think we are still very much in that dynamic process 
of thinking through these ideas, and you are absolutely 
correct, we are spending a lot of time on the who. But Bob 
Corker raised, I think, an important question that I have 
raised any number of times. It is not just the who but what. 
What powers? Just identifying who is going to be a systemic 
risk is an important question, but what powers are you going to 
give them is an equally important question, if you are going to 
give them any powers at all, in a sense.
    So I think there are a lot of really important issues, and, 
again, I am very optimistic about the process that we have in 
place here for arriving at some of these answers. So I thank my 
colleague very much for his observation on that.
    Senator Bennet of Colorado.
    Senator Bennet. Thank you, Mr. Chairman. I want to pick up 
right where you left off and where Senator Johanns left off, 
because I think--it is, by the way, a fascinating conversation. 
I appreciate all of you being here today. I think this is 
fraught with incredible amounts of potential unintended 
consequences, and we need to be enormously careful about 
keeping our mind or our focus on what is the problem that we 
are trying to solve here, because I am enormously skeptical of 
our ability to predict--or the regulatory agency's ability to 
predict these economic cycles and then to be able to respond in 
a way that does not actually compound the problem that we are 
facing. I think we have just seen 20 years of leverage piling 
up on our system and lack of attention to that that has led to 
the destruction of, you know, our economy and the dreams of a 
lot of people who live in my State and other States.
    I fully agree that we need to--that having resolution 
authority in place would have made an enormous difference in 
this case and kept us out of the Alice in Wonderland world that 
we are in now where we are having conversations here about how 
people get paid in private institutions where the taxpayer has 
actually had to come to the rescue of firms that we should 
never have had to rescue. I think both the Fed Chairman and the 
Treasury Secretary have been doing good work trying to get us 
out of here, and I think they are right to say that we were 
left with an assortment of terrible choices and we took the 
least bad. And I think our objective here needs to be to make 
sure we never find ourselves in that place again.
    I guess the question that I have for you, Chairman Bair, is 
when you talk about a council--and, again, I do not have 
anything against a council or any of this, and it might help. 
But when you talk about a council that anticipates risk, I 
think I get that. I am a little skeptical, but I get it. You 
also talked about a council that mitigates risk. Could you tell 
us more about what that means, if you would put some flesh on 
those bones for us?
    Ms. Bair. Mitigate or reduce risk--you cannot get risk 
completely out of the system. We are a capitalist system, so 
there has got to be some risk and return. But I think excessive 
risk perhaps would be a better example.
    In terms of the powers of the systemic risk council, I 
would put prudential requirements at the top of my list, and 
requirements for capital and margining and other constraints on 
leverage. There was too much leverage that had been built up on 
the system, and we believe that this council should have the 
authority to set minimum standards.
    For example, if the council decides that the FDIC is not 
setting high enough capital standards for its banks, or if the 
Federal Reserve is not setting high enough standards for its 
bank holding companies, or having high enough standards for the 
quality of capital, the council could step in and raise those 
standards.
    So I think there are some checks and balances as well that 
you get that you may not with vesting all this power in one 
single entity.
    Senator Bennet. That is an interesting idea, and would the 
effect of that be to remove some of the risk of regulatory 
capture of the other agency?
    Ms. Bair. I think that is exactly right.
    Senator Bennet. This is a question for the panel generally. 
One thing we have learned in this economic crisis is that the 
United States economy is in no way isolated from the rest of 
the world. As we think about this set of new laws and 
regulations, how should we think about how we connect to the 
rest of the world and the regulators connect to regulators 
across the globe?
    Ms. Bair. Well, I think we should lead the world. I do not 
think we should wait for the rest of the world, or we could be 
waiting a very long time--at least in my limited experience 
with some of these international groups. I think especially on 
resolution authority they are looking to the United States to 
define the model. So I think you should seize the moment and 
forge ahead and lead, not follow, because I do think there are 
still a lot of folks looking to us for leadership, and I think 
we can help define what the international standards ultimately 
will be.
    Senator Bennet. Mr. Chairman, I will end just by saying 
that I hope that whatever it is we arrive at here and whatever 
we do, the Administration leads toward a bias that when firms 
need to fail, they fail, and we can make sure we do that in an 
orderly way and that we are not ever again in the circumstance 
we are in today, which is to prop up institutions simply 
because we had no other good choice.
    These were problems that were avoidable, and it is just a 
shame that the taxpayers have found themselves where we are.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator. I couldn't 
agree more, and the point has been made by several, the options 
being, one, to pour billions in or to collapse them. There have 
to be alternatives within those two bookends that give us far 
more flexibility to respond to these situations. If we don't do 
anything else, I think a resolution mechanism is going to be a 
tremendously important contribution to this.
    And again, I think as I listen--as the Chair of this 
Committee, my job is in part to listen to all of my 
colleagues--and as I listen to this, while we haven't settled 
on a process yet, I am certainly beginning to sense a consensus 
developing around the importance of that issue, so I thank my 
colleagues and thank Senator Bennet for raising that issue 
again.
    Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman. I would like to 
ask unanimous consent to enter my opening statement into the 
record.
    Chairman Dodd. Yes, and I would ask that of all my 
colleagues, as well.
    Senator Bunning. OK. Chairman Bair, I have asked you this 
question before and probably will ask you again. When do you 
expect to end the Temporary Liquidity Guarantee Program?
    Ms. Bair. October 31.
    Senator Bunning. For sure?
    Ms. Bair. For sure, yes. All indications are that we will 
be able to exit the program, yes. The guaranteed balances are 
down. Use of the program is down significantly. And yes, I 
anticipate we will be in a very good position to exit October 
31.
    Senator Bunning. Good. This is for all of the witnesses. 
This question has two parts. As I have said before, I doubt we 
can create a regulator that will be able to see and stop 
systemic risk. So the first question for each of you is, if you 
really think Government can assemble a regulator that will not 
be outsmarted by Wall Street, first of all--in other words, can 
the Government really understand what the financial industries 
are doing and spot the risk ahead of time, or at least as they 
are happening?
    And second, it seems to me a more practical and effective 
way to limit the damage firms can do is to limit their size and 
exposure to other firms, in other words, the interaction 
between major firms. That also has a benefit of allowing the 
free markets to operate, but within reasonable limits.
    My question for each of you is do you agree with that, and 
answer also the first one, if you will. You can all take a shot 
at it, in no order.
    Ms. Bair. I will be happy to. Look, we can have better 
quality regulation. We can have more even regulation. But 
regulation will never correct all of this. You need more robust 
market discipline, which is why we really need an effective 
resolution mechanism. The market will then understand that when 
these institutions get into trouble, those who invested with 
them or extended credit to them are going to take losses.
    On the interconnectedness and exposures, yes, Senator, I 
think you are absolutely right to focus on that. One thing we 
suggest in our testimony that would be an area ripe for 
consideration through a council, if it is formed, would be 
whether there should be some limits on the firms' reliance on 
short-term liabilities.
    Senator Bunning. Well, shouldn't we include everything, 
though?
    Ms. Bair. Well, I think----
    Senator Bunning. In other words, we are talking about 
things that are not regulated at all. Secretary Chairman Reed 
and myself are having hearings on those things outside the 
regulatory bodies right now.
    Ms. Bair. Right. So I think you are right. The 
relationships of financial intermediaries to other entities in 
the economy, stress testing those on a marketwide basis, are 
all things that require a lot of interagency cooperation and 
something that the council would be well-equipped to provide.
    You are absolutely right. Interconnectedness is a key 
indicator of systemic risk and it is something, I think, we can 
do a better job addressing through regulation in containing 
risk.
    Senator Bunning. Ms. Schapiro.
    Ms. Schapiro. Senator, I think we can do better as 
regulators. We will never be perfect, but we can certainly do 
better.
    Senator Bunning. We all know that, so you don't have to----
    [Laughter.]
    Ms. Schapiro. I thought self-confession was helpful here.
    [Laughter.]
    Ms. Schapiro. I think we can constrain risk taking through 
heightened capital requirements, more effective capital 
requirements, margin.
    But I really want to address your second question because I 
think it is particularly important in the context, for example, 
of over-the-counter derivatives, which trade in the hundreds of 
trillions of dollars on a bilateral or counterparty to 
counterparty basis, without transparency, without in many 
instances sufficient margin or collateral behind those 
positions.
    Senator Bunning. Our markets, they just trade.
    Ms. Schapiro. Exactly right. And so the goal of moving as 
many of those transactions onto central clearing platforms so 
that we take out the counterparty risk and remove the bilateral 
nature of those contracts so a clearinghouse is interposed 
between all the parties, I think would do an enormous amount to 
reduce the systemic risk and reduce the exposure of financial 
institutions to each other----
    Senator Bunning. Just by registering?
    Ms. Schapiro. By clearing them through a central----
    Senator Bunning. Clearing.
    Ms. Schapiro. ----through a central clearinghouse.
    Senator Bunning. OK. Mr. Tarullo.
    Mr. Tarullo. Senator, with respect to the first part of 
your question, I would agree and go further, actually. I think 
part of what we have observed is not only that Government 
observers can't figure out every instance of systemic risk, but 
market participants themselves are sometimes unaware of the 
fact that they are engaging in practices that are subject to 
the domino effect of everything falling down.
    I don't think that means we should give up. I think it 
means we have to go into the exercise with a realistic sense of 
what you can and cannot accomplish. You are going to have false 
positives and you are going to have false negatives, which 
means that there needs to be a certain modesty associated with 
the exercise. But I do think that with efforts to quantify--to 
get data in a standardized form where you see the amount of 
leverage building up in different parts of the economy--you can 
take some steps down the road.
    Your interconnectedness point, I think, is critical. That 
is why we suggested in the prepared testimony that in thinking 
about capital regulation for larger firms, one should try to 
devise a metric that looks at interconnectedness, that looks at 
the very things that create systemic risk, rather than just 
replicate the siloed approach to capital regulation we have had 
in the past.
    Senator Bunning. Let me get my last question in, and this 
is for Sheila. All the largest institutions, financial 
institutions, have international ties, or at least most of 
them, and money can flow across borders very easily. AIG is 
probably the best known example of how problems can cross 
borders. How do you deal with the risk created in our country 
by actions somewhere else as well as the impact of actions on 
the U.S. markets themselves?
    Ms. Bair. Well, I think the international component of this 
is very difficult, and that is why I said earlier, I think we 
should try to lead and set the standards which then we can try 
to leverage into international agreements, especially when 
these large institutions get into trouble. The FDIC cochairs a 
working group with the Basel Committee to address the situation 
where a U.S. firm with large international operations gets into 
trouble, or vice-versa.
    One advantage we have here in the United States is that we 
require banks to be chartered here--organized under our laws, 
insured separately, and regulated as if they were domiciled 
here. So there is some insulation for U.S. customers of those 
entities if they get into trouble.
    We do not require the opposite, though--that our banks and 
financial institutions doing business overseas must be 
organized separately. So we suggest in our written testimony 
that this might be something to think about. Clearly, with 
greater legal autonomy and organization within each of these 
home jurisdictions, if the entity does get into trouble, it 
makes the resolution a lot simpler.
    Senator Bunning. Thank you very much, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator.
    Senator Brown.
    Senator Brown. Thank you, Mr. Chairman.
    I want to follow--thank you all for joining us and thank 
you, each of you, for your public service in very trying, 
difficult times.
    I want to follow up on Chairman Dodd's discussion or 
allusion to the powers given to the systemic risk regulator. I 
was intrigued by Senator Bunning's statement that we not be 
outsmarted by Wall Street and that we in the Senate not be 
outsmarted by Wall Street, that you as regulators in the 
structure we build not be outsmarted by Wall Street.
    And I think sort of the longer time you spend here 
watching, whether it is the financial system or the health care 
system or anything else, history is replete with industry 
always trying to, in some sense--not accusing of illegality, 
but in some sense staying ahead of the sheriff, that they are 
always trying to find a way around whatever rules we write, 
whether it is health insurance companies gaming the system and 
we try to write rules for them or whether it is financial 
institutions or anything else in the whole regulatory system 
structure that we have built.
    I ask you, and I would start with Mr. Tarullo, but I would 
like all of you to just comment on it. Give me sort of a 
prescriptive walk-through of what, in fact, we are able to do 
with the--what kind of powers the systemic risk regulator 
should have to prevent another mortgage meltdown. Be as 
specific as you can walking through for us in very 
understandable terms about what kind of powers the systemic 
risk regulator has to prevent those kind of market meltdowns, 
if you would.
    Mr. Tarullo. So Senator, again, I just want to qualify the 
notion of systemic risk regulator, because again, it depends on 
how many of those powers you invest in a particular agency. I 
would say, getting at Senator Dodd's perspective, as to where 
the powers ought to be. I think you are going to need simple, 
straightforward but strong rules to get at things like leverage 
for precisely the reason you said. If you try to go too 
activity-specific, you are always going to have people 
arbitraging and trying to do something that accomplishes the 
same end. So one has to look to overarching rules that provide 
some constraint upon it. I would say that is number one.
    Number two, I think you do have to have an adaptable set of 
regulators and supervisors who are looking at emerging 
practices and are able to--and have the backup authority to act 
against those practices.
    Number three, and I guess I would say in the consumer 
protection arena, I think that there--most importantly of all--
you probably needed a change in attitude. I think--again, as an 
academic, teaching through the 2000s--during that period, I 
just didn't see an enormous amount of interest in financial 
services consumer protection, frankly, at any of the financial 
regulatory agencies. There was, as Senator Dodd pointed out, 
power to take action. There was certainly examination 
authority. Each of the agencies had things they could have 
done. Perhaps not everything. They couldn't have stopped some 
things, but could certainly have stopped a lot. So, I actually 
do think in the consumer protection area the basic problem is 
one of attitude, orientation, and leadership.
    Senator Brown. Would you--and I want to hear from the two 
Chairs, too, but would you in writing discuss with me, because 
I want to get to them, what you mean by change in attitude, and 
more importantly, how we get there, how we----
    Mr. Tarullo. Sure.
    Senator Brown. Just send me a letter about that----
    Mr. Tarullo. Happy to.
    Senator Brown. ----if you would think about it and come up 
with it.
    Mr. Tarullo. Yes.
    Senator Brown. OK. Chairman Schapiro.
    Ms. Schapiro. Thank you. Well, I would agree with you. It 
is always a challenge for regulators to keep up with the latest 
financial innovation and the latest trading practices, product 
designs from Wall Street. I would say, I think to some extent, 
Wall Street outsmarted itself over the last couple of years and 
not just the regulators, which is why, through a lack of good 
risk management procedures, perhaps a lack of understanding 
entirely the nature of the businesses they were engaged in or 
the degree to which they were dependent upon counterparties is 
significant contributors to the situation.
    I think there are a few things we can do and we really must 
do. We have got to bring unregulated products under the 
regulatory umbrella. I talked already about OTC derivatives and 
I won't go back through that, but I think it is a very 
significant gap.
    I think we have to be much more robust about capital 
requirements and risk management procedures within the firms. 
We have to have regulators who are willing to be skeptical 
every single day and every hour of every day about the quality 
of risk management procedures within the firms that we are all 
responsible for regulating.
    I think we have to have an across-the-board commitment to 
much more robust stress testing so that we are thinking more 
about the huge impact but low probability events and factoring 
that into how we go forward with our regulatory programs.
    And to refer back to something we talked about with Senator 
Corker, I think we need to find ways to encourage more engaged 
and knowledgeable boards in these financial institutions.
    Senator Brown. OK. Chairman Bair.
    Ms. Bair. Specifically focusing on the resolution 
mechanism, under the regime we would suggest going forward, a 
Wall Street firm couldn't come and ask for assistance from the 
Government without submitting to a resolution procedure, 
meaning that they would be closed. So I think that they will 
stop asking, number one, if that is the tradeoff.
    I do agree that there has been some Balkanization of 
regulatory responsibility . That is why we think a council with 
ownership and a clear statutory mandate to be responsible for 
the system, addressing systemic risk, and getting ahead of 
systemic risk, will help change that attitude. It would get us 
all working together as opposed to saying that it is not really 
my agency's responsibility.
    I do think the ability of the council to set minimum 
standards, as well, will be an important check against 
regulatory capture or perhaps a lax attitude. That is another 
feature that could create a more robust regulatory environment.
    Senator Brown. Thank you. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator.
    Senator Crapo.
    Senator Crapo. Thank you, Mr. Chairman, and Chairman Bair, 
I am going to focus most of my questions on you, although I 
may, if I have time, be able to get to the others on the same 
issue.
    I am going to focus on the resolution authority issue 
again. I know that you have proposed that the resolution 
authority be with the FDIC and that it be expanded to bank 
holding companies and there is a bit of a discussion as to how 
broadly it should be expanded and where this authority should 
reside, or should be placed.
    But when you look at the issue of the need for a resolution 
authority, we have, first of all, the fact that right now, we 
only have resolution authority for banks. You indicated that we 
should expand that to bank holding companies. We also have the 
issue or a piece of the issue that Senator Bunning raised with 
regard to international holdings and what we deal with when we 
have American institutions that have acquired sometimes dozens 
if not hundreds of foreign subsidiaries and how we deal with 
those kinds of jurisdictional issues.
    I would just be curious as to your thoughts about where 
should the resolution authority be placed--I think I know the 
answer to that--but also how broad do we need to be in terms of 
the establishment of such resolution authority.
    Ms. Bair. Well, as you said, for bank holding companies, 
the FDIC would like to be the resolution authority simply 
because we already are for the insured depository institutions 
and you need a consistent single unified resolution regime. For 
other types of entities, if Congress wanted to give us that 
authority, we would take it. We are really the only place where 
this very specialized expertise resides. We have closed over 
3,000 institutions throughout our existence, small ones, large 
ones, and we have the staff and the ability to ramp up very 
quickly, as we have done over the past 18 months and have in 
the past. Institutionally, this is what we are equipped to do, 
so I think it would make some sense.
    The international component of this is very difficult and 
we think that this will be a multiyear process to get some of 
these institutions in shape where their resolution could be 
much more streamlined. One of the things we suggest in my 
written testimony, it is also suggested in the Administration's 
white paper, is to require these large institutions to have 
their own will, so to speak. They need to have their own 
liquidation plan that they would update, say, on a quarterly 
basis. The plan would also be facilitated by having greater 
legal separateness among the functional components. Part of the 
problem is these functional components are so intertwined, so 
deposits you may get overseas may be funding assets in the 
United States. Trying to tease all of that out in an orderly 
fashion is difficult. So we do think there is some 
infrastructure that needs to be put in place here.
    By designating some entity as the resolution authority, it 
will facilitate international discussions. We are doing that 
now, but we just have the bank piece of it. I think whoever is 
designated with the resolution authority would be the entity 
that could negotiate agreements with other jurisdictions and 
have systems and agreements in place to deal with situations 
where an internationally active organization gets into trouble. 
Protocols would be in place to deal with that situation.
    Senator Crapo. Would expansion of the authority at FDIC to 
include bank holding companies have allowed you to reach to 
Lehman Brothers and AIG?
    Ms. Bair. Well, yes, theoretically it could have. AIG was a 
thrift holding company. Assuming that you expanded the 
authorities to both bank and thrift holding companies or the 
charters were collapsed under Federal Reserve jurisdiction, 
requiring everybody to become a bank holding company, yes, it 
would.
    Senator Crapo. And then where would we stop--or, I guess, 
is expansion to bank holding companies sufficient? I am 
thinking we have insurance companies, hedge funds----
    Ms. Bair. Right.
    Senator Crapo. ----private equity firms, mutual funds, 
pension funds----
    Ms. Bair. Yes.
    Senator Crapo. How broadly do we need to reach?
    Ms. Bair. Yes. Well, again----
    Senator Crapo. What is the systemic system that we are 
talking about here?
    Ms. Bair. We would not want the FDIC to decide that. I 
think that is something that the Systemic Risk Council really 
would be best equipped to do. And also, our process does not 
contemplate that the FDIC would be the authority to decide to 
close the entity. That could be done a couple of different 
ways. One would be through the systemic risk process we have 
now. If it is a holding company, it could be done by the 
Federal Reserve Board as the primary regulator of the bank 
holding company. That is the way the process works now. The 
primary regulator makes the decision to close the institution--
that is frequently done in consultation with us--but then 
appoints us as a receiver.
    Senator Crapo. Do you think it would be adequate to simply 
extend jurisdiction to bank holding companies?
    Ms. Bair. That would be an option if you wanted to do 
something quickly. As I said before, I am concerned that we are 
not out of the woods yet, and as the market starts to 
differentiate between weak and strong and we exit these 
Government programs, we may be back in the soup. I hope that is 
not the case, but I am not sure.
    I think as an interim measure, you could very easily extend 
our authority to bank holding companies. This approach would 
not require Congress to address systemic risk or anything else. 
I think we would still need to do address systemic risk down 
the road. But yes, this could be a short-term measure. We have 
drafted language at the request of some of you which would be a 
very simple amendment process. That would be a very good tool 
to have now.
    Senator Crapo. And I assume that you would agree that 
establishing an expanded resolution authority would help us to 
get away from the concern that creating a systemic risk 
regulator for those so-called ``too-large-to-fail'' firms----
    Ms. Bair. Right.
    Senator Crapo. ----would create an implicit Government 
guarantee that they would be propped up as opposed to allowed 
to run down.
    Ms. Bair. That is right. We want it to be a bad thing, not 
a good thing, to be systemic. That is exactly right. I think 
you do that through a robust resolution regime that, as 
Chairman Schapiro said, makes it clear to the market that this 
is the process that will be used and shareholders and creditors 
will take losses.
    Senator Crapo. Well, thank you. My time is up. I would love 
to have had this same question answered by our other two 
witnesses. Maybe we will be able to get some----
    Chairman Dodd. Take a minute, Mike. Go ahead.
    Senator Crapo. Could we have the other two witnesses 
comment on this? Thank you.
    Ms. Schapiro. I really agree with what Sheila has said and 
am very supportive of that. I guess the only slight amendment I 
would have would be for bank holding companies that have a 
broker-dealer subsidiary where customer accounts are protected 
under the specific law that there be consultation in that 
process with the SEC, which I fully expect there would be.
    Senator Crapo. Thank you.
    Mr. Tarullo. Senator, just a couple of comments here. One, 
I would hope that the universe would actually not expand that 
greatly. That is, as we have commented before, Chapter 11 is 
the appropriate route for most entities, financial and 
nonfinancial. This ought to be a somewhat discrete mechanism 
which is used only in really unusual circumstances.
    Senator Crapo. Thank you. In that context, if we do--I tend 
to agree with that, as well, but if we do keep this narrowly 
focused, or as narrow as we are talking here, then I think we 
really need to face that question of the implicit Government 
guarantee of the firms that are regulated by the systemic risk 
regulator or the system we establish.
    Mr. Tarullo. And Senator, with respect to bank holding 
companies, you don't have to reach that question because there 
is no need to distinguish between the systemically important 
and nonsystemically important. It is only when you get to the 
entities that are not currently supervised that you have that 
issue.
    Senator Crapo. Right.
    Chairman Dodd. Thank you, Mike, very much. Good point.
    Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair.
    One of the components of the President's plan is the 
Consumer Financial Protection Agency. There hasn't been a lot 
of discussion of that this morning, so Chair Bair, can you give 
us a sense of your insights on the role of this potential 
institution and whether it is an appropriate one to create?
    Ms. Bair. We support the creation of the agency--an agency 
that is focused exclusively on consumer protection in financial 
services that can apply standards across the board for both 
banks and nonbanks and make sure they are the same standards. 
We think that would help the banking sector because one of the 
things that drove the rapid decline in mortgage origination 
standards was inadequate regulation and supervision outside the 
banking sector. Most of these very high-risk mortgages were 
done outside of the traditional banking sector, but as 
competitive pressure drew market share from banks and thrifts, 
which also lowered their standards in kind. So I think making 
sure there are even standards across the board is very 
important.
    Where we think the proposal could be strengthened is on its 
enforcement focus. We strongly recommend that the examination 
and enforcement component for banks be left with the bank 
regulators. I say that as a bank regulator but also as an 
insurer of all institutions with, ultimately, taxpayer exposure 
with the deposit insurance guarantee. There is a reason why we 
focus on prudential regulation of banks, as well, and a lot of 
it is because of FDIC insurance, which is a taxpayer backstop.
    There are important synergies you can get between 
prudential and consumer supervision. We typically cross-train 
our examiners. We can send in teams of both safety and 
soundness and consumer compliance. A prime example of where 
joint safety and soundness and compliance examination can be 
beneficial can be seen in cases where mortgages that were 
abusive to consumers were also found to be unsafe and unsound. 
And frequently, we will find where there is a consumer 
compliance problem that can flag a more fundamental problem 
with risk management at the institution.
    We think strongly that the rule writing should be for both 
banks and nonbanks. We are fine with that. But the examination 
and enforcement mechanism of a newly formed consumer protection 
agency should focus outside of the banking sector where you 
really don't have much examination and enforcement activity at 
all with the mortgage brokers or payday lenders. There are a 
lot of abuses outside the banking system that we think could 
and should be addressed by this agency. But, we really think 
their focus should be on creating more robust enforcement 
mechanisms for the nonbank sector.
    I don't understand why moving all the examiners from the 
bank regulators to this new agency and then making them 
responsible for both banks and nonbanks is going to work. I 
don't think it will. It would be highly disruptive to the FDIC. 
That is, about 21 percent of our examiners being pulled out of 
the FDIC. I assume it is a similar percentage for the other 
regulators. We think we do a good job on examination and 
enforcement. We have never had the ability to write rules, so 
that doesn't really change things for us. So we would ask you 
to consider that change in the Administration's proposal, but 
we do support the agency.
    Senator Merkley. Somewhat related to this, the systemic 
risk conversation is partly about institutions and it is partly 
about practices. By practices, I would mention things such as 
prepayment penalties in mortgage, regulatory arbitrage, whether 
there is a fundamental conflict of interest in the rating 
system in which the entity that you are rating is paying for 
that rating, and the issue of the amounts of leverage that were 
established in the system under Cox's supervision of the SEC.
    I am trying to sort out, how does one decide when you have 
a consumer issue that would be driven by the Consumer Financial 
Protection Agency? When is it an issue that the systemic risk 
regulators would take on? And when would it be an issue that 
the regular bank regulators would take on, and how would it get 
worked out in terms of how to proceed?
    Ms. Bair. Well, I think it does go both ways. What we have 
suggested in my written testimony, is that bank regulators 
should be represented on the board of the new consumer agency. 
Again, as an insurer as well as supervisor, we think the FDIC 
would have a unique perspective that should be represented. We 
also would be happy to have the head of these two agencies 
serve on our board because there are synergies and 
interconnectedness between prudential supervision and safety 
and soundness, and I think those need to be dealt with and that 
would be one way to deal with them.
    There has always been a separation between rule writing and 
enforcement for the consumer laws, at least for banks. The 
Federal Reserve Board has had that authority for federally 
insured banks. The FDIC and the OCC have never had the ability 
to write rules. We have just had the examination enforcement 
component.
    Senator Merkley. I want to get in one last question before 
I run out of time. Paul Volcker had a report that came out in 
January--I think it was called the ``Group of 30 Report''--that 
addressed the issue of proprietary trading by banks and 
essentially using the capital assets of the bank, should banks 
freely engage in purchasing assets regardless of the risk, and 
does that create systemic risk, and they had recommendations 
for constraints on proprietary trading.
    I open it up to all three of you. Do you have any thoughts 
about--this hasn't gotten a lot of attention and I am curious 
of your thinking.
    Ms. Bair. This probably doesn't surprise you, but as the 
insurer of banks we would strongly prefer that the proprietary 
trading occur outside the bank, in an affiliate. If it does 
occur in a bank holding company that includes an insured 
depositor institution, that is a risk factor that should be 
considered in setting assessments if the Congress decides to 
approve an assessment system for larger institutions.
    Ms. Schapiro. I would just add that I think proprietary 
trading with either taxpayers' money in the event of a 
supported institution or a customer's money does absolutely 
create risks that we need to be sensitive to. On the broker-
dealer side, you are not permitted to proprietary trade with 
customer funds, and most of that activity takes place outside 
the regulated broker-dealer.
    Mr. Tarullo. Senator, I would just say that regardless of 
where these activities are taking place, they can create risk 
under some circumstances. There needs to be capital, liquidity, 
and other kinds of regulation which contain the risk no matter 
where it takes place.
    Senator Merkley. Thank you very much.
    Senator Warner [presiding]. Senator Bennett.
    Senator Bennett. Thank you, Mr. Chairman. I appreciate it. 
And thank you to the witnesses. I think we have covered most of 
the ground, and I do not necessarily need to rerake the same 
set of leaves. But I have an overall concern here, and I do not 
expect a specific answer. I just want to raise it and get some 
conversation.
    Systemic risk, what is it? If we do not have a definition 
of systemic risk that everybody can understand and buy into, we 
are getting into a messy situation that could end up being just 
as bad as what we have just come through.
    I listened to all of this and think, OK, if I were the CEO 
of one of these companies, and, Sheila, you are saying we want 
to stigmatize the company if it becomes too-big-to-fail or is 
showing a systemic risk, the first thing I would say to all of 
my staff would be, ``Find out what will cause us to cross the 
threshold of being stigmatized as a Tier 1 `too-big-to-fail' 
and make sure we manage our business in such a way as to avoid 
that.''
    Now, if the definition of systemic risk is sufficiently 
loose, we can find ways around the definition, become too-big-
to-fail without being defined as ``too-big-to-fail,'' and end 
up with the board or the single regulator, whoever it is, 
facing the mess that we have talked about.
    If the definition is clear and accurate, then the reaction 
on the part of the CEOs of the company will be, ``We want to 
avoid being stigmatized,'' and the whole thing will be self-
policing. So the market will react to that definition by saying 
we will not do this and we will not do that and we will not do 
the other thing.
    So who gets to decide what is too-big-to-fail? Who gets to 
define what is a systemic risk? And what should we be looking 
for as we do that?
    I guess one last--I have tried to probe into the Lehman 
Brothers decision because I, with the benefit of hindsight, 
think the Lehman Brothers decision is probably what triggered 
the mess that got us into the need for TARP. And digging down 
through it, I am told ultimately we did not have enough data. 
When we made the Lehman Brothers decision that said, ``yes, we 
will allow Lehman to go down,'' we did not have enough data. 
And if we had had more, we probably would have made the 
different decision and would have stepped in to try to save 
Lehman the same way we saved Bear Stearns.
    So that is a real-life example of what happens when you do 
not have a clear definition of what is too-big-to-fail. 
Comments?
    Ms. Schapiro. Senator, I think you raise really a critical 
point here, and I think it is one reason I believe the 
existence of a council will be so important, because making a 
determination about what is a systemically important 
institution and how its business practices are evolving over 
time to move it perhaps in and out of that definition is 
something a council, a diverse perspective and diverse 
expertise on different types of financial institutions, I think 
will be pretty well-suited to do based on an analysis of data, 
examination reports, information from counterparties and so 
forth.
    And so I think for us to be able to determine--I mean, we 
can come up with a definition of systemically important. It is 
an institution whose failure puts at risk other institutions or 
the financial system as a whole. But I do not think it tells us 
very much because it is, in fact, so general.
    So I think a council will actually have the ability, and it 
will have to be an incredibly dynamic process, and that is why 
I think designating them that way is a mistake, because you 
will be designated and undesignated. People will structure 
their business to fall right under the designation. But I think 
for the primary regulators and the council to understand those 
institutions that we need to be particularly focused on will be 
important and facilitated by a council.
    Senator Bennett. OK. I am glad that Sheila referred earlier 
about a dollar threshold might be the trigger. An efficiency 
threshold might be the trigger. An interconnected threshold 
might be the trigger. There is no single trigger, is what it 
has come down to.
    Mr. Tarullo. Senator, I think your question is going to 
have importance regardless of whether it is a council, the Fed, 
a new agency, or somebody else. I think the question you put 
your finger on matters, no matter who the designator is. And 
here is the basic dilemma, though, that you all face.
    As I said a moment ago, with respect to already supervised 
institutions--bank holding companies--you do not have to draw 
that sharp line in the sand. You can have an approach to 
regulation and supervision which is in a sense graduated, 
squeezing more tightly as there is more interconnectedness, but 
there is no one place at which you say here is the line.
    The problem comes with institutions that are currently 
outside the perimeter of regulation.
    Senator Bennett. Exactly.
    Mr. Tarullo. And there, the choices, I think, are several. 
Basically you have got three choices.
    Choice one is you say here are the group of institutions 
which we think under stressed conditions would pose a systemic 
risk under some set of criteria.
    Two, here is a set of institutions about which we would not 
say that with that level of assurance, but it at least would be 
in the ballpark to think about them in this way.
    Either of those requires you to draw a line somewhere.
    The third option, of course, is to say that basically every 
financial firm, no matter what it calls itself, has to be 
subject to basic rules and regulations. But that, of course, is 
itself a change from our current circumstance because we do not 
have that kind of perimeter.
    I do not think any of those is a clean choice. There are 
advantages and disadvantages to each, and that is why I think 
the question you raised is one that we are going to have to 
address as best we can no, matter which road people choose to 
go down.
    Senator Bennett. Sheila, you wanted to comment.
    Ms. Bair. I did. We are suggesting that the resolution 
authority be applicable to any bank holding company, so for 
resolution purposes, you would not have to differentiate up 
front. And whether it was used I think would be a determination 
made by the primary supervisor about whether to avoid systemic 
ramifications from a normal bankruptcy process by employing the 
special resolution process, which still has the same claims 
priority that bankruptcy has with unsecured creditors and 
shareholders taking losses before the Government. It is a way 
that we can plan and use additional powers we have to set up 
bridge banks or to accept or repudiate contracts. The special 
powers we have really work better for financial intermediaries. 
But you do not have to make that determination in advance.
    I think the dollar threshold I mentioned, in the context of 
whether there would be an assessment to fund a large 
institution resolution fund, would really determine who is not 
systemic as opposed to who is. So for maybe anybody below--pick 
a number--$25 billion, you can safely assume they are not 
systemic, so they would not be caught in this assessment. But 
even those caught in the assessment, the amount of the 
assessment would be risk based. So if you are a plain vanilla 
regional bank, you take deposits, you make loans, you do not do 
much else, you are probably not going to have much of an 
assessment. If you are a complex bank holding company with a 
lot of proprietary trading, OTC dealmaking, et cetera, you are 
probably going to have a higher assessment.
    As Governor Tarullo said, really the only time where you 
would need to do it in advance is if there was a large 
systemically important institution that is not already under 
consolidated Federal supervision. I do think the council should 
have the flexibility and authority to define those institutions 
and bring them under prudential supervision if that is the 
case. I think that is something the council should do. It would 
be a tremendous power, and I think it would benefit from the 
multiplicity of views that would be on the council.
    Senator Bennett. The power to define becomes ultimately the 
power that controls everything.
    Ms. Bair. In terms of institutions, especially if you do 
away with the thrift charter, there are only a few 
institutions--I am not going to name any specific 
institutions--that come to mind that would not already be under 
Federal prudential supervision. So I am not sure actually if 
that piece of it in practice would be that profound. As a 
result of the crisis, pretty much everybody has become a bank 
holding company or are on their way to doing so. So I am not 
sure in practical terms that it would be that huge of a change.
    Senator Bennett. Thank you, Mr. Chairman.
    Senator Warner. Well, I want to thank the panel for hanging 
in, and I think it is down to Senator Martinez and me for the 
last two on this, and we have actually a second panel. I have a 
slew of questions, and I will try to ask them very quickly, 
again, so that Senator Martinez can get his questions in, and 
we can respect the second panel if we could try to answer 
fairly quickly.
    I strongly, as I made clear, believe that the council is 
the right approach. I guess I would ask for rather quick 
responses here--if possible, even kind of yes/no. I would love 
to--should that council have an independently appointed, 
Presidential appointment with congressional approval chair? 
Should it have the ability to look across all financial 
markets? Should it be able to be the aggregator of data from 
all of the prudential regulators up to with an independent 
staff that could aggregate and assess this data?
    Should it have, as I think we have heard you say, the power 
to issue rules, require enhanced leverage, or capital rules? 
And should it be able to force the day-to-day prudential 
regulators to take action and, if not, have backup authority to 
take action if the prudential regulator does not?
    I want to try to--I think Senator Bennett asked very 
appropriate questions about how we define. I am trying now to 
get into how we structure if we went forward with this council 
approach, recognizing that Professor Tarullo may not concur on 
the----
    Mr. Tarullo. As you know, Senator, the Board at this 
juncture has a somewhat more contained view of the council, so 
let me just--you said ``Professor'' before rather than 
``Governor,'' and I will slip back into that prior role, which 
is to say that I think you need to ask yourself at some point 
whether you are not basically creating a new agency that has 
brought in all the functions of the other agencies. If you have 
got a council that basically is able to direct everybody to do 
what the council thinks you ought to do, it is not that far 
from the Financial Services Authority mechanism in the U.K. or 
something like that. Obviously, there are a lot of gradations 
along the way.
    Senator Warner. Thank you.
    Chairman Schapiro and Chairman Bair.
    Ms. Schapiro. I think you asked five questions, and I think 
I have five yeses to all of them. I have not thought very 
carefully through the structure in terms of Presidential 
appointee confirmed by the Senate, but I think that makes 
sense. I do believe it needs to have the ability to aggregate 
data, to look across financial markets and all financial 
institutions. That is the whole purpose to my way of thinking. 
And I believe very strongly it needs the power to set capital 
requirements, leverage limitations, and other prudential 
regulatory requirements.
    And I would have, I guess, one caveat on the ability to 
force prudential regulators to take action if they do not do 
that, and my view on that would be to raise standards, yes, not 
to lower standards.
    Senator Warner. Chairman Bair.
    Ms. Bair. I would say yes.
    Senator Warner. Thank you.
    One of the things that Senator Corker has brought before 
you all a number of times, and I agree with him, is this notion 
of enhanced resolution authority for the FDIC for bank holding 
companies. I concur with his approach and that our goal ought 
to be allowing these institutions to actually fail in an 
orderly process and not be simply propped up ad infinitum.
    You know, there are a lot of questions beyond that, and we 
may even have an interim basis here, but one of the concerns I 
have with the Administration's proposal is there is still a--
how do you fund that resolution? There is still the idea of 
having to go to the Treasury or the Fed to get the dollars in 
the interim and go back and do a retroactive funding of the 
resolution. And clearly you do not want to have prefund so much 
from existing small banks.
    How have you thought about a prefunding mechanism? And how 
do we make sure that the prefunding, if you do agree with the 
prefunding, is a large enough net that you are going to capture 
potentially some of these institutions that may not obviously 
fall into a current FDIC coverage area?
    Ms. Bair. We support a prefunding mechanism, and it is 
important to note that this fund would be for working capital. 
This is not an insurance program, so we would not be 
guaranteeing liabilities as we do with the Deposit Insurance 
Fund. This would be for working capital to facilitate 
resolutions where necessary to make sure there are no 
disruptions to the system.
    It would take some time to build that fund up, so initially 
you might have to establish a line of credit with the Treasury 
Department. This should all be completely separate from the 
Deposit Insurance Fund and what goes on with insured depository 
institutions. To the extent we resolved a bank holding company 
with both banks, and nonbank functions, we would allocate 
losses to each fund in a way that would keep them completely 
separate.
    Similarly, those with the large deposit bases should not be 
double-assessed, so whatever they are paying into the Deposit 
Insurance Fund, will take care of what is in the bank. Any 
other costs would be allocated outside the bank.
    I do think prefunding is important from the perspective not 
only of making sure there is something to call upon so you do 
not have to immediately borrow from taxpayers to facilitate one 
of these resolutions. But I also think it is a tool that can 
complement prudential supervision to disincent high-risk 
behavior. We use risk-based assessments now for deposit 
insurance. Congress gave us that authority in early 2006. We 
like some of the impact it has had on behavior, and I think 
through this assessment system you could do the same types of 
things.
    So, for instance, if you did not want to be so extreme as 
to tell bank holding companies they could not do proprietary 
trading anymore, maybe you say they can do that in an 
affiliate, but we are going to charge you a higher assessment. 
I think it does have a way to impact behavior, but not in a way 
that you set hard and fast rules or limits that can be 
arbitraged or may result in unintended consequences.
    Mr. Tarullo. Senator, I think this is another one of those 
areas where you have got downsides as well as upsides whichever 
way you go. The downside of ex post funding, as has already 
been suggested, is you have to go back and do an assessment ex 
post. You have to borrow money from the Treasury in the 
interim--I certainly hope not the Federal Reserve here--for 
setting up this mechanism.
    But if you go the prefunding route, there is not really 
much experience to know what you are prefunding. As Sheila 
already said, you are probably not going to be at a point any 
time in the near future where you would have the fund you would 
need, so you would need a backup line of authority.
    And I guess the incentive, or signal, question would have 
to be asked: If you already have a preset pot of money which is 
reserved for resolution situations, does that make it more 
likely that it will be used? And I do not think there is a 
clear answer to that either.
    Senator Warner. I have got another--I am just going to make 
one quick comment, because I do not want to interfere on 
Senator Martinez's time. But just as we think about these 
gradations--and I think, you know, as we think size, I hope 
there will be some scaling of this as opposed to a simple line 
that you cross over. The one question I also would want to ask 
for your answer on, but as we look at bank holding companies 
taking on a whole series of additional functions that 
oftentimes look a lot like hedge fund functions, as you 
mentioned, Chairman Bair, in terms of their internal trading 
functions, should there be additional capital requirements for 
these nonbank functions that are taking place inside bank 
holding companies? And as we look at putting barriers on that 
``too-big-to-fail,'' ``too-big-to-fail'' is size and sometimes 
also a series of additional functions.
    I will move now to Senator Martinez.
    Senator Martinez. Thank you, Senator Warner. I appreciate 
it very much. I just believe a lot has been covered, and I do 
not want to again go over ground that has been covered. But 
there is one area that we have not talked about, and I would 
like to know the views of all three of you. It has to do with 
the GSEs, the Government-sponsored enterprises. They are 
entities that I think define ``too-big-to-fail.'' I think they 
also were systemically very risky. However, they had this 
implied Government guarantee that they continue to enjoy.
    Obviously, we have done a great deal to do what we should 
have done much earlier, which is put a regulatory scheme in 
place that might prevent some of the problems in the past. But 
thinly capitalized, a huge and ever growing market share which 
even continues to this day, an implied Government guarantee 
which provided investors a buffer from reality or from the 
consequences of investments, and I think the whole ball of wax 
of our mortgage system became very much troubled as a result of 
their activities and their actions. And I cannot--I think if we 
were to look back upon this period and what we have been 
through, I think it would be impossible to overestimate the 
impact that they have had and all the problems we have seen.
    How do they fit into what we are talking about here? What 
is the appropriate place for them to fit? Is there a future 
that they even should have as Government-sponsored enterprises? 
Or should they be simply part of the private sector?
    As I look at each of your functions, they fall under none 
of you--maybe perhaps a little bit under Chair Schapiro, but 
not a lot. Exactly. So we are still in the problem.
    So if we look at what it is that got us where we are today, 
I would love for us to focus on what got us here rather than 
just--and, obviously, AIG is a big part of the problem, and, 
obviously, there are a lot of other, you know, issues and 
relationships and interconnectedness and all of that. But would 
you please address the GSEs for me?
    Mr. Tarullo. So, Senator, one thing for sure, the guarantee 
is no longer implicit. It is now----
    Senator Martinez. Which, by the way, some would say it 
never was.
    Mr. Tarullo. There is considerable force to that as well.
    The Board, as you know--long before my arrival there--had 
expressed concerns about the GSEs, and I do not think anything 
that has happened in the last 10 months would have reduced 
those concerns.
    I guess I would say that there are a number of ways one can 
go but, going forward, what would be critical is to distinguish 
private roles from a public role. There is a real public role 
that can be played by GSEs. That is why they were originally 
started. But when you have a public role, that is when 
guarantees, implicit or explicit, are going to be involved. And 
that is when you are trying to implement a set of policies, so 
those activities are going to have to be constrained, and you 
are going to have to make sure that the entity is really 
functioning as a public entity under a certain obvious set of 
constraints.
    My characterization of some of the GSEs over the last 10 
years would be that nobody could tell where the public ended 
and the private began.
    Ms. Bair. I would just add that the Federal Reserve Board 
was an early sounder of risk. And at Treasury, especially when 
I was at Treasury, similarly, we tried to sound the alarms.
    I think, though, one of the advantages of----
    Senator Martinez. I will speak up for HUD as well.
    [Laughter.]
    Ms. Bair. Absolutely. A lot of people. I think this council 
would be able to give voice to those concerns and have real 
authority to address them. I think that is one of the 
advantages of the council. I think the Administration proposal 
would put the FHFA on the council. And if you continue with 
these GSEs--I do not know what their future is, but if they 
continue--they clearly still represent tremendous systemic 
exposure. So I think this would be a prime area where in the 
past you would have had a mechanism where we could have forced 
some real action through this council. Going forward, if the 
GSEs continue to function this way, the regulators should be 
represented as well.
    Ms. Schapiro. I do not have much to add, although let me 
stand up for the SEC, long before I arrived, in their push for 
public reporting by the GSEs.
    I do think Dan makes an excellent point about 
distinguishing the public and private roles and attendant 
consequences of having that public policy mission. It needs to 
be, I think, very transparent and well-understood by the 
marketplace.
    Senator Martinez. Well, I think the market, you know, when 
you put paper in the market and people invest, I do not know 
how that is ever a public role, really. I am not sure you can 
have private investors and a board of directors that is then 
beholden to the investors or to their public role. And that is 
my trouble with the whole idea of the GSEs the way they are 
chartered. So I think I for one would wonder how their future 
should really be and whether, in fact, they still have a role 
that ought to be as it has been in the past. Or should we very 
dramatically alter that going forward?
    Thank you for your input, and thank you for being here this 
morning.
    Senator Warner. Senator Menendez.
    Senator Menendez. Well, thank you, Mr. Chairman. Thank you 
all for your testimony.
    Let me ask, you know, for those of us who are struggling to 
define what the boundaries of systemic risk are, which is, I 
think, one of the key questions--and I know you have been asked 
some of these, and you have given some answers. But to me, it 
is more complicated than just the size of a firm or what 
business it is in, but how significant its activities are as 
well as how extensive its relationships are with other firms 
and consumers. So we have used very often ``too-big-to-fail.'' 
Sometimes I wonder whether we should be looking at too 
interconnected to fail.
    And in that respect, you know, should, for example, 
extensive relationships with small business and consumers count 
in defining systemic risk? By way of example, CIT. CIT is the 
largest lender to small businesses in America and has been in 
financial difficulties. It seems to me that unless an entity 
like that can find its way out of its financial difficulties, 
we are talking about hundreds of thousands of small businesses 
across the Nation who will not have the type of financing they 
need to conduct their activities, which is the greatest creator 
of jobs in the country at a time in which the country is 
desperately in need of jobs.
    So how do we look, for example, at that? Is that an element 
of systemic risk? If it is, then define it for me a little 
better. If it is not, tell me why it is not.
    Mr. Tarullo. So I will start, Senator. I do not think any 
of us probably wants to be speaking with reference to any 
particular entity, so let me just try to speak in more abstract 
terms.
    I think we do need to draw a distinction between entities 
that are economically significant and entities that pose 
systemic financial risk. There are many entities in this 
country whose failure would have very adverse economic 
consequences on a lot of people who deal with them--a lot of 
employees, communities, suppliers, and the like--but that do 
not create systemic financial risk in the sense that their 
failure leads to a kind of immediate cascading effect, in which 
leverage that is consecutively held by a lot of institutions 
that have counterparty relationships with one another suddenly 
becomes a problem. As asset values deteriorate and margin calls 
increase, you have to put up more collateral or you have to 
sell assets because you do not have enough collateral to put 
up. That is the pattern that we saw with Bear, Lehman, and AIG, 
and, in fact, you can go back 11 years and say that is the 
pattern you saw with Long Term Capital Management.
    Senator Menendez. So a cascading of thousands of businesses 
that would not have access to capital would not be a systemic 
risk?
    Mr. Tarullo. It would be a very severe economic problem, 
but the reason I would say it would not be a systemic financial 
risk is that it does not unwind essentially overnight or----
    Senator Menendez. So the automobile industry would fall in 
the same context as you are describing.
    Mr. Tarullo. I think the judgment on the automobile 
industry was that, again, there were truly enormous costs, 
particularly in a situation in which the economy was headed 
down so quickly anyway, and I gather that is why the 
Administration and many Members of Congress thought that action 
should be taken.
    But it did not pose a systemic financial risk even though 
it did impose substantial financial hardship. I do not think 
any of us wants to tell you that an approach to systemic risk 
will either prevent or mitigate all important economic----
    Senator Menendez. So let me take a different--I do not know 
if any of you want to jump in to that question, but let me take 
a different tack on that. So we are looking at a $3, $4 
trillion commercial mortgage problem coming down the pike in a 
marketplace that at this point in time I am told by entities 
across the country there is no--largely speaking, in the 
private sector there is not the wherewithal for that market to 
take these mortgages that will be rolling over.
    Now, having looked at our lack of action on the 
homeownership sign and what happened there, is that something 
that we think poses systemic risk? Or do you put it under your 
same category, may create enormous economic consequences but 
obviously does not have financial risk? Although I would say 
that if all those people default and cannot find a mortgage in 
the marketplace, those institutions will be holding a large 
number--maybe backed up by some degree of security with the 
properties, but they will have large numbers of defaults and 
less under a marketplace that has reduced in value and less 
than their holdings presently require. So what is that?
    Mr. Tarullo. Well, I think it depends, Senator, again, on 
where the concentration is to be found and what the impact of 
the failure of an institution holding any form of exposure 
would be.
    Let me just say with respect to commercial real estate, I 
agree with your assessment that it is a looming problem. It is 
a looming problem for communities and for economic performance 
generally. It is a looming problem for many financial 
institutions in this country. I do not know that one can 
classify it in and of itself as being a systemic risk or not 
being a systemic risk. It is surely an issue and a problem, 
which is why I think all the bank supervisors have been paying 
attention to the exposures. And now speaking only for the Fed, 
we extended the TALF program to commercial mortgages precisely 
because of the absence of credit flows and the absence of 
secondary markets there.
    Ms. Schapiro. Senator, I would just add briefly that I 
think there are--your question really points out something very 
important. We are very focused on systemically important 
institutions, but there are absolutely systemically risky 
practices that, if engaged in by a broad range of institutions, 
no one of which might be a systemically important institution, 
but those practices taken together across the marketplace as a 
whole absolutely have the potential to create broad systemic 
risk for the financial system at large.
    Senator Menendez. My time is up, but I will submit a 
question to you, Chairman Bair, about your FDIC-OCC dispute on 
big banks versus community banks, because I just do not quite 
understand that community banks that were not the cause of the 
challenges we face get hit at the same rate as entities that 
did create some of those risks and that have greater risk 
overall. So I do not quite get it, but I would love to hear the 
answer.
    Senator Warner. Thank you, Senator Menendez, and I would 
like to thank the panel. You have hung in for a long time and 
we will, I know, have additional questions which we will submit 
to you. Thank you all.
    If we could go ahead and move to the second panel, and my 
thanks to the second panel's forbearance. If the second panel 
could move quickly to their seats so that we could move 
forward, I think we do have a vote, as I understand, coming up 
in the next 45 minutes, so we want to make sure folks get a 
chance to testify.
    I am going to go ahead and introduce our panel, even though 
they are in the midst of still being seated. Vincent Reinhart 
has spent more than two decades working on domestic and 
international aspects of U.S. monetary policy. He served for 
the last 6 years of his Federal Reserve career as Secretary and 
Economist to the Federal Open Market Committee and has served 
in a variety of senior positions at the Federal Reserve. Mr. 
Reinhart, thank you for being here.
    Paul Schott Stevens has served as President and Chief 
Executive Officer of the Investment Company Institute since 
June 2004. Outside ICI, Mr. Stevens' career has included varied 
roles in private law practices, corporate counsel, and in 
Government service. Mr. Stevens, thank you for being here, as 
well.
    Alice Rivlin, as we all know, is the Senior Fellow in 
Economic Studies Programs at Brookings. She was the Founding 
Director of the CBO and has served as Director of the White 
House Office of Management and Budget. Alice, thank you for 
appearing here, as well.
    Allan Meltzer is a Professor of Political Economy and 
Public Policy at the Carnegie Mellon University and is also a 
visiting scholar at AEI.
    I don't normally get a chance to sit here in the chair. I 
don't want to mess it up too much, but recognizing that Senator 
Bunning said we actually may have a series of votes starting 
even earlier than 45 minutes from now, I would ask each of the 
panel, recognizing there are only three of us here still on 
this side of the dais, if they could make their statements 
relatively short so that we could make sure we could get a 
chance to ask questions.
    Mr. Reinhart.

 STATEMENT OF VINCENT R. REINHART, RESIDENT SCHOLAR, AMERICAN 
                      ENTERPRISE INSTITUTE

    Mr. Reinhart. Thank you for the opportunity to testify 
today, even if it is late in the session. No doubt, the 
American people expect significant remedial action in the 
aftermath of the extraordinary Government support to financial 
institutions over the past year.
    In my view, the Congress should form a committee of 
existing supervisors headed by an independent director, 
appointed by the President, and confirmed by the Senate. The 
director should have a budget for staff and real powers to 
compel cooperation among the constituent agencies and reporting 
from unregulated entities, if necessary. The constituent 
agencies should regularly be directed to draft reports in their 
areas of expertise for consideration by the full committee and 
transmittal to the Congress. This could include twice-a-year 
reports on financial stability from the Fed, appraisals of the 
health of the banking system from the FDIC, and assessments of 
the resilience of markets from the CFTC and the SEC.
    I believe there are compelling reasons that the 
responsibility of the financial stability supervisor should not 
be given to the Fed. I worked in the Federal Reserve system for 
a quarter century and hold its staff in high esteem. But any 
group of people in an independent agency given too many goals 
will be pulled in too many directions. And there is one goal 
given to the Fed that should not be jeopardized, the pursuit of 
maximum employment and stable prices. Indeed, that goal is so 
pivotal that Congress should be thinking of narrowing, not 
broadening, the Fed's focus.
    A financial stability committee could foster the 
achievement over time for robust rules on the resolution of 
private firms, simplification of the financial system, and 
consolidation of financial agencies. That is the opportunity 
for real, long-lasting benefits.
    Senator Warner. Thank you, Mr. Reinhart.
    Mr. Stevens.

STATEMENT OF PAUL SCHOTT STEVENS, PRESIDENT AND CEO, INVESTMENT 
                       COMPANY INSTITUTE

    Mr. Stevens. Thank you, Senator Warner, Senator Shelby, and 
Members of the Committee. You may recall I testified before the 
Committee in March and recommended at that time that the best 
way to approach systemic risk regulation would be to create a 
statutory council of senior Federal regulators. Such a body 
would be best equipped to look across the system and anticipate 
and address emerging threats to its stability.
    As I thought about the challenge, I told the Committee that 
my model was the National Security Council, which Congress 
established in 1947 to coordinate and integrate, quote, 
``domestic foreign and military policies relating to the 
national security.'' From 1987 to 1989, I served on the NSC 
staff. I was its first legal advisor. I helped lead a 
reorganization of the NSC, of the system and of its staff, and 
I then served as Chief of the NSC staff under National Security 
Advisor Colin Powell.
    Based on that experience, I believe an interagency council 
with a strong authority in a focused area, in this case 
monitoring and directing the response to risks that threaten 
overall financial stability, could, like the NSC, serve the 
Nation well in addressing complex and multifaceted risks.
    The Administration has proposed creation of a Financial 
Services Oversight Council, but one that would have at best an 
advisory or consultative role. The lion's share of systemic 
risk authority would be vested in the Fed, and that approach 
strikes me as achieving the wrong balance. Most importantly, it 
fails to make meaningful use of the expertise and viewpoints of 
other regulators and it represents, as some Members of the 
Committee have observed, a very worrisome expansion of the 
Federal Reserve's authority over the Nation's entire financial 
system.
    I would note my reading of the Administration's legislative 
proposals would, for example, suggest that dozens of mutual 
fund companies could conceivably be under scrutiny as Tier 1 
Financial Holding Companies, a result that was, to say the 
least, surprising to me.
    I would urge Congress instead to create a strong Systemic 
Risk Council, one with teeth. Effectively addressing risk to 
the financial system at large requires diverse inputs and 
perspectives. The standing membership of the council should 
include the core Federal regulators, within my judgment, the 
Treasury Secretary serving as Chair. For independence, the 
council should be supported by a very strong Executive Director 
appointed by the President and a small, highly experienced 
staff. For accountability, the council should be required to 
report regularly on its activities to the Congress.
    By statute, the council should be charged with identifying 
risks and directing regulatory actions needed to mitigate them. 
Responsibility for addressing the risks should lie with the 
functional regulators, operating for this purpose only under 
the council's direction. The council would thus have clear 
authority, but over a very limited range of issues, only major 
unaddressed hazards, not day-to-day regulation.
    This approach has several advantages. The council would 
enlist expertise across the spectrum of financial services. It 
would be well-suited to balancing competing interests. It would 
engage the functional regulators as full partners. At the same 
time, its independent staff could serve as a check on the 
functional regulators and avoid the regulatory capture that 
could result if one agency were set over all institutions 
deemed systemically risky or too-big-to-fail. And the council 
could be up and running quickly, while it might take years for 
any existing agency to assemble the requisite skills to oversee 
all areas of the financial system.
    Critics of the model have said that convening a committee 
is not the best way to put out a fire, and that may be, but the 
goal of systemic risk regulation should be to prevent or 
contain fires before they consume our financial system, and a 
broad-based council surely is the very best body for designing 
a strong fire code.
    Thank you for the opportunity to testify. I look forward to 
your questions.
    Senator Warner. Thank you for both getting your statements 
in under your time.
    Ms. Rivlin, the Chairman is back. Let us see if we can keep 
this, you know, if I can show off a little bit to show that 
everybody gets through their statements quickly.

STATEMENT OF ALICE M. RIVLIN, SENIOR FELLOW, ECONOMIC STUDIES, 
                     BROOKINGS INSTITUTION

    Ms. Rivlin. We are on a roll here. Thank you, Mr. Chairman 
and Members of the Committee.
    Controlling systemic risk breaks into two questions, I 
think, how to avoid the excesses of a bubble economy that can 
burst and cause a catastrophic downward spiral, and second, how 
to make sure that if a large interconnected institution fails, 
it doesn't start that downward spiral and take others with it.
    On the first question, how to prevent the excesses of a 
bubble, we need to fix regulatory gaps. Ineffective regulation 
contributed to the excesses and allowed lax lending standards 
and all of the things that we have worried about. And we need 
to correct the perverse incentives that crept into the system, 
as with the originate-to-distribute model.
    That can be done, correcting the gaps and perverse 
incentives, but however we do that, the job is not over. 
Participants in the financial system will try to avoid the 
rules, whatever they are. The system will need constant 
monitoring to make sure that new gaps and perverse incentives 
are not creeping in that lead to new excesses and instability.
    So I think one job is this monitoring function. The Obama 
Administration would put this function with a Financial 
Oversight Council chaired by the Treasury but with its own 
staff. I think it would make more sense to put this function at 
the Federal Reserve, perhaps consulting with a council. The Fed 
has the clear overview of the whole economy. It fits with the 
job that they already have for monitoring the economy and the 
health of the banking system.
    I would also give the Fed another tool, broader control of 
the amount of leverage in the system. Bubbles get out of hand 
when demand is fueled by big increases in speculation with 
other people's money. The short-term interest rate is not a 
sufficient tool for controlling as that price bubbles. So I 
would recommend working out a system in which not only capital 
requirements, but other constraints on leverage across the 
system could be tightened in the face of a serious bubble 
threat.
    Then there is the problem of the large interconnected 
institution. This can be mitigated by making it more expensive 
to get big, having capital requirements rise as institutions 
grow, for instance. We need much more effective prudential 
regulation of all financial institutions, especially as they 
get big enough to threaten the system.
    The Obama Administration proposes designating institutions 
that pose systemic risk and giving the Fed responsibility for 
consolidated prudential regulation of what they call Tier 1 
Financial Holding Companies. I think both parts of that 
proposition would be a mistake.
    We should not designate institutions as too-big-to-fail and 
give them their own regulator. It is hard to make up that list. 
But we would also be creating a new set of GSEs. There is a 
danger that the regulator of too-big-to-fail institutions would 
see its job as keeping them from failing and the result would 
eventually be expensive bailouts.
    Second, I would definitely not put additional regulatory 
responsibility at the Federal Reserve. The Fed is very good at 
monetary policy. It should be headed and staffed by strong 
macroeconomists who are charged with keeping on top of economic 
developments. These are different skills from regulation and I 
think putting an additional regulatory responsibility which 
they have historically not been very good at at the Fed would 
dilute their monetary policy focus.
    I also fear that adding a new set of regulatory authorities 
to the Fed's task would threaten the independence of monetary 
policy, which is very important to preserve. Congress would 
justifiably want more control over such a powerful agency, 
appropriations, accountability for policy, and so forth. It 
might easily threaten the independence of the Federal Reserve 
in taking unpopular decisions to rein in the bubble economy.
    Thank you, Mr. Chairman.
    Senator Warner. Professor Meltzer.

STATEMENT OF ALLAN H. MELTZER, PROFESSOR OF POLITICAL ECONOMY, 
     TEPPER SCHOOL OF BUSINESS, CARNEGIE MELLON UNIVERSITY

    Mr. Meltzer. Mr. Chairman, Senator Shelby, thank you for 
the opportunity to be here. I believe that effective regulation 
should await evidence and conclusions about the causes of the 
recent crisis. There are so many assertions about those causes 
that Congress should want to avoid a rush to regulate.
    During much of the past 15 years, I have written three 
volumes entitled The History of the Federal Reserve. Working 
with several assistants, we have read virtually all of the 
minutes of the Board of Governors, the Federal Open Market 
Committee, the Directors of the Federal Reserve Bank of New 
York, staff papers, internal memos, and so on. I speak from 
that perspective. I speak also from experience in Japan, where 
I served as the honorary advisor to the Bank of Japan during 
the 1990s when they were undergoing their banking and financial 
crisis.
    First, I do not know of any clear examples in the history 
of the Federal Reserve in which the Federal Reserve acted in 
advance of a crisis or a series of banking and financial 
failures. I have had the privilege of working with various 
Secretaries of the Treasury. Here is how the problem presents 
itself to them.
    There are a group of people who say, if you don't do the 
bailout now, you are going to have a crisis and it will go down 
in the history books with your name on it. There will be a few 
people who will say--very few, I may say--who will say, let the 
failing institution fail and make sure that you protect the 
market from having the failure spread. That is a question that 
really is at the center of this. It is not whether we should 
get rid of ``too-big-to-fail.'' I think many people recognize 
that ``too-big-to-fail'' is a disaster. What we need to worry 
about is how do we prevent problems from spreading. I am 
pleased to see that there is a good deal of skepticism among 
the Members of the Committee about simply appointing another 
regulator and saying to them, do what Secretaries of the 
Treasury, Chairmen of the Federal Reserve have done 
historically. That won't work.
    There are three things which I think are central to any 
such discussion. First is the question of incentives. How do we 
make incentives for prudent behavior on the part of bankers? We 
let them fail.
    Second, how do we make sure that bankers will not want to 
fail? We tell them you can fail and the best way to avoid 
failure is to hold capital. We need to buildup the capital. In 
the 1920s, banks everywhere had much more capital than they do 
now. A bank's window said, some of you may remember, listed the 
paid-in surplus and capital. By the 1950s, that was gone and it 
said, ``Member FDIC.'' That was a change in attitude. So we 
need to worry about capital.
    And last but something that I have not heard here but which 
should be part of your discussion is we need a lender of last 
resort proposal. The Federal Reserve in 96 years has never 
clearly enunciated what its role as lender of last resort is. 
It must be a role that the Congress will accept. No role will 
be viable if the Congress doesn't accept it. But there must be 
such a rule and that rule should say, hold capital and hold 
negotiable assets that you can sell to the Federal Reserve at 
the discount window what they will accept. That is the way in 
which we keep crises from spreading. We say, you are 
responsible as a banker and you must hold capital to protect 
yourself and you must have negotiable assets that you can sell 
to the Federal Reserve discount window because that is what it 
is there for. Without that, we won't have safety.
    What difference will there be if we establish one of these 
super-regulators? Why will they behave differently than the 
Treasury Secretaries that I have talked about, Federal Reserve 
Chairmen? Why will they not say about the Tier 1 risk people, 
you are too-big-to-fail. We can't allow that to happen. We have 
to use taxpayer money to bail you out. I don't believe that it 
will work.
    The first law of regulation--my first law of regulation is 
regulators make rules. Markets learn to circumvent them. You 
have heard lots of examples of that. It is a dynamic process. 
There is no set of rules which is going to for all time 
regulate this process. We need to change the incentives and the 
incentives have to be, you fail, we protect the market.
    Senator Warner. Thank you all for your testimony. Thank you 
for your abbreviated testimony.
    If I ever get a chance to sit here again, I am not going to 
go first, Chairman Dodd.
    [Laughter.]
    Chairman Dodd [presiding]. He has got a future in the 
Senate, I would say.
    [Laughter.]
    Chairman Dodd. Thank you, Mark, very much, and thanks for 
chairing the Committee for a few minutes.
    Well, thank all of you. What a wealth of talent at this 
table and a wealth of experience, as well. You really offer 
some very great counsel and advice to us as we try to navigate 
these waters. I think all of us, as I said earlier, are very 
conscious of the fact that this is a tremendous challenge and 
we want to get it right.
    I think you have heard a number of us make the point that, 
unlike other efforts ongoing today, this is one that is almost 
devoid of ideology as we are looking at it and how do we do 
this in a way that is going to provide the kind of confidence-
building measures that are so critical for the stability of our 
financial institutions, and that word ``confidence'' more than 
anything else is one that--I don't know of any specific formula 
that gets you there. It is one of those items that you know it 
when you have it and you know it when you don't, and trying to 
create through this process, even the process itself we are 
going through, I hope has some confidence-building qualities to 
it, as the Committee of primary jurisdiction over these matters 
to what steps do we take in order to reestablish that level of 
confidence.
    On the part of all the consumers and users of financial 
services, from the shareholder to the borrower to the depositor 
to the policy holder, all of whom have different assumptions of 
risk as they engage in financial activities, but essential in 
all of them, weaving its way through each one of them is 
confidence--confidence the system is going to work, that it is 
going to be there to protect them, that they are going to be 
safe, not that they necessarily have a guaranteed return on the 
activities they engage in, but the system won't fail them. They 
may make a bad bet, but it is not because the system was 
corrupt or fell apart on them. And so that is really, I think, 
what we are all trying to achieve in this.
    Senator Shelby chaired this Committee and has a strong 
understanding and sense of it. People like Mark Warner and Jim 
Bunning, Mark has had a great background and experience in this 
in his private life, and Jim Bunning was ahead of the curve on 
this Committee, working with others on the Committee, 
identifying very early on the issue of the residential 
mortgages. So there has been a lot of history on the Committee 
going back, so we are appreciative of it.
    And let me start with a question you have somewhat 
addressed already. The Fed has long argued that its prudential 
supervisory regulatory powers over banks and holding companies 
are critical to the effectiveness of its monetary policy, that 
they are interrelated, and three out of the four of you have 
experience at the Fed. Given your own past roles in setting and 
executing monetary policy at the Fed, we would like to hear 
your views on this. This idea that you can separate and 
distinguish in those roles is one that really is not wise.
    And a follow-up, Dr. Meltzer. Based on your study of the 
Federal Reserve's history, do you see the Fed's bank 
supervisory role as critical to its monetary policy function, 
as well----
    Mr. Meltzer. No, sir, and the staff has told them many 
times the answer is it really is unrelated. I mean, they can 
get the information from the other agencies. The reason the 
Fed, I believe, the reason the Fed wants supervisory authority 
is because it wants a coalition of people to protect themselves 
against pressures that come from the Administration and 
Congress. It wants people who know about the Fed, that want to 
protect its monetary policy responsibilities and they have used 
it in that way.
    At one time in the history, the Committee, your Committee--
not you, but your Committee got very angry at Chairman Burns 
because of the extent to which he had used that mechanism to 
protect himself against something that the Congress wanted to 
do.
    Chairman Dodd. Alice.
    Ms. Rivlin. I don't think that the supervising individual 
banks is important to making monetary policy. I know that was 
said around the table when I was at the Fed, but I didn't 
really experience that we learned a lot from the supervising 
particular banking institutions that was useful to monetary 
policy.
    What is important is for the Fed to have access to 
information about how things are going and that is why I think 
the monitoring function of being in charge of monitoring for 
systemic risk is--they ought to be doing that anyway, but to 
give them that formal responsibility, I think, would be 
helpful. But I don't think they have to supervise individual 
institutions. In fact, I think it would be bad to do that.
    Chairman Dodd. Let me ask you this, Alice, and the question 
has been raised with others and you may have addressed it 
before I walked back in in your statements, and that is the 
potential conflict. Given the principal function and 
responsibility of the Fed of monetary policy--and I don't think 
anyone disagrees, that is the primary responsibility--is there 
not the risk of being in conflict from time to time when you 
are asked to be both simultaneously the systemic risk regulator 
and functioning as the fundamental, chief responsibility of 
monetary policy, where you could actually--you are letting one 
trump the other. There are not necessarily going to be 
consistent objectives at given moments in time.
    Ms. Rivlin. That could be true. I think the more important 
point, though, is that they are different skills. If you really 
want a set of people who are good at regulating institutions 
and helping them not make stupid decisions, then it is a 
different kind of staff and leadership than the people who are 
good at macroeconomics and figuring out what to do about the 
economy.
    Chairman Dodd. Yes. Mr. Reinhart, do you have a view on 
this?
    Mr. Reinhart. Sure, a couple points. One is when you give 
an entity that has macropowers a supervisory responsibility, 
they have the ability to clean up their mistakes after the 
fact. Would a Fed that can lend to an institution be more 
willing to lend to it when it hadn't identified it as a 
systemic threat? Would it be willing to use its monetary policy 
tool to make markets function better in an environment where it 
had failed to identify some market areas as posing systemic 
risk?
    Now, for 6 years, I signed off on the minutes and 
transcripts of the Federal Open Market Committee, a wonderful 
resource actually giving the details of deliberations of 
monetary policy. And the next time you hear someone say there 
is important cross-pollination between monetary policy 
decisions and bank supervision, you should ask them to go back 
to the FOMC transcripts and give you the examples where there 
was a significant discussion about bank supervisory matters 
that informed the monetary policy decision.
    The fact is, as has already been noted, an agency is filled 
with hardened silos and the economists don't talk to the 
lawyers who don't talk to the bank supervisors. What is 
important is to enforce an information sharing, and in some 
ways, it is easier to do that across agencies than within an 
agency.
    Chairman Dodd. Paul, I want to give you a quick chance to 
respond to that. My time is up, but it is good to see you and 
thanks for being here.
    Mr. Stevens. Thank you, Chairman Dodd. Lacking the 
experience that my colleagues have at the Fed, I will pass on 
that question.
    Chairman Dodd. All right.
    Mr. Meltzer. Mr. Chairman, may I just say, Congress passed 
FDICIA to try to prevent exactly what you just described. They 
have not used FDICIA.
    Chairman Dodd. Good point.
    Senator Shelby.
    Senator Shelby. Dr. Reinhart, you were the Director, it is 
my understanding, of the Division of Monetary Policy at the 
Fed.
    Mr. Reinhart. Yes, sir.
    Senator Shelby. And from what I gather from your testimony, 
you do not believe the Fed needs to regulate financial 
institutions in order to conduct or perform its monetary policy 
functions, do you, or do you not?
    Mr. Reinhart. Yes. I think the Fed needs an understanding, 
a deep understanding of the ways markets work, about the way 
the institutions work in general. They need to share 
information from other agencies. But the talents to be able to 
tell a macrostory to fit all those parts of the picture 
together for the implications for policy are not ones that need 
supervision.
    Senator Shelby. Dr. Meltzer, in your testimony, you 
question the wisdom of relying too much on capital standards to 
guard against systemic risk. You point out the problems of the 
Basel Accord that they caused. You also note that banks have 
been very successful in circumventing regulation, which we see. 
My question to you, are there limits on how much Congress can 
manage systemic risk through regulation, and if so, what 
measures can be adopted to create incentives for the private 
sector to better manage risk?
    Mr. Meltzer. Two critical things. Get rid of ``too-big-to-
fail'' and replace it with more capital in the banks.
    Second, get a lender of last resort rule that you are 
willing to live with, that the Fed is willing to live with, 
that the regulators are willing to live with, which says 
institutions can fail. The market will be protected from the 
spread of that failure to other institutions. Without those 
changes, no regulation is going to work.
    I gave this talk at the council on Foreign Relations and I 
said, lawyers make regulations. Markets learn to circumvent 
them. The first question was from a lawyer. He said, it is we 
lawyers who teach them how to circumvent them.
    Senator Shelby. You have got it right.
    Doctor, in your examination of history, has the Federal 
Reserve demonstrated that it is inherently better at 
identifying systemic risk than any other regulator?
    Mr. Meltzer. It is hard to identify systemic risk. You 
know, the term ``systemic risk'' is a term of art. I mean, it 
is indeed a term of art, because as the questions on the 
Committee showed earlier, every Congressman, every Senator will 
see--properly see--a failing institution in his region as a 
problem which is systemic. How are they going to fight that? I 
mean, you, Senator, along with many people argued against the 
GSEs----
    Senator Shelby. That is right.
    Mr. Meltzer. ----thought that something had to be done. But 
Congress wasn't going to do that. Is a systemic regulator going 
to say, ignore Congress and do that? Is that what we want? No. 
Is it possible? I don't believe it is possible in the American 
system of Government, nor do I think it should be possible in 
the American system of Government for people to say the 
Congress doesn't have a right even to make the mistakes that it 
makes.
    Senator Shelby. Ms. Rivlin, the Fed's wide-ranging 
responsibilities seem to me to appear at times to distract it 
from its primary mission of monetary policy. For example, just 
the other day, the topics covered at our recent Humphrey-
Hawkins hearing demonstrate this point. While the discussion 
should have centered on monetary policy, by our count, only 
about 27 percent of the questions even addressed monetary 
policy from this Committee. How concerned are you that we may 
be asking one institution to do too much?
    Ms. Rivlin. I am very concerned, Senator Shelby, and that 
is why I don't think it is a good idea to have a new 
responsibility for ``too-big-to-fail'' institutions at the Fed 
or indeed to identify those institutions at all. I am not sure 
that the Humphrey-Hawkins questioning, since we are in the 
middle of a catastrophe and there were all sorts of things to 
ask about, is exactly an example of that, but I do fear that we 
will distract the Fed from monetary policy.
    Senator Shelby. Thank you very much. Thank you, Mr. 
Chairman.
    Senator Warner [presiding]. Senator Reed.
    Senator Reed. Thank you, Mr. Chairman, and thank you for 
your testimony today and for your answers.
    As the President's plan evolves, if it is not modified, the 
Federal Reserve essentially would be the direct regulator of 
most of the major financial institutions of the country. It 
would eliminate OTS, et cetera. There has been the suggestion 
here, or at least the recommendation, that they get out of the 
business of regulating banks. But then I would presume they 
would still have the authority, in fact, the responsibility to 
regulate the holding company structure, the subsidiaries, the 
affiliates where a lot of the problems really evolved. Is that 
your sense, Mr. Reinhart?
    Mr. Reinhart. That is why actually I would be a strong 
proponent of simplification of the rules, consolidation of the 
agencies, and putting in place a forceful resolution mechanism 
for entities. So my preference would be to roll in the existing 
agencies, including the supervisory part of the Federal Reserve 
for holding companies, into a new Federal regulator.
    Senator Reed. Mr. Stevens, do you have an opinion?
    Mr. Stevens. Yes. Thank you, Senator. I had an occasion to 
look through, at least briefly, the Administration's 
legislative language and the entities that would be vetted to 
determine whether they are Tier 1 Financial Holding Companies, 
at least potentially, represent an enormous universe of firms--
$10 billion or more in assets, $100 billion or more in assets 
under management, $2 billion or more in gross annual revenue. 
All of those firms would be potentially subject to review for 
whether they should be designated Tier 1 Financial Holding 
Companies under a series of standards, the last of which is any 
other factor that the Fed thinks is important.
    So I don't know, reading the legislation, what the universe 
of Fed-regulated entities will be, but it is potentially 
enormously large. I asked our research department, how many 
mutual fund firms are there, through their mutual funds or 
other asset management activities, that may have $100 billion 
or more in assets under management, and as I said in my 
statement, our best guess is that there are dozens of them, 
many of whom would be quite surprised to learn that they are 
systemically risky, none of whom thinks that they are too-big-
to-fail.
    Senator Reed. Dr. Rivlin.
    Ms. Rivlin. I would go with Mr. Reinhart on this. Moving to 
a consolidated regulator with less potential for regulatory 
arbitrage would seem to me fine, and moving the regulation of 
bank holding companies out of the Fed would also seem to me 
fine. But the real point is, don't make it worse. Don't put a 
huge new regulatory responsibility at the Federal Reserve.
    Senator Reed. And Dr. Meltzer.
    Mr. Meltzer. Senator, I don't have any quarrel with Vince 
Reinhart's proposal. I would say that if you look around the 
world, we have separation of regulation and monetary policy. We 
have it together. It doesn't seem to make a great deal of 
difference. That is, for the failures that we have, why is 
that? Because we lack the incentives on the regulators to close 
down ``too-big-to-fail'' and protect the market.
    Senator Reed. And your proposal is, I think, a very direct 
response to that, which would be to have higher capital levels 
which presumably smaller institutions could result or would 
result from that.
    One other question, because it is implicit, I think, in 
what we are talking about in terms of dealing with derivatives, 
et cetera, and that is establishing capital ratios for risky 
operations. Can you comment on that approach, too?
    Mr. Meltzer. Yes. I would say, let the institution choose 
its size, but increase the capital requirement more than 
proportional to the size of the assets so that we--the reason I 
want that is I want the stockholders and the management to bear 
the losses. There is no gain in economies of scale and 
economies of scope that the public is going to realize from 
large institutions that compensates for the costs we just paid. 
So we want the costs to be on them, and that gives them an 
incentive not to do the things they have been doing.
    Senator Reed. Thank you, Mr. Chairman. Thank you.
    Senator Warner. A vote has started and----
    Senator Bunning. I am going to be very short. I have got 
one question, because I have waited for this panel a long time.
    [Laughter.]
    Senator Bunning. This is for anybody that would like to 
answer. Do you think the Federal Reserve would do a better job 
at monetary policy if its only mission was keeping a stable 
currency?
    Mr. Meltzer. I will start with that. I believe--I like the 
dual requirement. I think that represents what all central 
banks, whatever their requirements are, all central banks have 
to be concerned about what is happening to the public. But they 
also need to have much more attention on maintaining price 
stability. I think the Committee needs to say, we are going to 
require the Federal Reserve to adopt some principle by which 
they operate that limits their discretion to make the mistakes 
that they have been making.
    Senator Bunning. Thank you, because they don't pay any 
attention to us. Go ahead.
    Mr. Meltzer. They do it if it is in the law.
    Senator Bunning. Well, even if we write it into the law, 
they don't do it, because in 1994, we wrote it into the law 
that they monitor all mortgages within the banking system that 
they control and within the mortgage brokers. And for 14 years, 
they didn't write a regulation.
    Alice.
    Ms. Rivlin. I would actually keep the dual focus on 
employment, as well as inflation.
    Senator Bunning. OK.
    Ms. Rivlin. And I think the Fed gets pretty high marks, 
actually, on the inflation front, as do other central banks 
over the last few years.
    Senator Bunning. Depending on who is scoring.
    Ms. Rivlin. Well, OK, but we have not had a big inflation 
problem. Now, maybe the Fed doesn't get all the credit for it, 
but it is not that they haven't paid attention on that front. 
They may not have paid attention----
    Senator Bunning. Oh, I didn't say they didn't pay 
attention, but they failed to act is all I can tell you.
    Go ahead.
    Mr. Stevens. Senator, all I would say, not being the Fed 
expert here, is----
    Senator Bunning. You don't have to be a Fed expert to 
understand.
    Mr. Stevens. ----at least there is a strong question to 
ask--why the authority should be so dramatically expanded.
    Senator Bunning. OK.
    Mr. Reinhart. I believe the Fed Reserve would be better off 
if it had a narrow mandate. Maximum employment and stable 
prices sounds right to me. I think are many reasons why that 
would be better, including keeping the focus of the 
institution, also providing----
    Senator Bunning. Rather than expanding their portfolio.
    Mr. Reinhart. Certainly not expanding. Also making it 
clearer to the public exactly what the Federal Reserve does and 
improving the relationships with the Congress.
    Senator Bunning. That would take a lot of work.
    Mr. Reinhart. If it was narrowly focused. When you think 
about it, a lot of these hearings get consumed by issues other 
than monetary policy.
    Senator Bunning. When they came to us, when they asked for 
the TARP money and said, this is going to be as transparent as 
anything that we have ever dealt with, and they have completely 
stonewalled who they lent the money to, how much money they 
printed, and what banks got it and what they spent it for. So 
transparency is out the door.
    Thank you for your answers. Thank you.
    Senator Warner. Well, I am not going to get a chance to ask 
my questions. That is the last time I will take this middle 
position here as the temporary Chair. But just two quick 
comments because we are going to have to run off and vote.
    One, thank you all very much for your testimony this 
morning. My apologies that the session started late. We will, I 
am sure, all have additional questions.
    I share the overwhelming view of the panel that systemic 
risk ought to not be placed with the Fed and ought to be 
empowered with a new independent council that includes the Fed. 
I also would like to hear a longer--a written question I will 
submit. I do believe we ought to further explore the idea of a 
single end-to-end depository regulator for all prudential 
regulation and take that out of the Fed and out of the FDIC as 
well as the consolidation of the OCC and OTS.
    And I do share Professor Meltzer's concerns about how we 
put stumbling blocks in front of ``too-big-to-fail.'' Increased 
capital, obviously one. I think we have to look at increased 
capital on resolution and whether even a contingent liability 
fund inside firms of ``too-large'' that might actually cause 
some self-policing among those institutions.
    The question I will also submit to you is whether those 
nontraditional banking activities, as more and more of these 
large bank holding companies look like hedge funds, look like 
trading funds, have all these other nontraditional banking 
aspects, should there be higher capital requirements on those 
what would be arguably riskier activities. But I will submit 
those as questions and look forward to your answers.
    I again thank the panel for their patience and indulgence. 
Thank you all very much.
    The hearing is adjourned.
    [Whereupon, at 12:44 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
           PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
    The economic crisis introduced a new term to our national 
vocabulary--systemic risk. It is the idea that in an interconnected 
global economy, it's easy for some people's problems to become 
everybody's problems.
    The failures that destroyed some of our Nation's most prestigious 
financial institutions also devastated the economic security of 
millions of working Americans who did nothing wrong--their jobs, homes, 
retirement security, gone in a flash because of Wall Street greed and 
regulatory neglect.
    After years of focusing on short term profits while ignoring long 
term risks, a number of companies, giants of the financial industry 
found themselves in serious trouble.
    Some failed. Some were sold under duress. And an untold number only 
survived because of Government intervention: loans, guarantees, and 
direct injections of capital.
    Taxpayers had no choice but to step in, assuming billions of 
dollars of risk, and save companies because our system wasn't set up to 
withstand their failure. These efforts saved our economy from 
catastrophe, but real damage remains.
    Investors, who lost billions, were scared to invest. Credit markets 
dried up. With no one willing to make loans, businesses couldn't make 
payroll, employees were laid off, and families couldn't get mortgages 
or loans to buy an automobile.
    Wall Street's failures have hit Main Streets across the country. It 
will take years, perhaps decades, to undo damage that a stronger 
regulatory system could have prevented.
    While many Americans understand why we had to take extraordinary 
measures this time, it doesn't mean they aren't angry. It doesn't mean 
they aren't worried. And it doesn't mean they don't expect us to fix 
the problems that allowed this to happen.
    First and foremost, we need somebody looking at the whole economy 
for the next big problem, with the authority to do something about it.
    The Administration has a bold proposal to modernize our financial 
regulatory system. It would give the Federal Reserve new authority to 
identify, regulate, and supervise all financial companies considered to 
be systemically important.
    It would establish a council of regulators to serve in a solely 
advisory role.
    And it would provide a framework for companies to fail, if they 
must fail, in a way that does not jeopardize the entire financial 
system.
    It's a thoughtful proposal. But the devil is in the details and I 
expect changes to be made.
    I share my colleagues' concerns about giving the Fed additional 
authority to regulate systemic risk.
    The Fed hasn't done a perfect job with the responsibilities it 
already has.
    This new authority could compromise the independence the Fed needs 
to carry out effective monetary policy.
    Additionally, systemic risk regulation involves too broad of a 
range of issues for any one regulator to oversee.
    And so, I am especially interested to hear from our witnesses your 
ideas on how we get this right.
    Many of you have suggested a council with real authority that would 
effectively use the combined knowledge of all of the regulatory 
agencies.
    As President Obama has said, when we rebuild our economy, we must 
ensure that its foundation rests on rock, not on sand. Today, we 
continue our work to lay the cornerstones for that foundation--strong, 
smart, effective regulation that protects working families without 
hindering growth.
                                 ______
                                 
            PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
    Thank you Mr. Chairman.
    At the core of the Administration's financial regulatory reform 
proposal is the concept of systemic risk. The President believes that 
it can be regulated and that the Fed should be the regulator.
    As we begin to consider how to address systemic risk, my main 
concern is that while there appears to be a growing consensus on the 
need for a systemic risk regulator, there is no agreement on how to 
define systemic risk, let alone how to manage it.
    I believe that it would be legislative malfeasance to simply tell a 
particular regulator to manage all financial risks without having 
reached some consensus on what systemic risk is and whether it can be 
regulated at all.
    Should we reach such a consensus, we then must be very careful not 
to give our markets a false sense of security that could actually 
exacerbate our ``too-big-to-fail'' problem.
    If market participants believe that they no longer have to closely 
monitor risks presented by financial institutions, the stage will be 
set for our next economic crisis.
    If we can decide what systemic risk is and that it is something 
that should and can be regulated, our next question should be: Who 
should regulate it?
    Unfortunately, the Administration's proposal largely places the 
Federal Reserve in charge of regulating systemic risk.
    It would grant the Fed authority to regulate any bank, securities 
firm, insurer, investment fund or any other type of financial 
institution that the Fed deems a systemic risk.
    The Fed would be able to regulate any aspect of these firms, even 
over the objections of other regulators. In effect, the Fed would 
become a regulatory leviathan of unprecedented size and scope.
    I believe that expanding the Fed's powers in this manner could be 
very dangerous.
    The mixing of monetary policy and bank regulation has proven to be 
a formula for taxpayer-funded bailouts and poor monetary policy 
decisions.
    Giving the Fed ultimate responsibility for the regulation of 
systemically important firms will provide further incentive for the Fed 
to hide its regulatory failures by bailing out troubled firms.
    Rather than undertaking the politically painful task of resolving 
failed institutions, the Fed could take the easy way out and rescue 
them by using its lender-of-last-resort facilities or open market 
operations.
    Even worse, it could undertake these bailouts without having to 
obtain the approval of Congress.
    In our system of Government, elected-officials should make 
decisions about fiscal policy and the use of taxpayer dollars, not 
unelected central bankers.
    Handing over the public purse to an enhanced Fed is simply 
inconsistent with the principles of democratic Government.
    Augmenting the Federal Reserve's authority also risks burdening it 
with more responsibility than one institution can reasonably be 
expected to handle.
    In fact, the Federal Reserve is already overburdened with its 
responsibility for monetary policy, the payment system, consumer 
protection, and bank supervision.
    I believe anointing the Fed as the systemic risk regulator will 
make what has proven to be a bad bank regulator even worse.
    Let us not forget that it was the Fed that pushed for the adoption 
of the flawed Basel II capital accords, which would have drained our 
banking system of capital.
    It was the Fed that failed to adequately supervise Citigroup and 
Bank of America, setting the stage for bailouts in excess of $400 
billion.
    It was the Fed that failed to adopt mortgage underwriting 
guidelines until well after this crisis was underway.
    It was the Fed that said there was no need to regulate derivatives.
    It was also the Fed that lobbied to become the regulator of 
financial holding companies as part of Gramm-Leach-Bliley.
    The Fed won that fight and got the additional authority it sought. 
Ten years later, however, it is clear that the Fed has proven that it 
is incapable of handling that responsibility.
    Ultimately, if we are able to reach some sort of agreement on 
systemic risk and whether it can be managed, I strongly believe that we 
should consider every possible alternative to the Fed as the systemic 
risk regulator.
    Thank you Mr. Chairman.
                                 ______
                                 
               PREPARED STATEMENT OF SENATOR TIM JOHNSON
    Thank you Mr. Chairman for holding today's hearing. Hearings like 
this will be important as the Committee prepares to consider 
legislation to modernize our financial regulatory system and establish 
a mechanism to identify systemic risks to our economy.
    There is widespread agreement that institutions exploiting gaps in 
our regulatory system greatly contributed to the current economic 
crisis. These institutions, while oftentimes large and complex, were 
able to offer products with minimal regulation and operate with little 
oversight. The scope of the economic crisis is indicative of the 
breadth of the gaps in our regulatory system.
    Many have suggested that the best way to close these gaps is 
through the creation of an entity to oversee systemically risky firms, 
what some have termed ``too-big-to-fail.'' This entity could watch, 
evaluate, and when necessary, intervene to prevent failures of large 
firms from leading to an economy-wide meltdown.
    That said, we must be able to identify systemic risks without 
creating unnecessary regulation and without giving large firms the idea 
that the Federal Government is there to bail them out if they make poor 
decisions. A systemic risk regulator would have to put taxpayer 
protection at the top of its priority list.
    It is my hope that Members of this Committee from both sides of the 
aisle can find a proposal to better monitor systemic risk, whether 
within an existing agency or with the creation of a new entity. 
Regardless of who does it, we need to identify systemic risk in our 
financial markets to prevent another crisis like the one we are 
experiencing from happening again and to aid in our economic recovery 
and reform. We must get this right. I look forward to hearing from 
today's witnesses.
                                 ______
                                 
                PREPARED STATEMENT OF SENATOR JACK REED
    Today's hearing will help us create a new framework for identifying 
and minimizing systemic risks, so that we can prevent our financial 
markets from ever again facing the turmoil we have witnessed over the 
last year. We need to be thoughtful and deliberate in our approach, but 
we need to act soon. As part of this process, we should think carefully 
about some key remaining questions.
    First, there seems to be a consensus emerging among regulators and 
many in Congress on the need for a Council to address risks in the 
financial system. But my colleagues and I will need to think carefully 
about the specific role and tools available to such a Council. The 
Administration's proposal would establish a Financial Services 
Oversight Council, to be chaired by Treasury and consisting of the 
banking, securities, and other financial regulators.
    Such an approach gathers the right people around the table but may 
leave them with no ``teeth'' to intervene to prevent or react to 
problems. Much of the responsibility for setting standards would remain 
with the Federal Reserve, which raises serious concerns given its 
failure in recent years to identify serious risks to our financial 
system, and the agency's inaction on consumer protection issues.
    Second, under the Administration's plan, there would be heightened 
supervision and consolidation of all large, interconnected financial 
firms, including a process for identifying Tier 1 financial holding 
companies. This approach has merit, but requires careful consideration, 
especially as it would apply to firms that have operated under various 
exemptions and grandfathering provisions. We will also need to 
carefully consider if and how to identify Tier 1 firms on an ongoing 
basis. Today's hearing will allow for the consideration of the best 
approach in this area, including whether it is best done by a Council 
or a single regulator.
    Finally, among the issues we should consider is the 
Administration's proposal to enhance the Federal Reserve's authority 
with respect to the safety and soundness of systemically important 
payment, clearing, and settlement arrangements. This issue is of 
particular importance because of the role of these systems in 
increasing regulation of over-the-counter derivatives, and the existing 
responsibilities of the SEC and the CFTC in this area.
    I appreciate the testimony of the witnesses today and I look 
forward to discussing these important questions.
                                 ______
                                 
               PREPARED STATEMENT OF SENATOR JIM BUNNING
    Thank you, Mr. Chairman.
    As I have said several times before, I do not think we can create a 
new regulator that will be able to outsmart Wall Street and prevent 
future financial failures. And I know the Federal Reserve is not up to 
the task. In fact, the Fed needs to be reformed so it can get monetary 
policy right and not create future bubbles through easy money.
    Instead of putting all our faith in a super regulator, I think we 
are better off taking steps to reduce the damage done by future 
failures. That means making financial institutions smaller, reducing 
risk factors like leverage, banning some risky practices, sound 
supervision, and making financial actors live with the consequences of 
their actions. That also means treating similar activities the same way 
no matter if they are done by a bank, broker, or other firm, and ending 
regulation shopping. If we do these things, we will greatly reduce the 
impact of future failures.
    Finally, of all the proposals we have seen, the one outlined in 
Chairman Bair's testimony today makes the most sense so far. While I 
think there are other matters that need to be addressed and I may not 
agree with everything she proposes, I think her plan is a better 
starting point than the proposal from Treasury and the Fed.
    Thank you, Mr. Chairman. I look forward to hearing from the 
witnesses today.
                                 ______
                                 

                  PREPARED STATEMENT OF SHEILA C. BAIR
            Chairman, Federal Deposit Insurance Corporation
                             July 23, 2009
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
I appreciate the opportunity to testify on behalf of the Federal 
Deposit Insurance Corporation (FDIC) on the importance of reforming our 
financial regulatory system. The issues under discussion today rival in 
importance those before the Congress in the wake of the Great 
Depression.
    The proposals put forth by the Administration regarding the 
structure of the financial system, the supervision of financial 
entities, the protection of consumers, and the resolution of 
organizations that pose a systemic risk to the economy provide a useful 
framework for discussion of areas in vital need of reform. However, 
these are complex issues that can be addressed in a number of different 
ways. We all agree that we must get this right and enact regulatory 
reforms that address the fundamental causes of the current crisis 
within a carefully constructed framework that guards against future 
crises.
    It is clear that one of these causes was the presence of 
significant regulatory gaps within the financial system. Differences in 
the regulation of capital, leverage, complex financial instruments, and 
consumer protection provided an environment in which regulatory 
arbitrage became rampant. Reforms are urgently needed to close these 
regulatory gaps.
    At the same time, we must recognize that much of the risk in recent 
years was built up, within and around, financial firms that were 
already subject to extensive regulation and prudential supervision. One 
of the lessons of the past several years is that regulation and 
prudential supervision alone are not sufficient to control risk taking 
within a dynamic and complex financial system. Robust and credible 
mechanisms to ensure that market participants will actively monitor and 
control risk taking must be in place.
    We must find ways to impose greater market discipline on 
systemically important institutions. In a properly functioning market 
economy there will be winners and losers, and when firms--through their 
own mismanagement and excessive risk taking--are no longer viable, they 
should fail. Actions that prevent firms from failing ultimately distort 
market mechanisms, including the market's incentive to monitor the 
actions of similarly situated firms. Unfortunately, the actions taken 
during the past year have reinforced the idea that some financial 
organizations are too-big-to-fail. The solution must involve a 
practical, effective and highly credible mechanism for the orderly 
resolution of these institutions similar to that which exists for FDIC-
insured banks. In short, we need an end to ``too-big-to-fail.''
    The notion of ``too-big-to-fail'' creates a vicious circle that 
needs to be broken. Large firms are able to raise huge amounts of debt 
and equity and are given access to the credit markets at favorable 
terms without consideration of the firms' risk profile. Investors and 
creditors believe their exposure is minimal since they also believe the 
Government will not allow these firms to fail. The large firms leverage 
these funds and become even larger, which makes investors and creditors 
more complacent and more likely to extend credit and funds without fear 
of losses. In some respects, investors, creditors, and the firms 
themselves are making a bet that they are immune from the risks of 
failure and loss because they have become too big, believing that 
regulators will avoid taking action for fear of the repercussions on 
the broader market and economy.
    If anything is to be learned from this financial crisis, it is that 
market discipline must be more than a philosophy to ward off 
appropriate regulation during good times. It must be enforced during 
difficult times. Given this, we need to develop a resolution regime 
that provides for the orderly wind-down of large, systemically 
important financial firms, without imposing large costs to the 
taxpayers. In contrast to the current situation, this new regime would 
not focus on propping up the current firm and its management. Instead, 
under the proposed authority, the resolution would concentrate on 
maintaining the liquidity and key activities of the organization so 
that the entity can be resolved in an orderly fashion without 
disrupting the functioning of the financial system. Losses would be 
borne by the stockholders and bondholders of the holding company, and 
senior management would be replaced. Without a new comprehensive 
resolution regime, we will be forced to repeat the costly, ad hoc 
responses of the last year.
    My testimony discusses ways to address and improve the supervision 
of systemically important institutions and the identification of issues 
that pose risks to the financial system. The new structure should 
address such issues as the industry's excessive leverage, inadequate 
capital, and overreliance on short-term funding. In addition, the 
regulatory structure should ensure real corporate separateness and the 
separation of the bank's management, employees, and systems from those 
affiliates. Risky activities, such as proprietary and hedge fund 
trading, should be kept outside of insured banks and subject to 
enhanced capital requirements.
    Although regulatory gaps clearly need to be addressed, supervisory 
changes alone are not enough to address these problems. Accordingly, 
policy makers should focus on the elements necessary to create a 
credible resolution regime that can effectively address the resolution 
of financial institutions regardless of their size or complexity and 
assure that shareholders and creditors absorb losses before the 
Government. This mechanism is at the heart of our proposals--a bank and 
bank holding company resolution facility that will impose losses on 
shareholders and unsecured debt investors, while maintaining financial 
market stability and minimizing systemic consequences for the national 
and international economy. The credibility of this resolution mechanism 
would be further enhanced by the requirement that each bank holding 
company with subsidiaries engaged in nonbanking financial activities 
would be required to have, under rules established by the FDIC, a 
resolution plan that would be annually updated and published for the 
benefit of market participants and other customers.
    The combined enhanced supervision and unequivocal prospect of an 
orderly resolution will go a long way to assuring that the problems of 
the last several years are not repeated and that any problems that do 
arise can be handled without cost to the taxpayer.
Improving Supervision and Regulation
    The widespread economic damage that has occurred over the past 2 
years has called into question the fundamental assumptions regarding 
financial institutions and their supervision that have directed our 
regulatory efforts for decades. The unprecedented size and complexity 
of many of today's financial institutions raise serious issues 
regarding whether they can be properly managed and effectively 
supervised through existing mechanisms and techniques. Our current 
system clearly failed in many instances to manage risk properly and to 
provide stability. Many of the systemically significant entities that 
have needed Federal assistance were already subject to extensive 
Federal supervision. For various reasons, these powers were not used 
effectively and, as a consequence, supervision was not sufficiently 
proactive.
    Insufficient attention was paid to the adequacy of complex 
institutions' risk management capabilities. Too much reliance was 
placed on mathematical models to drive risk management decisions. 
Notwithstanding the lessons from Enron, off-balance sheet-vehicles were 
permitted beyond the reach of prudential regulation, including holding 
company capital requirements. The failure to ensure that financial 
products were appropriate and sustainable for consumers caused 
significant problems not only for those consumers but for the safety 
and soundness of financial institutions. Lax lending standards employed 
by lightly regulated nonbank mortgage originators initiated a downward 
competitive spiral which led to pervasive issuance of unsustainable 
mortgages. Ratings agencies freely assigned AAA credit ratings to the 
senior tranches of mortgage securitizations without doing fundamental 
analysis of underlying loan quality. Trillions of dollars in complex 
derivative instruments were written to hedge risks associated with 
mortgage-backed securities and other exposures. This market was, by and 
large, excluded from Federal regulation by statute.
    A strong case can be made for creating incentives that reduce the 
size and complexity of financial institutions. A financial system 
characterized by a handful of giant institutions with global reach and 
a single regulator is making a huge bet on the performance of those 
banks and that regulator.
    Financial firms that pose systemic risks should be subject to 
regulatory and economic incentives that require these institutions to 
hold larger capital and liquidity buffers to mirror the heightened risk 
they pose to the financial system. In addition, restrictions on 
leverage and the imposition of risk-based premiums on institutions and 
their activities would act as disincentives to growth and complexity 
that raise systemic concerns. In contrast to the standards implied in 
the Basel II Accord, systemically important firms should face 
additional capital charges based on both their size and complexity. To 
address procyclicality, the capital standards should provide for higher 
capital buffers that increase during expansions and are available to be 
drawn down during contractions. In addition, these firms should be 
subject to higher Prompt Corrective Action standards under U.S. laws 
and holding company capital requirements that are no less stringent 
than those applicable to insured banks. Regulators also should take 
into account off-balance-sheet assets and conduits as if these risks 
were on-balance-sheet.
The Need for a Financial Services Oversight Council
    The significant size and growth of unsupervised financial 
activities outside the traditional banking system--in what is termed 
the shadow financial system--has made it all the more difficult for 
regulators or market participants to understand the real dynamics of 
either bank credit markets or public capital markets. The existence of 
one regulatory framework for insured institutions and a much less 
effective regulatory scheme for nonbank entities created the conditions 
for arbitrage that permitted the development of risky and harmful 
products and services outside regulated entities.
    A distinction should be drawn between the direct supervision of 
systemically significant financial firms and the macroprudential 
oversight and regulation of developing risks that may pose systemic 
risks to the U.S. financial system. The former appropriately calls for 
the identification of a prudential supervisor for any potential 
systemically significant entity. Entities that are already subject to a 
prudential supervisor, such as insured depository institutions and 
financial holding companies, should retain those supervisory 
relationships.
    The macroprudential oversight of systemwide risks requires the 
integration of insights from a number of different regulatory 
perspectives--banks, securities firms, holding companies, and perhaps 
others. Only through these differing perspectives can there be a 
holistic view of developing risks to our system. As a result, for this 
latter role, the FDIC supports the creation of a Council to oversee 
systemic risk issues, develop needed prudential policies and mitigate 
developing systemic risks. In addition, for systemic entities not 
already subject to a Federal prudential supervisor, this Council should 
be empowered to require that they submit to such oversight, presumably 
as a financial holding company under the Federal Reserve--without 
subjecting them to the activities restrictions applicable to these 
companies.
    Supervisors across the financial system failed to identify the 
systemic nature of the risks before they were realized as widespread 
industry losses. The performance of the regulatory system in the 
current crisis underscores the weakness of monitoring systemic risk 
through the lens of individual financial institutions and argues for 
the need to assess emerging risks using a systemwide perspective. The 
Administration's proposal addresses the need for broader-based 
identification of systemic risks across the economy and improved 
interagency cooperation through the establishment of a new Financial 
Services Oversight Council. The Oversight Council described in the 
Administration's proposal currently lacks sufficient authority to 
effectively address systemic risks.
    In designing the role of the Council, it will be important to 
preserve the longstanding principle that bank regulation and 
supervision are best conducted by independent agencies. Careful 
attention should be given to the establishment of appropriate 
safeguards to preserve the independence of financial regulation from 
political influence. The Administration's plan gives the role of 
Chairman of the Financial Services Oversight Council to the Secretary 
of the Treasury. To ensure the independence and authority of the 
Council, consideration should be given to a configuration that would 
establish the Chairman of the Council as a Presidential appointee, 
subject to Senate confirmation. This would provide additional 
independence for the Chairman and enable the Chairman to focus full 
time on attending to the affairs of the Council and supervising Council 
staff. Other members on the Council could include, among others, the 
Federal financial institution, securities and commodities regulators. 
In addition, we would suggest that the Council include an odd number of 
members in order to avoid deadlocks.
    The Council should complement existing regulatory authorities by 
bringing a macroprudential perspective to regulation and being able to 
set or harmonize prudential standards to address systemic risk. Drawing 
on the expertise of the Federal regulators, the Oversight Council 
should have broad authority and responsibility for identifying 
institutions, products, practices, services and markets that create 
potential systemic risks, implementing actions to address those risks, 
ensuring effective information flow, and completing analyses and making 
recommendations. In order to do its job, the Council needs the 
authority to obtain any information requested from systemically 
important entities.
    The crisis has clearly revealed that regulatory gaps, or 
significant differences in regulation across financial services firms, 
can encourage regulatory arbitrage. Accordingly, a primary 
responsibility of the Council should be to harmonize prudential 
regulatory standards for financial institutions, products and practices 
to assure that market participants cannot arbitrage regulatory 
standards in ways that pose systemic risk. The Council should evaluate 
differing capital standards which apply to commercial banks, investment 
banks, and investment funds to determine the extent to which differing 
standards circumvent regulatory efforts to contain excess leverage in 
the system. The Council could also undertake the harmonization of 
capital and margin requirements applicable to all OTC derivatives 
activities--and facilitate interagency efforts to encourage greater 
standardization and transparency of derivatives activities and the 
migration of these activities onto exchanges or Central Counterparties.
    The Council also could consider requiring financial companies to 
issue contingent debt instruments--for example, long-term debt that, 
while not counting toward the satisfaction of regulatory capital 
requirements, automatically converts to equity under specific 
conditions. Conditions triggering conversion could include the 
financial companies' capital falling below prompt corrective action 
mandated capital levels or regulators declaring a systemic emergency. 
Financial companies also could be required to issue a portion of their 
short-term debt in the form of debt instruments that similarly 
automatically convert to long-term debt under specific conditions, 
perhaps tied to liquidity. Conversion of long-term debt to equity would 
immediately recapitalize banks in capital difficulty. Conversion of 
short-term debt to long-term debt would ameliorate liquidity problems.
    Also, the Council should be able to harmonize rules regarding 
systemic risks to serve as a floor that could be met or exceeded, as 
appropriate, by the primary prudential regulator. Primary regulators 
would be charged with enforcing the requirements set by the Council. 
However, if the primary regulators fail to act, the Council should have 
the authority to do so. The standards set by the Council should be 
designed to provide incentives to reduce or eliminate potential 
systemic risks created by the size or complexity of individual 
entities, concentrations of risk or market practices, and other 
interconnections between entities and markets. Any standards set by the 
Council should be construed as a minimum floor for regulation that can 
be exceeded, as appropriate, by the primary prudential regulator.
    The Council should have the authority to consult with systemic and 
financial regulators from other countries in developing reporting 
requirements and in identifying potential systemic risk in the global 
financial market. The Council also should report to Congress annually 
about its efforts, identify emerging systemic risk issues and recommend 
any legislative authority needed to mitigate systemic risk.
    Some have suggested that a council approach would be less effective 
than having this authority vested in a single agency because of the 
perception that a deliberative council such as this would need 
additional time to address emergency situations that might arise from 
time to time. Certainly, some additional thought and effort will be 
needed to address any dissenting views in council deliberations. 
However, a Council with regulatory agency participation will provide 
for an appropriate system of checks and balances to ensure that 
decisions reflect the various interests of public and private 
stakeholders. In this regard, it should be noted that the board 
structure at the FDIC, with the participation of the Comptroller of the 
Currency and the Director of the Office of Thrift Supervision, is not 
very different from the way the Council would operate. In the case of 
the FDIC, quick decisions have been made with respect to systemic 
issues and emergency bank resolutions on many occasions. Based on our 
experience with a board structure, we believe that decisions could be 
made quickly by a deliberative council.
Resolution Authority
    Even if risk-management practices improve dramatically and we 
introduce effective macroprudential supervision, the odds are that a 
large systemically significant firm will become troubled or fail at 
some time in the future. The current crisis has clearly demonstrated 
the need for a single resolution mechanism for financial firms that 
will preserve stability while imposing the losses on shareholders and 
creditors and replacing senior management to encourage market 
discipline. A timely, orderly resolution process that could be applied 
to both banks and nonbank financial institutions, and their holding 
companies, would prevent instability and contagion and promote 
fairness. It would enable the financial markets to continue to function 
smoothly, while providing for an orderly transfer or unwinding of the 
firm's operations. The resolution process would ensure that there is 
the necessary liquidity to complete transactions that are in process at 
the time of failure, thus addressing the potential for systemic risk 
without creating the expectation of a bailout.
    Under the new resolution regime, Congress should raise the bar 
higher than existing law and eliminate the possibility of open 
assistance for individual failing entities. The new resolution powers 
should result in the shareholders and unsecured creditors taking losses 
prior to the Government, and consideration also should be given to 
imposing some haircut on secured creditors to promote market discipline 
and limit costs potentially borne by the Government.
Limitations of the Current Resolution Authority
    The FDIC's resolution powers are very effective for most failed 
bank situations (see Appendix). However, systemic financial 
organizations present additional issues that may complicate the FDIC's 
process of conducting an efficient and economical resolution. As noted 
above, many financial activities today take place in financial firms 
that are outside the insured depository institution where the FDIC's 
existing authority does not reach. These financial firms must be 
resolved through the bankruptcy process, as the FDIC's resolution 
powers only apply to insured depository institutions. Resolving large 
complex financial firms through the bankruptcy process can be 
destabilizing to regional, national, and international economies since 
the timing is uncertain and the process can be complex and protracted 
and may vary by jurisdiction.
    By contrast, the powers that are available to the FDIC under its 
statutory resolution authorities can resolve financial entities much 
more rapidly than under bankruptcy. The FDIC bears the unique 
responsibility for resolving failed depository institutions and is 
therefore able to plan for an orderly resolution process. Through this 
process, the FDIC works with the primary supervisor to gather 
information on a troubled bank before it fails and plans for the 
transfer or orderly wind-down of the bank's assets and businesses. In 
doing so, the FDIC is able to maintain public confidence and perform 
its public policy mandate of ensuring financial stability.
Resolution Authority for Systemically Important Financial Firms
    To ensure an orderly and comprehensive resolution mechanism for 
systemically important financial firms, Congress should adopt a 
resolution process that adheres to the following principles:

    The resolution scheme and processes should be transparent, 
        including the imposition of losses according to an established 
        claims priority where stockholders and creditors, not the 
        Government, are in the first loss position.

    The resolution process should seek to minimize costs and 
        maximize recoveries. The resolution should be conducted to 
        achieve the least cost to the Government as a whole with the 
        FDIC allocating the losses among the various affiliates and 
        subsidiaries proportionate to their responsibilities for the 
        cost of the failure.

    There should be a unified resolution process housed in a 
        single entity.

    The resolution entity should have the responsibility and 
        the authority to set assessments to fund systemic resolutions 
        to cover working capital and unanticipated losses.

    The resolution process should allow the continuation of any 
        systemically significant operations, but only as a means to 
        achieve a final resolution of the entity. A bridge mechanism, 
        applicable to the parent company and all affiliated entities, 
        allows the Government to preserve systemically significant 
        functions. It enables losses to be imposed on market players 
        who should appropriately bear the risk. It also creates the 
        possibility of multiple bidders for the financial organization 
        and its assets, which can reduce losses to the receivership.

    The resolution entity must effectively manage its financial 
        and operational risk exposure on an ongoing basis. The 
        receivership function necessarily entails certain activities 
        such as the establishment of bridge entities, implementing 
        purchase and assumption agreements, claims processing, asset 
        liquidation or disposition, and franchise marketing. The 
        resolving entity must establish, maintain, and implement these 
        functions for a covered parent company and all affiliated 
        entities.

    Financial firms often operate on a day-to-day basis without regard 
to the legal structure of the firm. That is, employees of the holding 
company may provide vital services to a subsidiary bank because the 
same function exists in both the bank and the holding company. However, 
this intertwining of functions can present significant issues when 
trying to wind down the firm. For this reason, there should be 
requirements that mandate greater functional autonomy of holding 
company affiliates.
    In addition, to facilitate the resolution process, the holding 
companies should have an acceptable resolution plan that could 
facilitate and guide the resolution in the event of a failure. Through 
a carefully considered rule making, each financial holding company 
should be required to make conforming changes to their organization to 
ensure that the resolution plans could be effectively implemented. The 
plans should be updated annually and made publicly available.
    Congress also should alter the current process that establishes a 
procedure for open bank assistance that benefits shareholders and 
eliminates the requirement that the resolution option be the least 
costly to the Deposit Insurance Fund (DIF). As stated above, 
shareholders and creditors should be required to absorb losses from the 
institution's failure before the Government.
    Current law allows for an exception to the standard claims priority 
where the failure of one or more institutions presents ``systemic 
risk.'' In other words, once a systemic risk determination is made, the 
law permits the Government to provide assistance irrespective of the 
least cost requirement, including ``open bank'' assistance which inures 
to the benefit of shareholders. The systemic risk exception is an 
extraordinary procedure, requiring the approval of super majorities of 
the FDIC Board, the Federal Reserve Board, and the Secretary of the 
Treasury in consultation with the President.
    We believe that the systemic risk exception should be narrowed so 
that it is available only where there is a finding that support for 
open institutions is necessary to address problems which pervade the 
system, as opposed to problems which are particular to an individual 
institution. Whatever support is provided should be broadly available 
and justified in that it will result in least cost to the Government as 
a whole. If the Government suffers a loss as a result an institution's 
performance under this exception, the institution should be required to 
be resolved in accordance with the standard claims priority.
    Had this narrower systemic risk exception been in place during the 
past year, open institution assistance would not have been permitted 
for individual institutions. An individual institution would likely 
have been put into a bridge entity, with shareholders and unsecured 
creditors taking losses before the Government. Broader programs that 
benefit the entire system, such as the Temporary Liquidity Guarantee 
Program and the Federal Reserve's liquidity facilities, would have been 
permitted. However if any individual institution participating in these 
programs had caused a loss, the normal resolution process would be 
triggered.
    The initiation of this type of systemic assistance should require 
the same concurrence of the supermajority of the FDIC Board, the 
Federal Reserve Board and the Treasury Department (in consultation with 
the President) as under current law. No single Government entity should 
be able to unilaterally trigger a resolution strategy outside the 
defined parameters of the established resolution process. Further, to 
ensure transparency, these determinations should be made in 
consultation with Congress, documented and reviewed by the Government 
Accountability Office.
Other Improvements to the Resolution Process
    Consideration should be given to allowing the resolution authority 
to impose limits on financial institutions' abilities to use collateral 
to mitigate credit risk ahead of the Government for some types of 
activities. The ability to fully collateralize credit risks removes an 
institution's incentive to underwrite exposures by assessing a 
counterparty's ability to perform from revenues from continuing 
operations. In addition, the recent crisis has demonstrated that 
collateral calls generate liquidity pressures that can magnify systemic 
risks. For example, up to 20 percent of the secured claim for companies 
with derivatives claims against the failed firm could be haircut if the 
Government is expected to suffer losses. This would ensure that market 
participants always have an interest in monitoring the financial health 
of their counterparties. It also would limit the sudden demand for more 
collateral because the protection could be capped and also help to 
protect the Government from losses. Other approaches could include 
increasing regulatory and supervisory disincentives for excessive 
reliance on secured borrowing.
    As emphasized at the beginning of this statement, a regulatory and 
resolution structure should, among other things, ensure real corporate 
separateness and the separation of the bank's management, employees, 
and systems from those of its affiliates. Risky activities, such as 
proprietary trading, should be kept outside the bank. Consideration 
also should be given to enhancing restrictions against transactions 
with affiliates, including the elimination of 23A waivers. In addition, 
the resolution process could be greatly enhanced if companies were 
required to have an acceptable resolution plan that and guides the 
liquidation in the event of a failure. Requiring that the plans be 
updated annually and made publicly available would provide additional 
transparency that would improve market discipline.
Funding Systemic Resolutions
    To be credible, a resolution process for systemically significant 
institutions must have the funds necessary to accomplish the 
resolution. It is important that funding for this resolution process be 
provided by the set of potentially systemically significant financial 
firms, rather than by the taxpayer. To that end, Congress should 
establish a Financial Company Resolution Fund (FCRF) to provide working 
capital and cover unanticipated losses for the resolution.
    One option for funding the FCRF is to prefund it through a levy on 
larger financial firms--those with assets above a certain large 
threshold. The advantage of prefunding the FCRF is the ability to 
impose risk-based assessments on large or complex institutions that 
recognize their potential risks to the financial system. This system 
also could provide an economic incentive for an institution not to grow 
too large. In addition, building the fund over time through consistent 
levies would avoid large procyclical charges during times of systemic 
stress.
    Alternatively, the FCRF could be funded after a systemic failure 
through an assessment on other large, complex institutions. The 
advantage to this approach is that it does not take capital out of 
institutions until there is an actual systemic failure. The 
disadvantages of this approach are that it is not risk sensitive, it is 
initially dependent on the ability to borrow from the Treasury, it 
assess institutions when they can least afford it and the institution 
causing the loss is the only one that never pays an assessment.
    The systemic resolution entity should have the authorities needed 
to manage this resolution fund, as the FDIC does for the DIF. The 
entity should also be authorized to borrow from the Treasury if 
necessary, but those borrowings should be repaid by the financial firms 
that contribute to the FCRF.
International Issues
    Some significant challenges exist for international banking 
resolution actions since existing bank crisis management and resolution 
arrangements are not designed to deal specifically with cross-border 
banking problems. However, providing resolution authority to a specific 
entity in the U.S. would enhance the ability to enter into definitive 
memoranda of understanding with other countries. Many of these same 
countries have recognized the benefits of improving their resolution 
regimes and are considering improvements. This provides a unique 
opportunity for the U.S. to be the leader in this area and provide a 
model for the effective resolution of failed entities.
    Dealing with cross-border banking problems is difficult. For 
example, provisions to allow the transfer of assets and liabilities to 
a bridge bank or other institution may have limited effectiveness in a 
cross-border context because these actions will not necessarily be 
recognized or promptly implemented in other jurisdictions. In the 
absence of other arrangements, it is presumed that ring fencing will 
occur. Ring fencing may secure the interests of creditors or 
individuals in foreign jurisdictions to the detriment of the resolution 
as a whole.
    In the United States, the Foreign Bank Supervision Enhancement Act 
of 1991 requires foreign banks that wish to do a retail deposit-taking 
business to establish a separately chartered subsidiary bank. This 
structural arrangement ensures that assets and capital will be 
available to U.S. depositors or the FDIC should the foreign parent bank 
and its U.S. subsidiary experience difficulties. In this sense, it is 
equivalent to ``prepackaged'' ring fencing. An idea to consider would 
be to have U.S. banks operating abroad to do so through bank 
subsidiaries. This could streamline the FDIC's resolution process for a 
U.S. bank with foreign operations. U.S. operations would be resolved by 
the FDIC and the foreign operations by the appropriate foreign 
regulator. However, this would be a major change and could affect the 
ability of U.S. banks to attract foreign deposits overseas.
Resolution Authority for Depository Institution Holding Companies
    To have a process that not only maintains liquidity in the 
financial system but also terminates stockholders' rights, it is 
important that the FDIC have the authority to resolve both systemically 
important and nonsystemically important depository institution holding 
companies, affiliates and majority-owned subsidiaries in the case of 
failed or failing insured depository institutions. When a failing bank 
is part of a large, complex holding company, many of the services 
essential for the bank's operation may reside in other portions of the 
holding company, beyond the FDIC's authority. The loss of essential 
services can make it difficult to preserve the value of a failed 
institution's assets, operate the bank or resolve it efficiently. The 
business operations of large, systemic financial organizations are 
intertwined with business lines that may span several legal entities. 
When one entity is in the FDIC's control while the other is not, it 
significantly complicates resolution efforts. Unifying the holding 
company and the failed institution under the same resolution authority 
can preserve value, reduce costs and provide stability through an 
effective resolution. Congress should enhance the authority of the FDIC 
to resolve the entire organization in order to achieve a more orderly 
and comprehensive resolution consistent with the least cost to the DIF.
    When the holding company structure is less complex, the FDIC may be 
able to effect a least cost resolution without taking over the holding 
company. In cases where the holding company is not critical to the 
operations of the bank or thrift, the FDIC should be able to opt out--
that is, allow the holding company to be resolved through the 
bankruptcy process. The decision on whether to employ enhanced 
resolution powers or allow the bank holding company to declare 
bankruptcy would depend on which strategy would result in the least 
cost to the DIF. Enhanced authorities that allow the FDIC to 
efficiently resolve failed depository institutions that are part of a 
complex holding company structure when it achieves the least costly 
resolution will provide immediate efficiencies in bank resolutions.
Conclusion
    The current financial crisis demonstrates the need for changes in 
the supervision and resolution of financial institutions, especially 
those that are systemically important to the financial system. The FDIC 
stands ready to work with Congress to ensure that the appropriate steps 
are taken to strengthen our supervision and regulation of all financial 
institutions--especially those that pose a systemic risk to the 
financial system.
    I would be pleased to answer any questions from the Committee.
Appendix
The FDIC's Resolution Authority
    The FDIC has standard procedures that go into effect when an FDIC-
insured bank or thrift is in danger of failing. When the FDIC is 
notified that an insured institution is in danger of failing, we begin 
assembling an information package for bidders that specifies the 
structure and terms of the transaction. FDIC staff review the bank's 
books, contact prospective bidders, and begin the process of auctioning 
the bank--usually prior to its failure--to achieve the best return to 
the bank's creditors, and the Deposit Insurance Fund (DIF).
    When the appropriate Federal or State banking authority closes an 
insured depository institution, it appoints the FDIC as conservator or 
receiver. On the day of closure by the chartering entity, the FDIC 
takes control of the bank and in most cases removes the failed bank's 
management. Shareholder control rights are terminated, although 
shareholders maintain a claim on any residual value remaining after 
depositors' and other creditors' claims are satisfied.
    Most bank failures are resolved by the sale of some or all of the 
bank's business to an acquiring bank. FDIC staff work with the 
acquiring bank, and make the transfer as unobtrusive, seamless and 
efficient as possible. Generally, all the deposits that are transferred 
to the acquiring bank are made immediately available online or through 
ATMs. The bank usually reopens the next business day with a new name 
and under the control of the acquiring institution. Those assets of the 
failed bank that are not taken by the acquiring institution are then 
liquidated by the FDIC.
    Sometimes banks must be closed quickly because of an inability to 
meet their funding obligations. These ``liquidity failures'' may 
require that the FDIC set up a bridge bank. The bridge bank structure 
allows the FDIC to provide liquidity to continue the bank's operations 
until the FDIC has time to market and sell the failed bank. The 
creation of a bridge also terminates stockholders rights as described 
earlier.
    Perhaps the greatest benefit of the FDIC's process is the quick 
reallocation of resources. It is a process that can be painful to 
shareholders, creditors and bank employees, but history has shown that 
early recognition of losses with closure and sale of nonviable 
institutions is the fastest path back to economic health.
                                 ______
                                 

                 PREPARED STATEMENT OF MARY L. SCHAPIRO
              Chairman, Securities and Exchange Commission
                             July 23, 2009
Introduction
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee: 
I am pleased to have the opportunity to testify concerning the 
regulation of systemic risk in the U.S. financial industry. \1\
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     \1\ My testimony is on my own behalf, as Chairman of the SEC. The 
commission has not voted on this testimony.
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    We have learned many lessons from the recent financial crisis and 
events of last fall, central among them being the need to identify, 
monitor, and reduce the possibility that a sudden shock will lead to a 
market seizure or cascade of failures that puts the entire financial 
system at risk.
    In turning those lessons into reforms, the following should guide 
us:
    First, there are two different kinds of ``systemic risk'': (1) the 
risk of sudden, near-term systemic seizures or cascading failures, and 
(2) the longer-term risk that our system will unintentionally favor 
large systemically important institutions over smaller, more nimble 
competitors, reducing the system's ability to innovate and adapt to 
change. We must be very careful that our efforts to protect the system 
from near-term systemic seizures do not inadvertently result in a long-
term systemic imbalance.
    Second, there are two different kinds of ``systemic risk 
regulation'': (1) the traditional oversight, regulation, market 
transparency and enforcement provided by primary regulators that helps 
keep systemic risk from developing in the first place, and (2) the new 
``macroprudential'' regulation designed to identify and minimize 
systemic risk if it does.
    Third, we must be cognizant of both kinds of regulation if we are 
to minimize both kinds of ``systemic risk.'' I believe the best way to 
achieve this balance is to:

    Address structural imbalances that facilitate the 
        development of systemic risk by closing gaps in regulation, 
        improving transparency and strengthening enforcement; and

    Establish a workable, macroprudential regulatory framework 
        consisting of a single systemic risk regulator (SRR) with clear 
        authority and accountability and a Financial Stability 
        Oversight Council (Council) that can identify risks across the 
        system, write rules to minimize systemic risk and help ensure 
        that future regulatory gaps--and arbitrage opportunities--are 
        minimized or avoided.

    Throughout this process, however, we must remain vigilant that our 
efforts to minimize ``sudden systemic risk'' do not inadvertently 
create new structural imbalances that undermine the long-term vibrancy 
of our capital markets.
Addressing Structural Imbalances Through Traditional Oversight
    Much of the debate surrounding ``systemic risk'' and financial 
regulatory reform has focused on new ``macroprudential'' oversight and 
regulation. This debate has focused on whether we need a systemic risk 
regulator to identify and minimize systemic risk and how to resolve 
large interconnected institutions whose failure might affect the health 
of others or the system. The debate also has focused on whether it is 
possible to declare our readiness to ``resolve'' systemically important 
institutions without unintentionally facilitating their growth and 
systemic importance.
    Before turning to those issues, it is important that we not forget 
the role that traditional oversight, regulation and market transparency 
play in reducing systemic risk. This is the traditional ``block and 
tackle'' oversight and regulation, that is vital to ensuring that 
systemic risks do not develop in the first place.
Filling Regulatory Gaps
    One central mechanism for reducing systemic risk is to ensure the 
same rules apply to the same or similar products and participants. Our 
global capital markets are incredibly fast and competitive: financial 
participants are competing with each other not just for ideas and 
talent but also with respect to ``microseconds'' and basis points. In 
such an environment, if financial participants realize they can achieve 
the same economic ends with fewer costs by flocking to a regulatory 
gap, they will do so quickly, often with size and leverage.
    We have seen this time and again, most recently with over-the-
counter derivatives, instruments through which major institutions 
engage in enormous, virtually unregulated trading in synthetic versions 
of other, often regulated financial products. We can do much to reduce 
systemic risk if we close these gaps and ensure that similar products 
are regulated similarly.
Improving Market Transparency
    In conjunction with filling regulatory gaps, market transparency 
can help to decrease systemic risk. We have seen tremendous growth in 
financial products and vehicles that work exactly like other products 
and vehicles, but with little or no transparency.
    For example, there are ``dark pools'' in which securities are 
traded that work like traditional markets without the oversight or 
information flow. Also, enormous risk resides in ``off-balance-sheet'' 
vehicles hidden from investors and other market participants who likely 
would have allocated capital more efficiently--and away from these 
risks--had the risks been fully disclosed.
    Transparency reduces systemic risk in several ways. It gives 
regulators and investors better information about markets, products and 
participants. It also helps regulators leverage market behavior to 
minimize the need for larger interventions.
    Where market participants are given sufficient information about 
assets, liabilities and risks, they, following their risk-reward 
analyses, could themselves allocate capital away from risk or demand 
higher returns for it. This in turn would help to reduce systemic risk 
before it develops. In this sense, the new ``macroprudential'' systemic 
risk regulation (set forth later in this testimony) can be seen as an 
important tool for identifying and reducing systemic risk, but not a 
first or only line of defense.
    I support the Administration's efforts to fill regulatory gaps and 
improve market transparency, particularly with respect to over-the-
counter derivatives and hedge funds, and I believe they will go a long 
way toward reducing systemic risk.
Active Enforcement
    It is important to note the role active regulation and enforcement 
plays in changing behavior and reducing systemic risks.
    Though we need vibrant capital markets and financial innovation to 
meet our country's changing needs, we have learned there are two sides 
to financial innovation. At their best, our markets are incredible 
machines capable of taking ``ordinary'' investments and savings and 
transforming them into new, highly useful products--turning today's 
thrift into tomorrow's stable wealth. At their worst, the self-
interests of financial engineers seeking short-term profit can lead to 
ever more complex and costly products designed less to serve investors' 
needs than to generate fees.
    Throughout this crisis we have seen how traditional processes 
evolved into questionable business practices, that, when combined with 
leverage and global markets, created extensive systemic risk. A 
counterbalance to this is active enforcement that serves as a ready 
reminder of (1) what the rules are and (2) why we need them to protect 
consumers, investors, and taxpayers--and indeed the system itself.
Macroprudential Oversight: The Need for a Systemic Risk Regulator and 
        Financial Stability Oversight Council
    Although I believe in the critical role that traditional oversight, 
regulation, enforcement, and market transparency must play in reducing 
systemic risk, they alone are not sufficient.
    Functional regulation alone has shown several key shortcomings. 
First, information--and thinking--can remain ``siloed.'' Functional 
regulators typically look at particular financial participants or 
vehicles even as individual financial products flow through them all, 
often resulting in their seeing only small pieces of the broader 
financial landscape.
    Second, because financial actors can use different vehicles or 
jurisdictions from which to engage in the same activity, actors can 
sometimes ``choose'' their regulatory framework. This choice can 
sometimes result in regulatory competition--and a race to the bottom 
among competing regulators and jurisdictions, lowering standards and 
increasing systemic risk.
    Third, functional regulators have a set of statutory powers and a 
legal framework designed for their particular types of financial 
products or entities. Even if a regulator could extend its existing 
powers over other entities not typically within its jurisdiction, these 
legal frameworks are not easily transferrable either to other entities 
or other types of risk.
    Given these shortcomings, I agree with the Administration on the 
need to establish a regulatory framework for macroprudential oversight.
    Within that framework, I believe a hybrid approach consisting of a 
single systemic risk regulator and a powerful council is most 
appropriate. Such an approach would provide the best structure to 
ensure clear accountability for systemic risk, enable a strong, nimble 
response should circumstances arise and maintain the broad and 
differing perspectives needed to best identify developing risks and 
minimize unintended consequences.
A Systemic Risk Regulator
    Given the (1) speed, size, and complexity of our global capital 
markets; (2) large role a relatively small number of major financial 
intermediaries play in that system; and (3) extent of Government 
interventions needed to address the recent turmoil, I agree there needs 
to be a Government entity responsible for monitoring our entire 
financial system for systemwide risks, with the tools to forestall 
emergencies. I believe this role could be performed by the Federal 
Reserve or a new entity specifically designed for this task.
    This ``systemic risk regulator'' should have access to information 
across the financial markets and, in addition to the individual 
functional regulators, serve as a second set of eyes upon those 
institutions whose failure might put the system at risk. It should have 
ready access to information about institutions that might pose a risk 
to the system, including holding company liquidity and risk exposures; 
monitor whether institutions are maintaining capital levels required by 
the Council; and have clear delegated authority to respond quickly in 
extraordinary circumstances.
    In addition, an SRR should be required to report to the Council on 
its supervisory programs and the risks and trends it identifies at the 
institutions it supervises.
Financial Stability Oversight Council
    Further, I agree with the Administration and FDIC Chairman Bair 
that this SRR must be combined with a newly created Council. I believe, 
however, that any Council must be strengthened beyond the framework set 
forth in the Administration's ``white paper.''
    This Council should have the tools needed to identify emerging 
risks, be able to establish rules for leverage and risk-based capital 
for systemically important institutions; and be empowered to serve as a 
ready mechanism for identifying emerging risks and minimizing the 
regulatory arbitrage that can lead to a regulatory race to the bottom.
    To balance the weakness of monitoring systemic risk through the 
lens of any single regulator, the Council would permit us to assess 
emerging risks from the vantage of a multidisciplinary group of 
financial experts with responsibilities that extend to different types 
of financial institutions, both large and small. Members could include 
representatives of the Department of the Treasury, SEC, CFTC, FRB, OCC, 
and FDIC.
    The Council should have authority to identify institutions, 
practices, and markets that create potential systemic risks and set 
standards for liquidity, capital and other risk management practices at 
systemically important institutions. The SRR would then be responsible 
for implementing these standards.
    The Council also should provide a forum for discussing and 
recommending regulatory standards across markets, helping to identify 
gaps in the regulatory framework before they morph into larger 
problems. This hybrid approach can help minimize systemic risk in a 
number of ways:

    First, a Council would ensure different perspectives to 
        help identify risks that an individual regulator might miss or 
        consider too small to warrant attention. These perspectives 
        would also improve the quality of systemic risk requirements by 
        increasing the likelihood that second-order consequences are 
        considered and flushed out;

    Second, the financial regulators on the Council would have 
        experience regulating different types of institutions 
        (including smaller institutions) so that the Council would be 
        more likely to ensure that risk-based capital and leverage 
        requirements do not unintentionally foster systemic risk. Such 
        a result could occur by giving large, systemically important 
        institutions a competitive advantage over smaller institutions 
        that would permit them to grow even larger and more risky; and

    Third, the Council would include multiple agencies, thereby 
        significantly reducing potential conflicts of interest (e.g., 
        conflicts with other regulatory missions).

    The Council also would monitor the development of financial 
institutions to prevent the creation of institutions that are either 
too-big-to-fail or too-big-to-succeed. In that regard, I believe that 
insufficient attention has been paid to the risks posed by institutions 
whose businesses are so large and diverse that they have become, for 
all intents and purposes, unmanageable. Given the potential daily 
oversight role of the SRR, it would likely be less capable of 
identifying and avoiding these risks impartially. Accordingly, the 
Council framework is vital to ensure that our desire to minimize short-
term systemic risk does not inadvertently undermine our system's long-
term health.
Coordination of Council/SRR With Primary Regulators
    In most times, I would expect the Council and SRR to work with and 
through primary regulators of systemically important institutions. The 
primary regulators understand the markets, products and activities of 
their regulated entities. The SRR, however, can provide a second layer 
of review over the activities, capital, and risk management procedures 
of systemically important institutions as a backstop to ensure that no 
red flags are missed.
    If differences arise between the SRR and the primary regulator 
regarding the capital or risk management standards of systemically 
important institutions, I strongly believe that the higher (more 
conservative) standard should govern. The systemic risk regulatory 
structure should serve as a ``brake'' on a systemically important 
institution's riskiness; it should never be an ``accelerator.''
    In emergency situations, the SRR may need to overrule a primary 
regulator (for example, to impose higher standards or to stop or limit 
potentially risky activities). However, to ensure that authority is 
checked and decisions are not arbitrary, the Council should be where 
general policy is set, and only then to implement a more rigorous 
policy than that of a primary regulator. This will reduce the ability 
of any single regulator to ``compete'' with other regulators by 
lowering standards, driving a race to the bottom.
Unwinding Systemic Risk--A Third Option
    I agree with the Administration, the FDIC, and others that the 
Government needs a credible resolution mechanism for unwinding 
systemically important institutions.
    Currently, banks and broker-dealers are subject to well-established 
resolution processes under the Federal Deposit Insurance Corporation 
Improvement Act and the Securities Investor Protection Act, 
respectively. No corresponding resolution process exists, however, for 
the holding companies of systemically significant financial 
institutions.
    In times of crisis when a systemically important institution may be 
teetering on the brink of failure, policy makers are left in the 
difficult position of choosing between two highly unappealing options: 
(1) providing Government assistance to a failing institution (or an 
acquirer of a failing institution), thereby allowing markets to 
continue functioning but potentially fostering more irresponsible risk 
taking in the future; or (2) not providing Government assistance but 
running the risk of market collapses and greater costs in the future.
    Markets recognize this Hobson's choice and can actually fuel more 
systemic risk by ``pricing in'' the possibility of a Government 
backstop of large-interconnected institutions. This can give them an 
advantage over their smaller competitors and make them even larger and 
more interconnected.
    A credible resolution regime can help address these risks by giving 
policy makers a third option: a controlled unwinding of the institution 
over time. Structured correctly, such a regime could force market 
participants to realize the full costs of their decisions and help 
reduce the ``too-big-to-fail'' dilemma. Structured poorly, such a 
regime could strengthen market expectations of Government support, as a 
result fueling ``too-big-to-fail'' risks.
    Avoidance of conflicts of interest in this regime will be 
paramount. Different regulators with different missions may have 
different priorities. For example, both customer accounts with broker-
dealers and depositor accounts in banks must be protected and should 
not be used to cross-subsidize other efforts. A healthy consultation 
process with a regulated entity's primary regulator will provide needed 
institutional knowledge to ensure that potential conflicts such as this 
are minimized.
Conclusion
    To better ensure that systemwide risks will be identified and 
minimized without inadvertently creating larger risk down the road, I 
recommend that Congress establish a strong Financial Stability 
Oversight Council, comprised of the primary regulators.
    The Council should have responsibility for identifying systemically 
significant institutions and systemic risks, making recommendations 
about and implementing actions to address those risks, promoting 
effective information flow, setting liquidity and capital standards, 
and ensuring key supervisors apply those standards appropriately.
    The various primary regulators offer broad perspectives across 
markets that represent a wide range of institutions and investors. This 
array of perspectives is essential to build a foundation for the 
development of a robust regulatory framework better designed to 
withstand future periods of market or economic volatility and help 
restore investors' confidence in our Nation's markets. I believe a 
structure such as this provides the best balance for reducing sudden 
systemic risk without undermining the competitive and resilient capital 
markets needed over the long term.
    Thank you again for the opportunity to present my views. I look 
forward to working with the Committee on any financial reform efforts 
it may undertake, and I would be pleased to answer any questions.

                PREPARED STATEMENT OF DANIEL K. TARULLO
        Member, Board of Governors of the Federal Reserve System
                             July 23, 2009
    Chairman Dodd, Ranking Member Shelby, and other Members of the 
Committee, I appreciate the opportunity to discuss how to improve the 
U.S. financial regulatory system so as to contain systemic risk and to 
address the related problem of too-big-to-fail financial institutions. 
Experience over the past 2 years clearly demonstrates that the United 
States needs a comprehensive strategy to help prevent financial crises 
and to mitigate the effects of crises that may occur.
    The roots of this crisis lie in part in the fact that regulatory 
powers and capacities lagged the increasingly tight integration of 
conventional lending activities with the issuance, trading, and 
financing of securities. This crisis did not begin with depositor runs 
on banks, but with investor runs on firms that financed their holdings 
of securities in the wholesale money markets. An effective agenda for 
containing systemic risk thus requires adjustments by all our financial 
regulatory agencies under existing authorities. It also invites action 
by the Congress to fill existing gaps in regulation, remove impediments 
to consolidated oversight of complex institutions, and provide the 
instruments necessary to cope with serious financial problems that do 
arise.
    In keeping with the Committee's interest today in a systemic risk 
agenda, I will identify some of the key administrative and legislative 
elements that should be a part of that agenda. Ensuring that all 
systemically important financial institutions are subject to effective 
consolidated supervision is a critical first step. Second, a more 
macroprudential outlook--that is, one that takes into account the 
safety and soundness of the financial system as a whole, as well as 
individual institutions--needs to be incorporated into the supervision 
and regulation of these firms and financial institutions more 
generally. Third, better and more formal mechanisms should be 
established to help identify, monitor, and address potential or 
emerging systemic risks across the financial system as a whole, 
including gaps in regulatory or supervisory coverage that could present 
systemic risks. A council with broad representation across agencies and 
departments concerned with financial supervision and regulation is one 
approach to this goal. Fourth, a new resolution process for 
systemically important nonbank financial firms should be created that 
would allow the Government to wind down a troubled systemically 
important firm in an orderly manner. Fifth, all systemically important 
payment, clearing, and settlement arrangements should be subject to 
consistent and robust oversight and prudential standards.
    The role of the Federal Reserve in a reoriented financial 
regulatory system derives, in our view, directly from its position as 
the Nation's central bank. Financial stability is integral to the 
achievement of maximum employment and price stability, the dual mandate 
that Congress has conferred on the Federal Reserve as its objectives in 
the conduct of monetary policy. Indeed, there are some important 
synergies between systemic risk regulation and monetary policy, as 
insights garnered from each of those functions informs the performance 
of the other. Close familiarity with private credit relationships, 
particularly among the largest financial institutions and through 
critical payment and settlement systems, makes monetary policy makers 
better able to anticipate how their actions will affect the economy. 
Conversely, the substantial economic analysis that accompanies monetary 
policy decisions can reveal potential vulnerabilities of financial 
institutions.
    While the improvements in the financial regulatory framework 
outlined above would involve some expansion of Federal Reserve 
responsibilities, that expansion would be an incremental and natural 
extension of the Federal Reserve's existing supervisory and regulatory 
responsibilities, reflecting the important relationship between 
financial stability and the roles of a central bank. An effective and 
comprehensive agenda for addressing systemic risk will also require new 
responsibilities for other Federal agencies and departments, including 
the Treasury, Securities and Exchange Commission (SEC), Commodity 
Futures Trading Commission (CFTC), and Federal Deposit Insurance 
Corporation (FDIC).
Consolidated Supervision of Systemically Important Financial 
        Institutions
    The current financial crisis has clearly demonstrated that risks to 
the financial system can arise not only in the banking sector, but also 
from the activities of other financial firms--such as investment banks 
or insurance organizations--that traditionally have not been subject, 
either by law or in practice, to the type of regulation and 
consolidated supervision applicable to bank holding companies. While 
effective consolidated supervision of potentially systemic firms is 
not, by itself, sufficient to foster financial stability, it certainly 
is a necessary condition. The Administration's recent proposal for 
strengthening the financial system would subject all systemically 
important financial institutions to the same framework for prudential 
supervision on the same consolidated or groupwide basis that currently 
applies to bank holding companies. In doing so, it would also prevent 
systemically important firms that have become bank holding companies 
during the crisis from reversing this change and escaping prudential 
supervision in calmer financial times. While this proposal is an 
important piece of an agenda to contain systemic risk and the ``too-
big-to-fail'' problem, it would not actually entail a significant 
expansion of the Federal Reserve's mandate.
    The proposal would entail two tasks--first identifying, and then 
effectively supervising, these systemically important institutions. As 
to supervision, the Bank Holding Company Act of 1956 (BHCA) designates 
the Federal Reserve as the consolidated supervisor of all bank holding 
companies. That act provides the Federal Reserve a range of tools to 
understand, monitor, and, when appropriate, restrain the risks 
associated with an organization's consolidated or groupwide activities. 
Under this framework, the Federal Reserve has the authority to 
establish consolidated capital requirements for bank holding companies. 
In addition, subject to certain limits I will discuss later, the act 
permits the Federal Reserve to obtain reports from and conduct 
examinations of a bank holding company and any of its subsidiaries. It 
also grants authority to require the organization or its subsidiaries 
to alter their risk-management practices or take other actions to 
address risks that threaten the safety and soundness of the 
organization.
    Under the BHCA, the Federal Reserve already supervises some of the 
largest and most complex financial institutions in the world. In the 
course of the financial crisis, several large financial firms that 
previously were not subject to mandatory consolidated supervision--
including Goldman Sachs, Morgan Stanley, and American Express--became 
bank holding companies, in part to assure market participants that they 
were subject to robust prudential supervision on a consolidated basis. 
While the number of additional financial institutions that would be 
subject to supervision under the Administration's approach would of 
course depend on standards or guidelines adopted by the Congress, the 
criteria offered by the Administration suggest to us that the initial 
number of newly regulated firms would probably be relatively limited. 
One important feature of this approach is that it provides ongoing 
authority to identify and supervise other firms that may become 
systemically important in the future, whether through organic growth or 
the migration of activities from regulated entities.
    Determining precisely which firms would meet these criteria will 
require considerable analysis of the linkages between firms and 
markets, drawing as much or more on economic and financial analysis as 
on bank supervisory expertise. Financial institutions are systemically 
important if the failure of the firm to meet its obligations to 
creditors and customers would have significant adverse consequences for 
the financial system and the broader economy. At any point in time, the 
systemic importance of an individual firm depends on a wide range of 
factors. Obviously, the consequences of a firm's failure are more 
likely to be severe if the firm is large, taking account of both its 
on- and off-balance sheet activities. But size is far from the only 
relevant consideration. The impact of a firm's financial distress 
depends also on the degree to which it is interconnected, either 
receiving funding from, or providing funding to, other potentially 
systemically important firms, as well as on whether it performs crucial 
services that cannot easily or quickly be executed by other financial 
institutions. In addition, the impact varies over time: the more 
fragile the overall financial backdrop and the condition of other 
financial institutions, the more likely a given firm is to be judged 
systemically important. If the ability of the financial system to 
absorb adverse shocks is low, the threshold for systemic importance 
will more easily be reached. Judging whether a financial firm is 
systemically important is thus not a straightforward task, especially 
because a determination must be based on an assessment of whether the 
firm's failure would likely have systemic effects during a future 
stress event, the precise parameters of which cannot be fully known.
    For supervision of firms identified as systemically important to be 
effective, we will need to build on lessons learned from the current 
crisis and on changes we are already undertaking in light of the 
broader range of financial firms that have come under our supervision 
in the last year. In October, we issued new consolidated supervision 
guidance for bank holding companies that provides for supervisory 
objectives and actions to be calibrated more directly to the systemic 
significance of individual institutions and bolsters supervisory 
expectations with respect to the corporate governance, risk management, 
and internal controls of the largest, most complex organizations. \1\ 
We are also adapting our internal organization of supervisory 
activities to take better advantage of the information and insight that 
the economic and financial analytic capacities of the Federal Reserve 
can bring to bear in financial regulation.
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     \1\ See Supervision and Regulation Letter 08-9, ``Consolidated 
Supervision of Bank Holding Companies and the Combined U.S. Operations 
of Foreign Banking Organizations'', and the associated interagency 
guidance.
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    The recently completed Supervisory Capital Assessment Process 
(SCAP) reflects some of these changes in the Federal Reserve's system 
for prudential supervision of the largest banking organizations. This 
unprecedented process specifically incorporated forward-looking, cross-
firm, and aggregate analyses of the 19 largest bank holding companies, 
which together control a majority of the assets and loans within the 
financial system. Importantly, supervisors in the SCAP defined a 
uniform set of parameters to apply to each firm being evaluated, which 
allowed us to evaluate on a consistent basis the expected performance 
of the firms, drawing on individual firm information and independently 
estimated outcomes using supervisory models. Drawing on this 
experience, we will conduct horizontal examinations on a periodic basis 
to assess key operations, risks, and risk-management activities of 
large institutions.
    We also plan to create a quantitative surveillance program for 
large, complex financial organizations that will use supervisory 
information, firm-specific data analysis, and market-based indicators 
to identify developing strains and imbalances that may affect multiple 
institutions, as well as emerging risks to specific firms. Periodic 
scenario analyses across large firms will enhance our understanding of 
the potential impact of adverse changes in the operating environment on 
individual firms and on the system as a whole. This work will be 
performed by a multidisciplinary group composed of our economic and 
market researchers, supervisors, market operations specialists, and 
accounting and legal experts. This program will be distinct from the 
activities of on-site examination teams so as to provide an independent 
supervisory perspective, as well as to complement the work of those 
teams.
    To be fully effective, consolidated supervisors must have clear 
authority to monitor and address safety and soundness concerns and 
systemic risks in all parts of an organization, working in coordination 
with other supervisors wherever possible. As the crisis has 
demonstrated, the assessment of nonbank activities is essential to 
understanding the linkages between depository and nondepository 
subsidiaries and the risk profile of the organization as a whole. The 
Administration's proposal would make useful modifications to the 
provisions added to the law in 1999 that limit the ability of the 
Federal Reserve to monitor and address risks within an organization and 
its subsidiaries on a groupwide basis. \2\
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     \2\ The Administration's proposal also would close the loophole in 
current law that allowed certain investment banks, as well as other 
financial and nonfinancial firms, to acquire control of a federally 
insured industrial loan company (ILC) while avoiding the prudential 
framework that Congress established for the corporate owners of other 
full-service insured banks. The Board has for many years supported such 
a change.
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A Macroprudential Approach to Supervision and Regulation
    The existing framework for the regulation and supervision of 
banking organizations is focused primarily on the safety and soundness 
of individual organizations, particularly their insured depository 
institutions. As the Administration's proposal recognizes, the 
resiliency of the financial system could be improved by incorporating a 
more explicit macroprudential approach to supervision and regulation. A 
macroprudential outlook, which considers interlinkages and 
interdependencies among firms and markets that could threaten the 
financial system in a crisis, complements the current microprudential 
orientation of bank supervision and regulation.
    Indeed, a more macroprudential focus is essential in light of the 
potential for explicit regulatory identification of systemically 
important firms to exacerbate the ``too-big-to-fail'' problem. Unless 
countervailing steps are taken, the belief by market participants that 
a particular firm is too-big-to-fail, and that shareholders and 
creditors of the firm may be partially or fully protected from the 
consequences of a failure, has many undesirable effects. It materially 
weakens the incentive of shareholders and creditors of the firm to 
restrain the firm's risk taking, provides incentives for financial 
firms to become very large in order to be perceived as too-big-to-fail, 
and creates an unlevel competitive playing field with smaller firms 
that may not be regarded as having implicit Government support.
    Creation of a mechanism for the orderly resolution of systemically 
important nonbank financial firms, which I will discuss later, should 
help remediate this problem. In addition, capital, liquidity, and risk-
management requirements for systemically important firms will need to 
be strengthened to help counteract moral hazard effects, as well as the 
greater potential risks these institutions pose to the financial system 
and to the economy. We believe that the agency responsible for 
supervision of these institutions should have the authority to adopt 
and apply such requirements, and thus have clear accountability for 
their efficacy. Optimally, these requirements should be calibrated 
based on the relative systemic importance of the institution, a 
different measure than a firm's direct credit and other risk exposures 
as calculated in traditional capital or liquidity regulation.
    It may also be beneficial for supervisors to require that 
systemically important firms maintain specific forms of capital so as 
to increase their ability to absorb losses outside of a bankruptcy or 
formal resolution procedure. Such capital could be in contingent form, 
converting to common equity only when necessary to mitigate systemic 
risk. A macroprudential approach also should be reflected in regulatory 
capital standards more generally, so that banks are required to 
increase their capital levels in good times in order to create a buffer 
that can be drawn down as economic and financial conditions 
deteriorate.
    The development and implementation of capital standards for 
systemically important firms is but one of many elements of an 
effective macroprudential approach to financial regulation. Direct and 
indirect exposures among systemically important firms are an obvious 
source of interdependency and potential systemic risk. Direct credit 
exposures may arise from lending, loan commitments, guarantees, or 
derivative counterparty relationships among institutions. Indirect 
exposures may arise through exposures to a common risk factor, such as 
the real estate market, that could stress the system by causing losses 
to many firms at the same time, through common dependence on 
potentially unstable sources of short-term funding, or through common 
participation in payment, clearing, or settlement systems.
    While large, correlated exposures have always been an important 
source of risk and an area of focus for supervisors, macroprudential 
supervision requires special attention to the interdependencies among 
systemically important firms that arise from common exposures. 
Similarly, there must be monitoring of exposures that could grow 
significantly in times of systemwide financial stress, such as those 
arising from OTC derivatives or the sponsorship of off-balance-sheet 
financing conduits funded by short-term liabilities that are 
susceptible to runs. One tool that would be useful in identifying such 
exposures would be the cross-firm horizontal reviews that I discussed 
earlier, enhanced to focus on the collective effects of market 
stresses.
    The Federal Reserve also would expect to carefully monitor and 
address, either individually or in conjunction with other supervisors 
and regulators, the potential for additional spillover effects. 
Spillovers may occur not only due to exposures currently on a firm's 
books, but also as a result of reactions to stress elsewhere in the 
system, including at other systemically important firms or in key 
markets. For example, the failure of one firm may lead to deposit or 
liability runs at other firms that are seen by investors as similarly 
situated or that have exposures to such firms. In the recent financial 
crisis, exactly this sort of spillover resulted from the failure of 
Lehman Brothers, which led to heightened pressures on other investment 
banks. One tool that could be helpful in evaluating spillover risks 
would be multiple-firm or system-level stress tests focused 
particularly on such risks. However, this type of test would greatly 
exceed the SCAP in operational complexity; thus, properly developing 
and implementing such a test would be a substantial challenge.
Potential Role of a Council
    The breadth and heterogeneity of the U.S. financial system have 
been great economic strengths of our country. However, these same 
characteristics mean that common exposures or practices across a wide 
range of financial markets and financial institutions may over time 
pose risks to financial stability, but may be difficult to identify in 
their early stages. Moreover, addressing the pervasive problem of 
procyclicality in the financial system will require efforts across 
financial sectors. To help address these issues, the Administration has 
proposed the establishment of a Financial Services Oversight Council 
composed of the Treasury and all of the Federal financial supervisory 
and regulatory agencies, including the Federal Reserve.
    The Board sees substantial merit in the establishment of a council 
to conduct macroprudential analysis and coordinate oversight of the 
financial system as a whole. The perspective of, and information from, 
supervisors on such a council with different primary responsibilities 
would be helpful in identifying and monitoring emerging systemic risks 
across the full range of financial institutions and markets. A council 
could be charged with identifying emerging sources of systemic risk, 
including: large and rising exposures across firms and markets; 
emerging trends in leverage or activities that could result in 
increased systemic fragility; possible misalignments in asset markets; 
potential sources of spillovers between financial firms or between 
firms and markets that could propagate, or even magnify, financial 
shocks; and new markets, practices, products, or institutions that may 
fall through the gaps in regulatory coverage and become threats to 
systemic stability. In addition, a council could play a useful role in 
coordinating responses by member agencies to mitigate emerging systemic 
risks identified by the council, and by helping coordinate actions to 
address procylicality in capital regulations, accounting standards 
(particularly with regard to reserves), deposit insurance premiums, and 
other supervisory and regulatory practices. In light of these 
responsibilities and its broad membership, a council also would be a 
useful forum for identifying financial firms that are at the cusp of 
being systemically important and, when appropriate, recommending such 
firms for designation as systemically important. Finally, should 
Congress choose to create default authority for regulation of 
activities that do not fall under the jurisdiction of any existing 
financial regulator, the council would seem the appropriate 
instrumentality to determine how the expanded jurisdiction should be 
exercised.
    A council could be tasked with gathering and evaluating information 
from the various supervisory agencies and producing an annual report to 
the Congress on the state of the financial system, potential threats to 
financial stability, and the responses of member agencies to identified 
threats. Such a report could include recommendations for statutory 
changes where needed to address systemic threats due to, for example, 
growth or changes in unregulated sectors of the financial system. More 
generally, a council could promote research and other efforts to 
enhance understanding, both nationally and internationally, of the 
underlying causes of financial instability and systemic risk and 
possible approaches to countering such developments.
    To fulfill such responsibilities, a council would need access to a 
broad range of information from its member financial supervisors 
regarding the institutions and markets under their purview, as well as 
from other Government agencies. Where the information necessary to 
monitor emerging risks was not available from a member agency, a 
council likely would need the authority to collect such information 
directly from financial institutions and markets. \3\
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     \3\ To facilitate information collections and interagency sharing, 
a council should have the clear authority for protecting confidential 
information subject, of course, to applicable law, including the 
Freedom of Information Act.
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Improved Resolution Process
    A key element to addressing systemic risk is the creation of a new 
regime that would allow the orderly resolution of systemically 
important nonbank financial firms. In most cases, the Federal 
bankruptcy laws provide an appropriate framework for the resolution of 
nonbank financial institutions. However, the bankruptcy code does not 
sufficiently protect the public's strong interest in ensuring the 
orderly resolution of a nonbank financial firm whose failure would pose 
substantial risks to the financial system and to the economy. Indeed, 
after the Lehman and AIG experiences, there is little doubt that there 
needs to be a third option between the choices of bankruptcy and 
bailout.
    The Administration's proposal would create such an option by 
allowing the Treasury to appoint a conservator or receiver for a 
systemically important nonbank financial institution that has failed or 
is in danger of failing. The conservator or receiver would have a 
variety of authorities--similar to those provided the FDIC with respect 
to failing insured banks--to stabilize and either rehabilitate or wind 
down the firm in a way that mitigates risks to financial stability and 
to the economy. For example, the conservator or receiver would have the 
ability to take control of the management and operations of the failing 
firm; sell assets, liabilities, and business units of the firm; and 
repudiate contracts of the firm. These are appropriate tools for a 
conservator or receiver. However, Congress may wish to consider adding 
some constraints as well--such as requiring that shareholders bear 
losses and that creditors be entitled to at least the liquidation value 
of their claims.
    Importantly, the proposal would allow the Government, through a 
receivership, to impose ``haircuts'' on creditors and shareholders of 
the firm, either directly or by ``bridging'' the failing institution to 
a new entity, when consistent with the overarching goal of protecting 
the financial system and the broader economy. This aspect of the 
proposal is critical to addressing the ``too-big-to-fail'' problem and 
the resulting moral hazard effects that I discussed earlier.
    The Administration's proposal appropriately would establish a high 
standard for invocation of this new resolution regime and would create 
checks and balances on its potential use, similar to the provisions 
governing use of the systemic risk exception to least-cost resolution 
in the Federal Deposit Insurance Act (FDI Act). The Federal Reserve's 
participation in this decision-making process would be an extension of 
our long-standing role in protecting financial stability, involvement 
in the current process for invoking the systemic risk exception under 
the FDI Act, and status as consolidated supervisor for large banking 
organizations. The Federal Reserve, however, is not well suited, nor do 
we seek, to serve as the resolution agency for systemically important 
institutions under the new framework.
    As we have seen during the recent crisis, a substantial commitment 
of public funds may be needed, at least on a temporary basis, to 
stabilize and facilitate the orderly resolution of a large, highly 
interconnected financial firm. The Administration's proposal provides 
for such funding needs to be addressed by the Treasury, with the 
ultimate costs of any assistance to be recouped through assessments on 
financial firms over an extended period of time. We believe the 
Treasury is the appropriate source of funding for the resolution of 
systemically important financial institutions, given the unpredictable 
and inherently fiscal nature of this function. The availability of such 
funding from Treasury also would eliminate the need for the Federal 
Reserve to use its emergency lending authority under section 13(3) of 
the Federal Reserve Act to prevent the failure of specific 
institutions.
Payment, Clearing, and Settlement Arrangements
    The current regulatory and supervisory framework for systemically 
important payment, clearing, and settlement arrangements is fragmented, 
with no single agency having the ability to ensure that all 
systemically important arrangements are held to consistent and strong 
prudential standards. The Administration's proposal would provide the 
Federal Reserve certain additional authorities for ensuring that all 
systemically important payment, clearing, and settlement arrangements 
are subject to robust standards for safety and soundness.
    Payment, settlement, and clearing arrangements are the foundation 
of the Nation's financial infrastructure. These arrangements include 
centralized market utilities for clearing and settling payments, 
securities, and derivatives transactions, as well as decentralized 
activities through which financial institutions clear and settle such 
transactions bilaterally. While payment, clearing, and settlement 
arrangements can create significant efficiencies and promote 
transparency in the financial markets, they also may concentrate 
substantial credit, liquidity, and operational risks. Many of these 
arrangements also have direct and indirect financial or operational 
linkages and, absent strong risk controls, can themselves be a source 
of contagion in times of stress. Thus, it is critical that systemically 
important systems and activities be subject to strong and consistent 
prudential standards designed to ensure the identification and sound 
management of credit, liquidity, and operational risks.
    The proposed authority would build on the considerable experience 
of the Federal Reserve in overseeing systemically important payment, 
clearing, and settlement arrangements for prudential purposes. Over the 
years, the Federal Reserve has worked extensively with domestic and 
foreign regulators to develop strong and internationally recognized 
standards for critical systems. Further, the Federal Reserve already 
has direct supervisory responsibility for some of the largest and most 
critical systems in the United States, including the Depository Trust 
Company and CLS Bank and has a role in overseeing several other 
systemically important systems. Yet, at present, this authority depends 
to a considerable extent on the specific organizational form of these 
systems as State member banks. The safe and efficient operation of 
payment, settlement, and clearing systems is critical to the execution 
of monetary policy and the flow of liquidity throughout the financial 
sector, which is why many central banks around the world currently have 
explicit oversight responsibilities for critical systems.
    Importantly, the proposed enhancements to our responsibilities for 
the safety and soundness of systemically important arrangements would 
complement--and not displace--the authority of the SEC and CFTC for the 
systems subject to their supervision under the Federal securities and 
commodities laws. We have an extensive history of working cooperatively 
with these agencies, as well as international authorities. For example, 
the Federal Reserve works closely with the SEC in supervising the 
Depository Trust Company and also works closely with 21 other central 
banks in supervising the foreign exchange settlements of CLS Bank.
Consumer Protection
    A word on the consumer protection piece of the Administration's 
plan may be appropriate here, insofar as we have seen how problems in 
consumer protection can in some cases contain the seeds of systemic 
problems. The Administration proposes to shift responsibility for 
writing and enforcing regulations to protect consumers from unfair 
practices in financial transactions from the Federal Reserve to a new 
Consumer Financial Protection Agency.
    Without extensively entering the debate on the relative merits of 
this proposal, I do think it important to point out some of the 
benefits that would be lost through this change.
    Both the substance of consumer protection rules and their 
enforcement are complementary to prudential supervision. Poorly 
designed financial products and misaligned incentives can at once harm 
consumers and undermine financial institutions. Indeed, as with 
subprime mortgages and securities backed by these mortgages, these 
products may at times also be connected to systemic risk. At the same 
time, a determination of how to regulate financial practices both 
effectively and efficiently can be facilitated by the understanding of 
institutions' practices and systems that is gained through safety and 
soundness regulation and supervision. Similarly, risk assessment and 
compliance monitoring of consumer and prudential regulations are 
closely related, and thus entail both informational advantages and 
resource savings.
    Under Chairman Bernanke's leadership, the Federal Reserve has 
adopted strong consumer protection measures in the mortgage and credit 
card areas. These regulations benefited from the supervisory and 
research capabilities of the Federal Reserve, including expertise in 
consumer credit markets, retail payments, banking operations, and 
economic analysis. Involving all these forms of expertise is important 
for tailoring rules that prevent abuses while not impeding the 
availability of sensible extensions of credit.
Conclusion
    Thank you again for the opportunity to testify on these important 
matters. The Federal Reserve looks forward to working with Congress and 
the Administration to enact meaningful regulatory reform that will 
strengthen the financial system and reduce both the probability and 
severity of future crises.
                                 ______
                                 

               PREPARED STATEMENT OF VINCENT R. REINHART
             Resident Scholar, American Enterprise Institute
                             July 23, 2009
For Best Results: Simplify
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee 
thank you for the opportunity to testify today.
    No doubt, the American people expect significant remedial action in 
the aftermath of the extraordinary Government support to financial 
institutions over the past year. Indeed, this is probably a 
generational moment in which this Congress will shape the financial 
landscape for decades to come. At the outset, however, we must remember 
that greater discipline does not always follow from more intricate 
oversight.
The Problem
    In fact, complexity has been the bane of our financial system for 
decades and cannot be the solution going forward. We have created an 
intricate, multifaceted terrain of opportunities through our financial 
regulations, tax codes, and accounting rules. There are multiple 
Federal regulators and State alternatives. Different jurisdictions 
offer varied enticements in terms of favorable legal structure and tax 
treatment. And the tax code ranges across region and over time.
    Financial firms have burrowed into every nook and cranny. This has 
required the effort of legal specialists, accounting experts, and 
financial engineers. As a result, the balance sheets of large firms 
have been splintered into a collection of special purpose vehicles, and 
securities have been issued with no other purpose than extracting as 
much value as possible from the Basel II Supervisory Accord.
    This complexity introduces three fundamental problems in monitoring 
behavior.
    First, supervisors are at a decided disadvantage in understanding 
risk taking and compliance for a firm that might involve dozens of 
jurisdictions, hundreds of legal entities, and thousands of contractual 
relationships. Firms know this and tailor individual instruments to a 
small slice of its clientele to take advantage of tax and accounting 
rules. Its balance sheet might respond quickly to advances in finance 
and legal interpretations. And the same risks might be booked in 
different ways across affiliates, let alone across different 
institutions, with evident consequences for capital requirements. 
Indeed, the reliance of self-regulation inherent in the Basel II 
supervisory agreement can be seen as an official admission of defeat: A 
large complex financial institution cannot be understood from outside.
    But if an institution is so difficult to understand from the 
outside, how can we expect market discipline to be effective? The 
second cost of complexity is that the outside discipline of credit 
counterparties and equity owners is blunted. Creditors are more likely 
to look to the firm's reputation or a stamp from a rating agency rather 
than the underlying collateral provided by the financial contract. 
Equity owners are more likely to defer to senior management, opening 
the way to compensation abuses and twisting incentives to emphasize 
short-term gains. In this regard, it is probably not an accident that 
financial firms tend not to be targets for hostile takeovers--their 
balance sheets are impenetrable from the outside.
    Third, the problems in understanding the workings of a complicated 
firm are not limited to those on the outside. A complicated firm is 
also difficult to manage. Employers will find it more difficult to 
monitor employees, especially when staff on the ground have highly 
specialized expertise in finance, law, and accounting. Simply put, 
employees who are difficult to monitor cannot be expected to promote 
the long-term interests of their workplace. What follows are abuses in 
matching loans and investments to the appropriate customer and, in some 
cases, outright fraud.
    Note the irony. A firm's effort to take advantage of Government 
induced distortions by becoming more complicated and by making its 
instruments more complex lessens the owner's ability to monitor 
management and management's ability to monitor workers. Market 
discipline breaks down.
The Simple Solution
    Sometimes the answer to a complicated problem is simple, as 
Alexander found with the Gordian Knot. Cut through the existing tangle 
of financial regulation. Consolidate Federal financial regulators and 
assume State responsibilities. Simplify accounting rules and the tax 
code. Make the components of financial firms modular so that the whole 
can be split up into basic parts at a time of stress, advice that may 
have eased resolution of AIG's financial products division. With simple 
rules that define lines more sharply, our Federal regulators will find 
enforcement much easier. If firms are more transparent, official 
supervision will be reinforced by the newfound discipline exercised by 
shareholders and creditors. And with fewer places for self-interest to 
hide, employees will be more accountable in their efforts to preserve 
the longer-term value of their firms.
    I recognize that a Congress pressed for results might be reluctant 
to enact radical simplification. The consolidation of multiple agencies 
and the shift of power away from States to a single Federal entity seem 
daunting. Even harder might be the necessary reduction in the variety 
of corporate charters and the pruning of the tax code and accounting 
rules. Indeed, this is an invitation to jurisdictional warfare, as each 
regulator jockeys for viability. But a more established set of rules 
for the resolution of large firms, simplification of regulations 
generally, and consolidation of supervision specifically should be the 
aspiration of this Congress. I shall argue that a well-designed 
financial stability supervisor can be a means to that end.
A Distinct Choice
    The Treasury recently laid out a new foundation for financial 
regulation. It envisions granting the Federal Reserve new authority to 
supervise all firms that could pose a threat to financial stability, 
even those that do not own banks. I disagree. Such powers should not be 
given to an existing agency, especially not the Nation's central bank. 
Rather, the Congress should form a committee of existing supervisors, 
headed by an independent director, appointed by the President, and 
confirmed by the Senate. The director should have a budget for staff 
and real powers to compel cooperation among the constituent agencies 
and reporting from unregulated entities, if necessary.
    Why shouldn't an existing agency head the committee? From the 
Congress's perspective, an agency is a black box that is difficult to 
monitor, filled with technicians given multiple tools directed toward 
multiple goals. The more complicated is its mission, the more 
opportunities those technicians will have to trade off among those 
goals. For example, consider the plight, admittedly abstract, of an 
agency told to enforce a capital standard and to foster lending. At a 
downturn in the business cycle, it might be tempted to allow overly 
optimistic asset valuations so as to prevent balance-sheet constraints 
from slackening lending. Perhaps, this compromise might be consistent 
with the implied wishes of the Congress. But perhaps not. Because an 
agency, especially focused on technical matters, tends to be opaque, it 
will be difficult for its legislative creators to hold it accountable.
    There are adverse implications of burdening an agency, any agency, 
with multiple goals. First, the public will be confused about what goes 
on behind the curtain. This makes it less likely that the agency will 
find widespread support for its core responsibilities or anyone who 
identifies with its mission. Second, and a bit more inside the Beltway, 
it will be hard to fill the slots at agencies where the job description 
calls for multiple technical talents and competing demands on time. 
Third, key relationships of an agency with the Congress and other 
regulators can become hostage to peripheral turf fights. From my own 
experience, the atmosphere at Fed hearings was especially charged in 
2004 and 2005 in both chambers. Some members and staff thought that 
Chairman Greenspan was dragging his feet on consumer disclosure 
regulation. My point is not that they were wrong in criticizing the 
Chairman. Rather, my point is that time set aside in legislation to 
discuss the plans and objectives of the Fed for monetary policy was 
chewed up on other topics. As a result, Fed credibility was impaired 
for reasons other than the performance of the economy.
The Fed Exception
    I have thus far offered general objections to giving financial 
stability responsibilities to an existing agency. I believe that there 
are even more compelling reasons that those responsibilities should not 
be given to the Fed. Please recognize that I worked in the Federal 
Reserve System for a quarter-century and that I hold its staff in high 
esteem. They are knowledgeable, competent, and committed to their 
mission. But any group of people in an independent agency assigned too 
many goals will be pulled in too many directions. And there is one goal 
given to the Fed that should not be jeopardized: the pursuit of maximum 
employment and stable prices. Indeed, that goal is so pivotal to the 
Nation's interest that the Congress should be thinking of narrowing, 
not broadening, the Fed's focus.
    Three other concerns should give you pause before signing on to the 
Treasury's blueprint of a new role for the Fed.
    First, as compared to other agencies, the Fed has significant 
macroeconomic policy and lending tools. If it failed in its role as 
systemic supervisor to identify the originator of the next financial 
crisis, might it be more likely to use those tools beyond what is 
necessary for the achievement of its core monetary policy 
responsibility?
    Second, you might hear that the expertise gained in assessing 
financial stability will help to inform the Fed's pursuit of 
macropolicy goals. That would work in principal. In practice, I believe 
that there are precious few instances of that favorable feedback, 
despite the Fed's involvement in bank supervision since its inception. 
But I stand willing to be proved wrong. The Fed's monetary policy 
deliberations over the years are extremely well-documented in thousands 
of pages of minutes and transcripts. Anyone making the case for 
beneficial spillovers should be asked to produce numerous relevant 
excerpts from that treasure trove. I do not think they will be able to 
do so because I do not think those examples exist.
    Third, the gift of extraordinary powers to an agency merits 
forthright accountability from that agency. It is up to you to 
determine whether the Fed has been sufficiently accountable during this 
recent episode. In that regard, however, I would note an inconsistency 
in the Treasury blueprint. It wants to give the Fed new powers 
regarding financial stability. At the same time, it seeks to 
circumscribe the one unusual power that the Fed has exercised over the 
past year by requiring the Treasury Secretary to sign off in advance of 
lending in unusual and exigent circumstances. Which best describes the 
true Fed--empowerment or limitation?
An Alternative
    My strong preference, absent radical simplification, is that the 
supervision of financial stability be delegated to a committee of 
existing financial supervisors. Those constituent agencies have the 
specific expertise to understand our complicated financial world. At 
the head should be someone appointed by the President and confirmed by 
the Senate. He or she should have a budget to staff a secretariat 
deemed suitable. And that agency should have independent powers. It 
should be able to compel the information sharing among the constituent 
supervisors and the reporting of information, if necessary, from 
unregulated entities. The constituent agencies should regularly be 
directed to draft reports in their areas of expertise for consideration 
by the full Committee and transmittal to the Congress. This would 
include twice-a-year reports on macroeconomic stability from the Fed, 
appraisals of the health of the banking system from the FDIC, and 
assessments on the resilience of financial market infrastructure from 
the SEC and the CFTC.
    Why does the committee head need to be appointed in that capacity 
and have unique powers? The committee head needs the heft associated 
with an independent selection. Without power, the committee would 
devolve to a debating society that spends the first 5 years of its 
existence negotiating memoranda of understanding on the sharing of 
information.
    Think about this analogy. In the run-up to the financial crisis, 
every single large complex financial institution had a senior risk 
management committee. In most cases, all those committees managed to do 
was to allow the build-up of large risks. Now the U.S. Government has a 
significant ownership stake in many of them. The few exceptional, 
successful firms were the ones that gave the risk managers real powers 
to control positioning. Why should the Federal Government settle for a 
toothless authority?
A Longer-Term Vision
    The real benefits of a financial stability committee would come if 
the Congress were forward-looking in writing its mandate. The committee 
could be a vehicle to foster the achievement over time of robust rules 
for the resolution of private firms, simplification of the financial 
system, and consolidation of financial agencies.
    Let me take each in turn.
    Resolution. At a time of crisis, we resort to the injection of 
public funds into private firms because we are afraid of letting market 
forces play out. Each major firm should negotiate a ``living will'' 
with its regulator each year. That living will should detail how the 
firm should be disassembled in the event of bankruptcy. It should list 
the segments of the firm that are systemically important and provide 
contractual mechanisms to ring-fence them. The secretariat of the 
financial stability committee should assess those plans to make sure 
what looked good on paper could be applied in extremis. Also, the 
secretariat can recommend industry initiatives to narrow over time the 
ambit of firm-specific systemically important activities.
    Periodically, the head of the committee should report to the 
Congress--in closed session if necessary--about the status of 
resolution plans. This would be the opportunity to identify areas for 
legislation, if necessary, to give the Government more effective 
resolution powers.
    Simplification. It will not take long for anyone tasked with 
working through the innermost machinations of major financial firms to 
conclude that our system is hopelessly complicated. The head of the 
financial stability committee should report annually on opportunities 
to hack away at that underbrush, be it agency regulations, accounting 
rules, or the tax code. The ambition of the new agency to simplify 
financial rules, across industries and products, should be as wide as 
the net cast for threats to financial stability. Those opportunities 
are both in Federal and State legislation and agency regulation. On a 
flow basis, new legislation should be scored, much as is already done 
for budgetary impact, for the effects on the complexity of the 
financial system.
    Consolidation. The low hanging fruit of simplification will most 
likely come in consolidating Federal agencies and State 
responsibilities. An independent agency head should have the 
perspective and stature to identify such opportunities that can be the 
basis of future legislation. That is, part of the job of the 
committee's chair should be explaining how the committee should get 
smaller over time.
Conclusion
    Facilitating resolution, simplifying rules, and consolidating 
regulators will go a long way in making financial firms more 
transparent. This will aid in enforcing remaining regulation, 
disciplining credit decisions, and monitoring employees. It is also 
patently fairer. Being bigger or more complicated or having better 
lobbyists will not covey an advantage in a world of clear lines, strict 
enforcement, and no exceptions. We have lived in a world of fine print 
and sharp lawyers and look where that got us. We are ready for change.
    I would prefer that this change come quickly, but others might see 
this as too abrupt. If significant simplification does not come now, a 
strong independent financial stability committee could provide 
immediate protection and the promise of identifying areas for future 
progress along the lines I have laid out.
                                 ______
                                 

               PREPARED STATEMENT OF PAUL SCHOTT STEVENS
            President and CEO, Investment Company Institute
                             July 23, 2009
I. Introduction
    My name is Paul Schott Stevens. I am President and CEO of the 
Investment Company Institute, the national association of U.S. 
investment companies, including mutual funds, closed-end funds, 
exchange-traded funds (ETFs), and unit investment trusts (UITs) 
(collectively, ``funds''). Members of ICI manage total assets of $10.6 
trillion and serve over 93 million shareholders.
    Millions of American investors have chosen funds to help meet their 
long-term financial goals. In addition, funds are among the largest 
investors in U.S. companies--they hold, for example, about 25 percent 
of those companies' outstanding stock, approximately 45 percent of U.S. 
commercial paper (an important source of short-term funding for 
corporate America), and about 33 percent of tax-exempt debt issued by 
U.S. municipalities. As both issuers of securities to investors and 
purchasers of securities in the market, funds have a strong interest in 
the ongoing consideration by policy makers and other stakeholders of 
how to strengthen our financial regulatory system in response to the 
most significant financial crisis many of us have ever experienced.
    In early March, ICI released a white paper outlining detailed 
recommendations on how to reform the U.S. financial regulatory system, 
with particular emphasis on reforms most directly affecting the 
functioning of the capital markets and the regulation of funds, as well 
as the subject of this hearing--how best to monitor for potential 
systemic risks and mitigate the effect of such risks on our financial 
system and the broader economy. \1\ At a March hearing before this 
Committee, I summarized ICI's recommendations and offered some of my 
own thoughts on a council approach to systemic risk regulation, based 
on my personal experience as the first Legal Adviser to and, 
subsequently, Executive Secretary of, the National Security Council. 
Since March, ICI has continued to develop and refine its reform 
recommendations and to study proposals advanced by others. I very much 
appreciate the opportunity to appear before this Committee again and 
offer further perspectives on establishing a framework for systemic 
risk regulation.
---------------------------------------------------------------------------
     \1\ See Investment Company Institute, Financial Services 
Regulatory Reform: Discussion and Recommendations (March 3, 2009), 
available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf (ICI White 
Paper).
---------------------------------------------------------------------------
    Section II below offers general observations on establishing a 
formal mechanism for identifying, monitoring, and managing potential 
risks to our financial system. Section III comments on the 
Administration's proposed approach to systemic risk regulation. 
Finally, Section IV describes in detail a proposal to structure a 
systemic risk regulator as a statutory council of senior Federal 
financial regulators.
II. Systemic Risk Regulation: General Observations
    The ongoing financial crisis has highlighted our vulnerability to 
risks that accompany products, structures, or activities that may 
spread rapidly throughout the financial system; and that may occasion 
significant damage to the system at large. Over the past year, various 
policy makers, financial services industry representatives, and other 
commentators have called for the establishment of a formal mechanism 
for identifying, monitoring, and managing risks of this dimension--one 
that would allow Federal regulators to look across the system and to 
better anticipate and address such risks.
    ICI was an early supporter of creating a systemic risk regulator. 
But we also have long advocated that two important cautions should 
guide Congress in determining the composition and authority of such a 
regulator. \2\ First, the legislation establishing a systemic risk 
regulator should be crafted to avoid imposing undue constraints or 
inapposite forms of regulation on normally functioning elements of the 
financial system that may stifle innovations, impede competition, or 
impose needless inefficiencies. Second, a systemic risk regulator 
should not be structured to simply add another layer of bureaucracy or 
to displace the primary regulator(s) responsible for capital markets, 
banking, or insurance.
---------------------------------------------------------------------------
     \2\ See id. at 4.
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    Accordingly, in our judgment, legislation establishing a systemic 
risk regulator should clearly define the nature of the relationship 
between this new regulator and the primary regulator(s) for the various 
financial sectors. It should delineate the extent of the authority 
granted to the systemic risk regulator, as well as identify 
circumstances under which the systemic risk regulator and primary 
regulator(s) should coordinate their efforts and work together. We 
believe, for example, that the primary regulators should continue to 
act as the first line of defense in addressing potential risks within 
their spheres of expertise.
    In view of the two cautions outlined above, ICI was an early 
proponent of structuring a systemic risk regulator as a statutory 
council comprised of senior Federal regulators. As noted above, I 
testified before this Committee at a March hearing focused on investor 
protection and the regulation of securities markets. At that time, I 
recommended that the Committee give serious consideration to the 
council model, based on my personal experience with the National 
Security Council (NSC), a body which has served the Nation well for 
more than 60 years. As the first Legal Adviser to the NSC in 1987, I 
was instrumental in reorganizing the NSC system and staff following the 
Iran-Contra affair. I subsequently served from 1987 to 1989 as chief of 
the NSC staff under National Security Adviser Colin Powell.
III. The Administration's Proposed Approach
    The council approach to a systemic risk regulator has received 
support from Federal and State regulators and others. \3\ It is 
noteworthy that the Administration's white paper on regulatory reform 
likewise includes recommendations for a Financial Services Oversight 
Council (Oversight Council). \4\ The Oversight Council would monitor 
for emerging threats to the stability of the financial system, and 
would have authority to gather information from the full range of 
financial firms to enable such monitoring. As envisioned by the 
Administration, the Oversight Council also would serve to facilitate 
information sharing and coordination among the principal Federal 
financial regulators, provide a forum for consideration of issues that 
cut across the jurisdictional lines of these regulators, and identify 
gaps in regulation. \5\
---------------------------------------------------------------------------
     \3\ See, e.g., Statement of Damon A. Silvers, Associate General 
Counsel, AFL-CIO, before the Senate Committee on Homeland Security and 
Government Affairs, Hearing on ``Systemic Risk and the Breakdown of 
Financial Governance'' (March 4, 2009); Statement of Sheila C. Bair, 
Chairman, Federal Deposit Insurance Corporation, before the Senate 
Committee on Banking, Housing, and Urban Affairs, Hearing on 
``Regulating and Resolving Institutions Considered `Too-Big-To-Fail' '' 
(May 6, 2009) (``Bair Testimony''); Senator Mark R. Warner, ``A Risky 
Choice for a Risk Czar'', Washington Post (June 28, 2009).
     \4\ See Financial Regulatory Reform, A New Foundation: Rebuilding 
Financial Supervision and Regulation (June 17, 2009), available at 
http://www.financialstability.gov/docs/regs/FinalReport_web.pdf 
(Administration white paper), at 17-19.
     \5\ See id. at 18.
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    Unfortunately, the Administration's proposal would vest the lion's 
share of authority and responsibility for systemic risk regulation with 
the Federal Reserve, relegating the Oversight Council to at most an 
advisory or consultative role. In particular, the Administration 
recommends granting broad new authority to the Federal Reserve in 
several respects. \6\ The Administration's white paper acknowledges 
that ``[t]hese proposals would put into effect the biggest changes to 
the Federal Reserve's authority in decades.'' \7\
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     \6\ Under this new authority, the Federal Reserve would have: (1) 
the ultimate voice in determining which financial firms would 
potentially pose a threat to financial stability, through designation 
of so-called ``Tier 1 Financial Holding Companies;'' (2) the ability to 
collect reports from all financial firms meeting minimum size 
thresholds and, in certain cases, to examine such firms, in order to 
determine whether a particular firm should be classified as a Tier 1 
FHC; (3) consolidated supervisory and regulatory authority over Tier 1 
FHCs and their subsidiaries, including the application of stricter and 
more conservative prudential standards than those applicable to other 
financial firms; and (4) the role of performing ``rigorous assessments 
of the potential impact of the activities and risk exposures of [Tier 1 
FHCs] on each other, on critical markets, and on the broader financial 
system.'' See id. at 19-24.
     \7\ Id. at 25.
---------------------------------------------------------------------------
    I believe that the Administration's approach would strike the wrong 
balance. Significantly, it fails to draw in a meaningful way on the 
experience and expertise of other regulators responsible for the 
oversight of capital markets, commodities and futures markets, 
insurance activities, and other sectors of the banking system. The 
Administration's white paper fails to explain why its proposed 
identification and regulation of Tier 1 Financial Holding Companies 
(Tier 1 FHCs) is appropriate in view of concerns over market 
distortions that could accompany ``too-big-to-fail'' designations. The 
standards that would govern determinations of Tier 1 FHC status are 
highly ambiguous. \8\ Finally, by expanding the mandate of the Federal 
Reserve well beyond its traditional bounds, the Administration's 
approach could jeopardize the Federal Reserve's ability to conduct 
monetary policy with the requisite degree of independence.
---------------------------------------------------------------------------
     \8\ The Administration proposes requiring the Federal Reserve to 
consider certain specified factors (including the firm's size and 
leverage, and the impact its failure would have on the financial system 
and the economy) and to get input from the Oversight Council. The 
Federal Reserve, however, would have discretion to consider other 
factors, and the final decision of whether to designate a particular 
firm for Tier 1 FHC status would be its alone. See id. at 20-21. This 
approach, in our view, would vest wide discretion in the Federal 
Reserve and provide financial firms with insufficient clarity about 
what activities, lines of business, or other factors might result in a 
Tier 1 FHC designation.
---------------------------------------------------------------------------
    The shortcomings that we see with the Administration's plan 
reinforce our conclusion that a properly structured statutory council 
would be the most effective mechanism to orchestrate and oversee the 
Federal Government's efforts to monitor for potential systemic risks 
and mitigate the effect of such risks. Below, we set forth our detailed 
recommendations for the composition, role, and scope of authority that 
should be afforded to such a council.
IV. Fashioning an Effective Systemic Risk Council
    In concept, an effective Systemic Risk Council (Council) could be 
similar in structure and approach to the National Security Council, 
which was established by the National Security Act of 1947. In the 
aftermath of World War II, Congress recognized the need to assure 
better coordination and integration of ``domestic, foreign, and 
military policies relating to the national security'' and the ongoing 
assessment of ``policies, objectives, and risks.'' The 1947 Act 
established the NSC under the President as a Cabinet-level council with 
a dedicated staff. In succeeding years, the NSC has proved to be a key 
mechanism used by Presidents to address the increasingly complex and 
multifaceted challenges of national security policy.
a. Composition of the Council and Its Staff
    As with formulating national security policy, addressing risks to 
the financial system at large requires diverse inputs and perspectives. 
The Council's standing membership accordingly should draw upon a broad 
base of expertise, and should include the core Federal financial 
regulators--the Secretary of the Treasury, Chairman of the Board of 
Governors of the Federal Reserve System, Chairman of the Securities and 
Exchange Commission, Chairman of the Commodity Futures Trading 
Commission, the Comptroller of the Currency (or head of any combined 
Office of the Comptroller of the Currency and of the Office of Thrift 
Supervision), the Chairman of the Federal Deposit Insurance 
Corporation, and the head of a Federal insurance regulator, if one 
emerges from these reform efforts. As with the NSC, flexibility should 
exist for the Council to enlist other Federal and State regulators into 
the work of the Council on specific issues as required--including, for 
example, self-regulatory organizations and State regulators for the 
banking, insurance or securities sectors.
    The Secretary of the Treasury, as a Presidential appointee 
confirmed by the Senate and the senior-most member of the Council, 
should be designated chairman. An executive director, appointed by the 
President, should run the day-to-day operations of the Council and 
serve as head of the Council's staff. The Council should meet on a 
regular basis, with an interagency process coordinated through the 
Council's staff to support and follow through on its ongoing 
deliberations.
    To accomplish its mission, the Council should have the support of a 
dedicated, highly experienced staff. The staff should represent a mix 
of disciplines (e.g., economics, accounting, finance, law) and areas of 
expertise (e.g., securities, commodities, banking, insurance). It 
should consist of individuals seconded from Government departments and 
agencies, as well as individuals having a financial services business, 
professional, or academic background recruited from the private sector. 
The Council's staff should operate, and be funded, independently from 
the functional regulators. \9\ Nonetheless, the background and 
experience of the staff, including those seconded from other parts of 
Government, would help assure the kind of strong working relationships 
with the functional regulators necessary for the Council's success. 
Such a staff could be recruited and at work in a relatively short 
period of time. The focus in recruiting a staff should be on quality, 
not quantity, and the Council's staff accordingly need not and should 
not be large.
---------------------------------------------------------------------------
     \9\ A Council designed in this way would differ from the 
Administration's Oversight Council, which would be staffed and operated 
within the Treasury Department.
---------------------------------------------------------------------------
b. Mission and Operation of the Council
    By statute, the Council should have a mandate to monitor conditions 
and developments in the domestic and international financial markets, 
and to assess their implications for the health of the U.S. financial 
system at large. The Council would be responsible for making threshold 
determinations concerning the systemic risks posed by given products, 
structures, or activities. It would identify regulatory actions to be 
taken to address these systemic risks as they emerge, would assess the 
effectiveness of these actions, and would advise the President and 
Congress regularly on emerging risks and necessary legislative or 
regulatory responses. The Council would be responsible for coordinating 
and integrating the national response to such risks. Nonetheless, it 
would not have a direct operating role (just as the NSC coordinates and 
integrates military and foreign policy that is implemented by the 
Defense or State Department and not by the NSC itself). Rather, 
responsibility for addressing identified risks would lie with the 
existing functional regulators, which would act pursuant to their 
normal statutory authorities but--for these purposes only--under the 
Council's direction.
    Similar to the Administration's Oversight Council proposal, the 
Council should have two separate but interrelated mandates--(1) the 
prevention and mitigation of systemic risk and (2) policy coordination 
and information sharing across the various functional regulators. Under 
this model, where all the functional regulators have an equal voice and 
stake in the success of the Council, the stronger working relationships 
and the sense of shared purpose that would grow out of the Council's 
collaborative efforts would greatly assist in sound policy development, 
prioritization of effort, and cooperation with the international 
regulatory community. Further, the staffing and resources of the 
Council could be leveraged for both purposes. This would address some 
of the criticisms and limitations of the existing President's Working 
Group on Financial Markets (PWG).
    Information will be the lifeblood of the Council's deliberations 
and the work of the Council's staff. Having information flow from 
regulated entities through their functional regulators to the Council 
and its staff would appropriately draw upon the regulators' existing 
information and data collection capabilities and avoid unnecessary 
duplication of effort. To the extent that a particular financial firm 
is not subject to direct supervision by a Council member, the Council 
should have the authority to require periodic or other reporting from 
such firm as the Council determines is necessary to evaluate the extent 
to which a particular product, structure, or activity poses a systemic 
risk. \10\
---------------------------------------------------------------------------
     \10\ The Administration likewise proposes to grant its Oversight 
Council the authority to require periodic reporting from financial 
firms, but the authority would extend to all firms, with simply a 
caveat that the Oversight Council ``should, wherever possible,'' rely 
upon information already being collected by Council members. See 
Administration white paper, supra note 4, at 19.
---------------------------------------------------------------------------
    Although the Council and its staff would continually monitor 
conditions and developments in the financial markets, the range of 
issues requiring action by the Council itself should be fairly limited 
in scope--directed only at major unaddressed hazards to the financial 
system, as opposed to day-to-day regulatory concerns. As noted above, 
the Council should be required, as a threshold matter, to make a formal 
determination that some set of circumstances could pose a risk to the 
financial system at large. That determination would mark the beginning 
of a consultative process among the Council members, with support from 
the Council's staff, to develop a series of responses to the identified 
risks. The Council could then recommend or direct action by the 
appropriate functional regulators to implement these responses.
    Typically, the Council should be able to reach consensus, both on 
identifying potential risks and developing responses to such risks. To 
address the rare instance where Council members are unable to reach 
consensus on a course of action, however, there should be a mechanism--
specified in the authorizing legislation--that would require the 
elevation of disputes to the President for resolution. There likewise 
should be reporting to Congress of such disputes and their resolution, 
so as to assure timely Congressional oversight.
    To ensure proper follow-through, we envision that the individual 
regulators would report back to the Council, which would monitor 
progress and ensure that the regulators are acting in accord with the 
policy direction set by the Council. At the same time, to ensure 
appropriate accountability, we recommend that the Council be required 
to report to Congress whenever it makes a threshold finding or 
recommends or directs a functional regulator to take action, so that 
the relevant oversight committees in Congress also may monitor progress 
and assess the adequacy of the regulatory response.
c. Advantages of a Council Model
    We believe that the council model outlined above would offer 
several important advantages.
    First, the Council would avoid risks inherent in designating an 
existing agency like the Federal Reserve to serve essentially as an 
all-purpose systemic risk regulator. In such a role, the Federal 
Reserve understandably may tend to view risks and risk mitigation 
through its lens as a commercial bank regulator focused on prudential 
regulation and ``safety and soundness'' concerns, potentially to the 
detriment of consumer and investor protection concerns and of nonbank 
financial institutions. A Council with a diverse membership would bring 
all competing perspectives to bear and, as a result, would be more 
likely to strike the proper balance. In ICI's view, such perspectives 
most certainly must include those of the SEC and the CFTC. In this 
regard, we are pleased to note that the Administration's reform 
proposals would preserve the role of the SEC as a strong regulator with 
broad responsibilities for overseeing the capital markets and key 
market functions such as clearance, settlement and custody 
arrangements, while also maintaining its investor protection focus. It 
is implausible that we could effectively regulate systemic risk in the 
financial markets without fully incorporating the SEC into that 
process.
    Second, systemic risks may arise in different ways and affect 
different parts of the domestic and global financial system. No 
existing agency or department has a comprehensive frame of reference or 
the necessary expertise to assess and respond to any and all such 
risks. In contrast, the Council would enlist the expertise of the 
entire regulatory community in identifying and devising strategies to 
mitigate systemic risks. These diverse perspectives are essential if we 
are to successfully identify new and unanticipated risks, and avoid 
simply refighting the ``last war.'' Whatever may be the specified cause 
of a future financial crisis, it is certain to be different than the 
one we are now experiencing.
    Third, the Council would provide a high degree of flexibility in 
convening those Federal and State regulators whose input and 
participation is necessary to addressing a specific issue, without 
creating an unwieldy or bureaucratic structure. As is the case with the 
NSC, the Council should have a core membership of senior Federal 
officials and the ability to expand its participants on an ad hoc basis 
when a given issue so requires. It also could be established and begin 
operation in relatively short order. Creating an all-purpose systemic 
risk regulator, on the other hand, would be a long and complex 
undertaking, and would involve developing expertise that duplicates 
that which already exists in the various functional regulators.
    Fourth, with an independent staff dedicated solely to pursuing the 
Council's agenda, the Council would be well-positioned to test or 
challenge the policy judgments or priorities of various functional 
regulators. This would help address any concerns about ``regulatory 
capture,'' including those raised by the Administration's proposal 
concerning the Federal Reserve's exclusive oversight of Tier 1 FHCs. 
Moreover, by virtue of their participation on the Council, the various 
functional regulators would themselves likely be more attentive to 
emerging risks or regulatory gaps. This would help assure a far more 
coordinated and integrated approach. Over time, the Council also could 
assist in framing a political consensus about addressing significant 
regulatory gaps and necessary policy responses.
    Fifth, the functional regulators, as distinct from the Council 
itself, would be charged with implementing regulations to mitigate 
systemic risks as they emerge. This operational role is appropriate 
because the functional regulators have the greatest knowledge of their 
respective regulated industries. Nonetheless, the Council and its staff 
would have an important independent role in evaluating the 
effectiveness of the measures taken by functional regulators to 
mitigate systemic risk and, where necessary, in prompting further 
actions.
    Finally, the council model outlined above would be sufficiently 
robust to ensure sustained follow-through to address critical and 
complex issues posing risk to the financial system. By way of 
illustration, consider the case of Long-Term Capital Management (LTCM), 
a very large and highly leveraged U.S. hedge fund, which in September 
1998 lost 90 percent of its capital and nearly collapsed. Concerned 
that the hedge fund's collapse might pose a serious threat to the 
markets at large, the Federal Reserve arranged a private sector 
recapitalization of LTCM. In the aftermath of this incident, there were 
studies, reports, and recommendations, including by the PWG and the 
U.S. Government Accountability Office (GAO). But 10 years later, a 
January 2008 GAO report noted ``the continuing relevance of questions 
raised over LTCM'' and concluded that it was still ``too soon to 
evaluate [the] effectiveness'' of the regulatory and industry response 
to the LTCM experience. \11\
---------------------------------------------------------------------------
     \11\ United States Government Accountability Office, ``Hedge 
Funds, Regulators, and Market Participants Are Taking Steps To 
Strengthen Market Discipline, But Continued Attention Is Needed'' 
(January 2008), at 3 and 8.
---------------------------------------------------------------------------
    Hopefully, had a Systemic Risk Council such as that described above 
been in operation at the time of LTCM's near collapse, it might have 
prompted more searching analysis of, and more timely and comprehensive 
regulatory action with respect to, the activities that led to LTCM's 
near collapse--such as the growing use of derivatives to achieve 
leverage. For example, under the construct outlined above, the Council 
would have the authority to direct functional regulators to take action 
to implement policy responses--authority that the PWG does not possess.
d. Potential Criticisms--And How They Can Be Addressed
    It has been argued that, because of the Federal Reserve's unique 
crisis-management capability as the central bank and lender of last 
resort, it is the only logical choice as a systemic risk regulator. To 
be sure, should our Nation encounter serious financial instability, the 
Federal Reserve's authorities will be indispensable to remedy the 
problems. So, too, will be any new resolution authority established for 
failing large and complex financial institutions. But the overriding 
purpose of systemic risk regulation should be to identify in advance, 
and prevent or mitigate, the causes of such instability. This is a role 
to which the Council, with its diversity of expertise and perspectives, 
would seem best suited. Put another way, critics of a council model may 
contend that convening a committee is not the best way to put out a 
roaring fire. But a broad-based council is the best body for designing 
a strong fire code--without which we cannot hope to prevent the fire 
before it ignites and consumes our financial system.
    Another potential criticism of the Council is that it may diffuse 
responsibility and pose difficulties in assuring proper follow-through 
by the functional regulators. While it is true that each functional 
regulator would have responsibility for implementing responses to 
address identified risks, it must be made clear in the legislation 
creating the Council (and in corresponding amendments to the organic 
statutes governing the functional regulators) that these responses must 
reflect the policy direction determined by the Council. Additionally, 
as suggested by FDIC Chairman Bair, the Council should have the 
authority to require a functional regulator to act as directed by the 
Council. \12\ In this way, Congress would be assured of creating a 
Systemic Risk Council with ``teeth.''
---------------------------------------------------------------------------
     \12\ See Bair Testimony, supra note 3.
---------------------------------------------------------------------------
    Finally, claiming that a council of Federal regulators ``would add 
a layer of regulatory bureaucracy without closing the gaps that 
regulators currently have in skills, experience and authority needed to 
track systemic risk comprehensively,'' a recent report instead calls 
for the creation of a wholly independent board to serve as a systemic 
risk ``adviser.'' \13\ As proposed, the board's mission would be to: 
(1) collect and analyze risk exposure of bank and nonbank institutions 
and their practices and products that could threaten financial 
stability; (2) report on those risks and other systemic 
vulnerabilities; and (3) make recommendations to regulators on how to 
reduce those risks. We believe this approach would be highly 
problematic. It would have precisely the effect that its proponents 
wish to avoid--by adding another layer of bureaucracy to the regulatory 
system. It would engender a highly intrusive mechanism that would 
increase regulatory costs and burdens for financial firms. For example, 
duplication likely would result from giving a new advisory board the 
authority to gather the financial information it needs to assess 
potential systemic risks. And if the board's sole function were to look 
for systemic risks in the financial system, it almost goes without 
saying that it would surely find them.
---------------------------------------------------------------------------
     \13\ See ``Investors' Working Group, U.S. Financial Regulatory 
Reform: The Investors' Perspective'' (July 2009), available at http://
www.cii.org/UserFiles/file/resource%20center/investment%20issues/
Investors'%20Working%20Group%20Report%20(July%202009).pdf.
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V. Conclusion
    I appreciate this opportunity to testify before the Committee, and 
I hope that the perspectives I have offered today will assist the 
Committee in its deliberations about the mechanism(s) needed to monitor 
and mitigate potential risks to our financial system. More broadly, I 
would like to commend Chairman Dodd, Ranking Member Shelby, and the 
other Members of the Committee for their considerable efforts in 
seeking meaningful reform of our financial services regulatory regime. 
I--and ICI and its members--look forward to working further with this 
Committee and Congress to achieve such reform.
                                 ______
                                 

                 PREPARED STATEMENT OF ALICE M. RIVLIN
         Senior Fellow, Economic Studies, Brookings Institution
                             July 23, 2009
    Mr. Chairman and Members of the Committee, I am happy to be back 
before this Committee to give my views on reducing systemic risk in 
financial services. I will focus on changes in our regulatory structure 
that might prevent another catastrophic financial meltdown and what 
role the Federal Reserve should play in a new financial regulatory 
system.
    It is hard to overstate the importance of the task facing this 
Committee. Market capitalism is a powerful system for enhancing human 
economic well-being and allocating savings to their most productive 
uses. But markets cannot be counted on to police themselves. Irrational 
herd behavior periodically produces rapid increases in asset values, 
lax lending and overborrowing, excessive risk taking, and outsized 
profits followed by crashing asset values, rapid deleveraging, risk 
aversion, and huge loses. Such a crash can dry up normal credit flows 
and undermine confidence, triggering deep recession and massive 
unemployment. When the financial system fails on the scale we have 
experienced recently the losers are not just the wealthy investors and 
executives of financial firms who took excessive risks. They are 
average people here and around the world whose jobs, livelihoods, and 
life savings are destroyed and whose futures are ruined by the effect 
of financial collapse on the world economy. We owe it to them to ferret 
out the flaws in the financial system and the failures of regulatory 
response that allowed this unnecessary crisis to happen and to mend the 
system so to reduce the chances that financial meltdowns imperil the 
world's economic well-being.
Approaches To Reducing Systemic Risk
    The crisis was a financial ``perfect storm'' with multiple causes. 
Different explanations of why the system failed--each with some 
validity--point to at least three different approaches to reducing 
systemic risk in the future.
The highly interconnected system failed because no one was in charge of 
        spotting the risks that could bring it down.
    This explanation suggests creating a Macro System Stabilizer with 
broad responsibility for the whole financial system charged with 
spotting perverse incentives, regulatory gaps and market pressures that 
might destabilize the system and taking steps to fix them. The Obama 
Administration would create a Financial Services Oversight Council (an 
interagency group with its own staff) to perform this function. I think 
this responsibility should be lodged at the Fed and supported by a 
Council.
The system failed because expansive monetary policy and excessive 
        leverage fueled a housing price bubble and an explosion of 
        risky investments in asset backed securities.
    While low interest rates contributed to the bubble, monetary policy 
has multiple objectives. It is often impossible to stabilize the 
economy and fight asset price bubbles with a single instrument. Hence, 
this explanation suggests stricter regulation of leverage throughout 
the financial system. Since monetary policy is an ineffective tool for 
controlling asset price bubbles, it should be supplemented by the power 
to change leverage ratios when there is evidence of an asset price 
bubble whose bursting that could destabilize the financial sector. 
Giving the Fed control of leverage would enhance the effectiveness of 
monetary policy. The tool should be exercised in consultation with a 
Financial Services Oversight Council.
The system crashed because large interconnected financial firms failed 
        as a result of taking excessive risks, and their failure 
        affected other firms and markets.
    This explanation might lead to policies to restrain the growth of 
large interconnected financial firms--or even break them up--and to 
expedited resolution authority for large financial firms (including 
nonbanks) to lessen the impact of their failure on the rest of the 
system. Some have argued for the creation of a single consolidated 
regulator with responsibility for all systemically important financial 
institutions. The Obama Administration proposes making the Fed the 
consolidated regulator of all Tier 1 Financial Institutions. I believe 
it would be a mistake to identify specific institutions as too-big-to-
fail and an even greater mistake to give this responsibility to the 
Fed. Making the Fed the consolidated prudential regulator of big 
interconnected institutions would weaken its focus on monetary policy 
and the overall stability of the financial system and could threaten 
its independence.
The Case for a Macro System Stabilizer
    One reason that regulators failed to head off the recent crisis is 
that no one was explicitly charged with spotting the regulatory gaps 
and perverse incentives that had crept into our rapidly changing 
financial structure in recent decades. In recent years, antiregulatory 
ideology kept the United States from modernizing the rules of the 
capitalist game in a period of intense financial innovation and 
perverse incentives to creep in.
    Perverse Incentives. Lax lending standards created the bad 
mortgages that were securitized into the toxic assets now weighting 
down the books of financial institutions. Lax lending standards by 
mortgage originators should have been spotted as a threat to stability 
by a Macro System Stabilizer--the Fed should have played this role and 
failed to do so--and corrected by tightening the rules (minimum down 
payments, documentation, proof that the borrow understands the terms of 
the loan and other no-brainers). Even more important, a Macro System 
Stabilizer should have focused on why the lenders had such irresistible 
incentives to push mortgages on people unlikely to repay. Perverse 
incentives were inherent in the originate-to-distribute model which 
left the originator with no incentive to examine the credit worthiness 
of the borrower. The problem was magnified as mortgage-backed 
securities were resecuritized into more complex instruments and sold 
again and again. The Administration proposes fixing that system design 
flaw by requiring loan originators and securitizers to retain 5 percent 
of the risk of default. This seems to me too low, especially in a 
market boom, but it is the right idea.
    The Macro System Stabilizer should also seek other reasons why 
securitization of asset-backed loans--long thought to be a benign way 
to spread the risk of individual loans--became a monster that brought 
the world financial system to its knees. Was it partly because the 
immediate fees earned by creating and selling more and more complex 
collateralized debt instruments were so tempting that this market would 
have exploded even if the originators retained a significant portion of 
the risk? If so, we need to change the reward structure for this 
activity so that fees are paid over a long enough period to reflect 
actual experience with the securities being created.
    Other examples, of perverse incentives that contributed to the 
violence of the recent perfect financial storm include Structured 
Investment Vehicles (SIV's) that hid risks off balance sheets and had 
to be either jettisoned or brought back on balance sheet at great cost; 
incentives of rating agencies to produce excessively high ratings; and 
compensation structures of corporate executives that incented focus on 
short-term earnings at the expense the longer run profitability of the 
company.
    The case for creating a new role of Macro System Stabilizer is that 
gaps in regulation and perverse incentives cannot be permanently 
corrected. Whatever new rules are adopted will become obsolete as 
financial innovation progresses and market participants find ways 
around the rules in the pursuit of profit. The Macro System Stabilizer 
should be constantly searching for gaps, weak links and perverse 
incentives serious enough to threaten the system. It should make its 
views public and work with other regulators and Congress to mitigate 
the problem.
    The Treasury makes the case for a regulator with a broad mandate to 
collect information from all financial institutions and ``identify 
emerging risks.'' It proposes putting that responsibility in a 
Financial Services Oversight Council, chaired by the Treasury, with its 
own permanent expert staff. The Council seems to me likely to be 
cumbersome. Interagency councils are usually rife with turf battles and 
rarely get much done. I think the Fed should have the clear 
responsibility for spotting emerging risks and trying to head them off 
before it has to pump trillions into the system to avert disaster. The 
Fed should make a periodic report to the Congress on the stability of 
the financial system and possible threats to it. The Fed should consult 
regularly with the Treasury and other regulators (perhaps in a 
Financial Services Oversight Council), but should have the lead 
responsibility. Spotting emerging risks would fit naturally with the 
Fed's efforts to monitor the State of the economy and the health of the 
financial sector in order to set and implement monetary policy. Having 
explicit responsibility for monitoring systemic risk--and more 
information on which to base judgments would enhance its effectiveness 
as a central bank.
    Controlling Leverage. The biggest challenge to restructuring the 
incentives is: How to avoid excessive leverage that magnified the 
upswing and turned the downswing into a rout? The aspect of the recent 
financial extravaganza that made it truly lethal was the overleveraged 
superstructure of complex derivatives erected on the shaky foundation 
of America's housing prices. By itself, the housing boom and bust would 
have created distress in the residential construction, real estate, and 
mortgage lending sectors, as well as consumer durables and other 
housing related markets, but would not have tanked the economy. What 
did us in was the credit crunch that followed the collapse of the 
highly leveraged financial superstructure that pumped money into the 
housing sector and became a bloated monster.
    One approach to controlling serious asset-price bubbles fueled by 
leverage would be to give the Fed the responsibility for creating a 
bubble Threat Warning System that would trigger changes in permissible 
leverage ratios across financial institutions. The warnings would be 
public like hurricane or terrorist threat warnings. When the threat was 
high--as demonstrated by rapid price increases in an important class of 
assets, such as land, housing, equities, and other securities without 
an underlying economic justification--the Fed would raise the threat 
level from, say, Three to Four or Yellow to Orange. Investors and 
financial institutions would be required to put in more of their own 
money or sell assets to meet the requirements. As the threat moderated, 
the Fed would reduce the warning level.
    The Fed already has the power to set margin requirements--the 
percentage of his own money that an investor is required to put up to 
buy a stock if he is borrowing the rest from his broker. Policy makers 
in the 1930s, seeking to avoid repetition of the stock price bubble 
that preceded the 1929 crash, perceived that much of the stock market 
bubble of the late 1920s had been financed with money borrowed on 
margin from broker dealers and that the Fed needed a tool distinct from 
monetary policy to control such borrowing in the future.
    During the stock market bubble of the late 1990s, when I was Vice 
Chair of the Fed's Board of Governors, we talked briefly about raising 
the margin requirement, but realized that the whole financial system 
had changed dramatically since the 1920s. Stock market investors in the 
1990s had many sources of funds other than borrowing on margin. While 
raising the margin requirements would have been primarily symbolic, I 
believe with hindsight that we should have done it anyway in hopes of 
showing that we were worried about the bubble.
    The 1930s legislators were correct: monetary policy is a poor 
instrument for counteracting asset price bubbles; controlling leverage 
is likely to be more effective. The Fed has been criticized for not 
raising interest rates in 1998 and the first half of 1999 to discourage 
the accelerating tech stock bubble. But it would have had to raise 
rates dramatically to slow the market's upward momentum--a move that 
conditions in the general economy did not justify. Productivity growth 
was increasing, inflation was benign and responding to the Asian 
financial crisis argued for lowering rates, not raising them. 
Similarly, the Fed might have raised rates from their extremely low 
levels in 2003 or raised them earlier and more steeply in 2004-5 to 
discourage the nascent housing price bubble. But such action would have 
been regarded as a bizarre attempt to abort the economy's still slow 
recovery. At the time there was little understanding of the extent to 
which the highly leveraged financial superstructure was building on the 
collective delusion that U.S. housing prices could not fall. Even with 
hindsight, controlling leverage (along with stricter regulation of 
mortgage lending standards) would have been a more effective response 
to the housing bubble than raising interest rates. But regulators 
lacked the tools to control excessive leverage across the financial 
system.
    In the wake of the current crisis, financial system reformers have 
approached the leverage control problem in pieces, which is appropriate 
since financial institutions play diverse roles. However the Federal 
Reserve--as Macro System Stabilizer--could be given the power to tie 
the system together so that various kinds of leverage ratios move in 
the same direction simultaneously as the threat changes.
    With respect to large commercial banks and other systemically 
important financial institutions, for example, there is emerging 
consensus that higher capital ratios would have helped them weather the 
recent crisis, that capital requirements should be higher for larger, 
more interconnected institutions than for smaller, less interconnected 
ones, and that these requirements should rise as the systemic threat 
level (often associated with asset price bubbles) goes up.
    With respect to hedge funds and other private investment funds, 
there is also emerging consensus that they should be more transparent 
and that financial derivatives should be traded on regulated exchanges 
or at least cleared on clearinghouses. But such funds might also be 
subject to leverage limitations that would move with the perceived 
threat level and could disappear if the threat were low.
    One could also tie asset securitization into this system. The 
percent of risk that the originator or securitizer was required to 
retain could vary with the perceived threat of an asset price bubble. 
This percentage could be low most of the time, but rise automatically 
if Macro System Stabilizer deemed the threat of a major asset price 
bubble was high. One might even apply the system to rating agencies. In 
addition to requiring rating agencies to be more transparent about 
their methods and assumptions, they might be subjected to extra 
scrutiny or requirements when the bubble threat level was high.
    Designing and coordinating such a leverage control system would not 
be an easy thing to do. It would require create thinking and care not 
to introduce new loopholes and perverse incentives. Nevertheless, it 
holds hope for avoiding the run away asset price exuberance that leads 
to financial disaster.
Systemically Important Institutions
    The Obama administration has proposed that there should be a 
consolidated prudential regulator of large interconnected financial 
institutions (Tier 1 Financial Holding Companies) and that this 
responsibility be given to the Federal Reserve. I think this is the 
wrong way to go.
    It is certainly important to reduce the risk that large 
interconnected institutions fail as a result of engaging in highly 
risky behavior and that the contagion of their failure brings down 
others. However, there are at least three reasons for questioning the 
wisdom of identifying a specific list of such institutions and giving 
them their own consolidated regulator and set of regulations. First, as 
the current crisis has amply illustrated, it is very difficult to 
identify in advance institutions that pose systemic risk. The 
regulatory system that failed us was based on the premise that 
commercial banks and thrift institutions that take deposits and make 
loans should be subject to prudential regulation because their deposits 
are insured by the Federal Government and they can borrow from the 
Federal Reserve if they get into trouble. But in this crisis, not only 
did the regulators fail to prevent excessive risk taking by depository 
institutions, especially thrifts, but systemic threats came from other 
quarters. Bear Stearns and Lehman Brothers had no insured deposits and 
no claim on the resources of the Federal Reserve. Yet when they made 
stupid decisions and were on the edge of failure the authorities 
realized they were just as much a threat to the system as commercial 
banks and thrifts. So was the insurance giant, AIG, and, in an earlier 
decade, the large hedge fund, LTCM. It is hard to identify a 
systemically important institution until it is on the point of bringing 
the system down and then it may be too late.
    Second, if we visibly cordon off the systemically important 
institutions and set stricter rules for them than for other financial 
institutions, we will drive risky behavior outside the strictly 
regulated cordon. The next systemic crisis will then likely come from 
outside the ring, as it came this time from outside the cordon of 
commercial banks.
    Third, identifying systemically important institutions and giving 
them their own consolidated regulator tends to institutionalize ``too-
big-to-fail'' and create a new set of GSE-like institutions. There is a 
risk that the consolidated regulator will see its job as not allowing 
any of its charges to go down the tubes and is prepared to put taxpayer 
money at risk to prevent such failures.
    Higher capital requirements and stricter regulations for large 
interconnected institutions make sense, but I would favor a continuum 
rather than a defined list of institutions with its own special 
regulator. Since there is no obvious place to put such a 
responsibility, I think we should seriously consider creating a new 
financial regulator. This new institution could be similar to the 
U.K.'s FSA, but structured to be more effective than the FSA proved in 
the current crisis. In the U.S. one might start by creating a new 
consolidated regulator of all financial holding companies. It should be 
an independent agency but might report to a board composed of other 
regulators, similar to the Treasury proposal for a Council for 
Financial Oversight. As the system evolves the consolidated regulator 
might also subsume the functional regulation of nationally chartered 
banks, the prudential regulation of broker-dealers and nationally 
chartered insurance companies.
    I don't pretend to have a definitive answer to how the regulatory 
boxes should best be arranged, but it seems to me a mistake to give the 
Federal Reserve responsibility for consolidated prudential regulation 
of Tier 1 Financial Holding Companies, as proposed by the Obama 
Administration. I believe the skills needed by an effective central 
bank are quite different from those needed to be an effective financial 
institution regulator. Moreover, the regulatory responsibility would 
likely grow with time, distract the Fed from its central banking 
functions, and invite political interference that would eventually 
threaten the independence of monetary policy.
    Especially in recent decades, the Federal Reserve has been a 
successful and widely respected central bank. It has been led by a 
series of strong macroeconomists--Paul Volcker, Alan Greenspan, Ben 
Bernanke--who have been skillful at reading the ups and downs of the 
economy and steering a monetary policy course that contained inflation 
and fostered sustainable economic growth. It has played its role as 
banker to the banks and lender of last resort--including aggressive 
action with little used tools in the crisis of 2008-9. It has kept the 
payments system functioning even in crises such as 9/11, and worked 
effectively with other central banks to coordinate responses to credit 
crunches, especially the current one. Populist resentment of the Fed's 
control of monetary policy has faded as understanding of the importance 
of having an independent institution to contain inflation has grown--
and the Fed has been more transparent about its objectives. Although 
respect for the Fed's monetary policy has grown in recent years, its 
regulatory role has diminished. As regulator of Bank Holding Companies, 
it did not distinguish itself in the run up to the current crisis (nor 
did other regulators). It missed the threat posed by the deterioration 
of mortgage lending standards and the growth of complex derivatives.
    If the Fed were to take on the role of consolidated prudential 
regulator of Tier 1 Financial Holding Companies, it would need strong, 
committed leadership with regulatory skills--lawyers, not economists. 
This is not a job for which you would look to a Volcker, Greenspan, or 
Bernanke. Moreover, the regulatory responsibility would likely grow as 
it became clear that the number and type of systemically important 
institutions was increasing. My fear is that a bifurcated Fed would be 
less effective and less respected in monetary policy. Moreover, the 
concentration of that much power in an institution would rightly make 
the Congress nervous unless it exercised more oversight and 
accountability. The Congress would understandably seek to appropriate 
the Fed's budget and require more reporting and accounting. This is not 
necessarily bad, but it could result in more Congressional interference 
with monetary policy, which could threaten the Fed's effectiveness and 
credibility in containing inflation.
    In summary, Mr. Chairman: I believe that we need an agency with 
specific responsibility for spotting regulatory gaps, perverse 
incentives, and building market pressures that could pose serious 
threats to the stability of the financial system. I would give the 
Federal Reserve clear responsibility for Macro System Stability, 
reporting periodically to Congress and coordinating with a Financial 
System Oversight Council. I would also give the Fed new powers to 
control leverage across the system--again in coordination with the 
Council. I would not create a special regulator for Tier 1 Financial 
Holding Companies, and I would certainly not give that responsibility 
to the Fed, lest it become a less effective and less independent 
central bank.
    Thank you, Mr. Chairman and Members of the Committee.
                                 ______
                                 

                 PREPARED STATEMENT OF ALLAN H. MELTZER
  Professor of Political Economy, Tepper School of Business, Carnegie 
                           Mellon University
                             July 23, 2009
Regulatory Reform and the Federal Reserve
    Thank you for the opportunity to present my appraisal of the 
Administration's proposal for regulatory changes. I will confine most 
of my comments to the role of the Federal Reserve as a systemic 
regulator and will offer an alternative proposal. I share the belief 
that change is needed and long delayed, but appropriate change must 
protect the public, not bankers. And I believe that effective 
regulation should await evidence and conclusions about the causes of 
the recent crisis. There are many assertions about causes. The Congress 
should want to avoid a rush to regulate before the relevant facts are 
established. If we are to avoid repeating this crisis, make sure you 
know what caused it.
    During much of the past 15 years, I have written three volumes 
entitled ``A History of the Federal Reserve.'' Working with two 
assistants we have read virtually all of the minutes of the Board of 
Governors, the Federal Open Market Committee, and the Directors of the 
Federal Reserve Bank of New York. We have also read many of the staff 
papers and internal memos supporting decisions. I speak from that 
perspective. I speak also from experience in Japan. During the 1990s, 
the years of the Japanese banking and financial crisis, I served as 
Honorary Adviser to the Bank. Their policies included preventing bank 
failures. This did not restore lending and economic growth.
    Two findings are very relevant to the role of the Federal Reserve. 
First, I do not know of any clear examples in which the Federal Reserve 
acted in advance to head off a crisis or a series of banking or 
financial failures. We know that the Federal Reserve did nothing about 
thrift industry failures in the 1980s. Thrift failures cost taxpayers 
$150 billion. AIG, Fannie, and Freddie will be much more costly. Of 
course, the Fed did not have responsibility for the thrift industry, 
but many thrift failures posed a threat to the financial system that 
the Fed should have tried to mitigate. The disastrous outcome was not a 
mystery that appeared without warning. Peter Wallison, Alan Greenspan, 
Bill Poole, Senator Shelby, and others warned about the excessive risks 
taken by Fannie and Freddie, but Congress failed to legislate. Why 
should anyone expect a systemic risk regulator to get requisite 
Congressional action under similar circumstances? Can you expect the 
Federal Reserve as systemic risk regulator to close Fannie and Freddie 
after Congress declines to act?
    Conflicts of this kind, and others, suggest that that the 
Administration's proposal is incomplete. Defining ``systemic risk'' is 
an essential, but missing part of the proposal. Trying to define the 
authority of the regulatory authority when Congress has expressed an 
interest points up a major conflict.
    During the Latin American debt crisis, the Federal Reserve acted to 
hide the failures and losses at money center banks by arranging with 
the IMF to pay the interest on Latin debt to those banks. This served 
to increase the debt that the Governments owed, but it kept the banks 
from reporting portfolio losses and prolonged the debt crisis. The 
crisis ended after one of the New York banks decided to write off the 
debt and take the loss. Others followed. Later, the Treasury offered 
the Brady plans. The Federal Reserve did nothing.
    In the dot-com crisis of the late 1990s, we know the Federal 
Reserve was aware of the growing problem, but it did not act until 
after the crisis occurred. Later, Chairman Greenspan recognized that it 
was difficult to detect systemic failures in advance. He explained that 
the Federal Reserve believed it should act after the crisis, not 
before. Intervention to control soaring asset prices would impose large 
social costs of unemployment, so the Federal Reserve, as systemic risk 
regulator would be unwise to act.
    The dot-com problem brings out that there are crises for which the 
Federal Reserve cannot be effective. Asset market exuberance and supply 
shocks, like oil price increases, are nonmonetary so cannot be 
prevented by even the most astute, far-seeing central bank.
    We all know that the Federal Reserve did nothing to prevent the 
current credit crisis. Before the crisis it kept interest rates low 
during part of the period and did not police the use that financial 
markets made of the reserves it supplied. The Board has admitted that 
it did not do enough to prevent the crisis. It has not recognized that 
its actions promoted moral hazard and encouraged incentives to take 
risk. Many bankers talked openly about a ``Greenspan put,'' their 
belief that the Federal Reserve would prevent or absorb major losses.
    It was the Reconstruction Finance Corporation, not the Fed, that 
restructured banks in the 1930s. The Fed did not act promptly to 
prevent market failure during the 1970 Penn Central failure, the 
Lockheed and Chrysler problems, or on other occasions. In 2008, the Fed 
assisted in salvaging Bear Stearns. This continued the ``too-big-to-
fail'' (TBTF) policy and increased moral hazard. Then without warning, 
the Fed departed from the course it had followed for at least 30 years 
and allowed Lehman to fail in the midst of widespread financial 
uncertainty. This was a major error. It deepened and lengthened the 
current deep recession. Much of the recent improvement results from the 
unwinding of this terrible mistake.
    In 1990-91, the Fed kept the spread between short- and long-term 
interest rates large enough to assist many banks to rebuild their 
capital and surplus. This is a rare possible exception, a case in which 
Federal Reserve action to delay an increase in the short-term rate may 
have prevented banking failures.
    Second, in its 96-year history, the Federal Reserve has never 
announced a lender-of-last-resort policy. It has discussed internally 
the content of such policy several times, but it rarely announced what 
it would do. And the appropriate announcements it made, as in 1987, 
were limited to the circumstances of the time. Announcing and following 
a policy would alert financial institutions to the Fed's expected 
actions and might reduce pressures on Congress to aid failing entities. 
Following the rule in a crisis would change bankers' incentives and 
reduce moral hazard. A crisis policy rule is long overdue. The 
Administration proposal recognizes this need.
    A lender-of-last-resort rule is the right way to implement policy 
in a crisis. We know from monetary history that in the 19th century the 
Bank of England followed Bagehot's rule for a half-century or more. The 
rule committed the Bank to lend on ``good'' collateral at a penalty 
rate during periods of market disturbance. Prudent bankers borrowed 
from the Bank of England and held collateral to be used in a panic. 
Banks that lacked collateral failed.
    Financial panics occurred. The result of following Bagehot's rule 
in crises was that the crises did not spread and did not last long. 
There were bank failures, but no systemic failures. Prudent bankers 
borrowed and paid depositors cash or gold. Bank deposits were not 
insured until much later, so bank runs could cause systemic failures. 
Knowing the Bank's policy rule made most bankers prudent, they held 
more capital and reserves in relation to their size than banks 
currently do, and they held more collateral to use in a crisis also.
    These experiences suggest three main lessons. First, we cannot 
avoid banking failures but we can keep them from spreading and creating 
crises. Second, neither the Federal Reserve nor any other agency has 
succeeded in predicting crises or anticipating systemic failure. It is 
hard to do, in part because systemic risk is not well-defined. 
Reasonable people will differ, and since much is often at stake, some 
will fight hard to deny that there is a systemic risk.
    One of the main reasons that Congress in 1991 passed FDICIA 
(Federal Deposit Insurance Corporation Improvement Act) was to prevent 
the Federal Reserve from delaying closure of failing banks, increasing 
losses and weakening the FDIC fund. The Federal Reserve and the FDIC 
have not used FDICIA against large banks in this crisis. That should 
change.
    The third lesson is that a successful policy will alter bankers' 
incentives and avoid moral hazard. Bankers must know that risk taking 
brings both rewards and costs, including failure, loss of managerial 
position and equity followed by sale of continuing operations.
An Alternative Proposal
    Several reforms are needed to reduce or eliminate the cost of 
financial failure to the taxpayers. Members of Congress should ask 
themselves and each other: Is the banker or the regulator more likely 
to know about the risks on a bank's balance sheet? Of course it is the 
banker, and especially so if the banker is taking large risks that he 
wants to hide. To me that means that reform should start by increasing 
a banker's responsibility for losses. The Administration's proposal 
does the opposite by making the Federal Reserve responsible for 
systemic risk.
    Systemic risk is a term of art. I doubt that it can be defined in a 
way that satisfies the many parties involved in regulation. Members of 
Congress will properly urge that any large failure in their district or 
State is systemic. Administrations and regulators will have other 
objectives. Without a clear definition, the proposal will bring 
frequent controversy. And without a clear definition, the proposal is 
incomplete and open to abuse.
    Resolving the conflicting interests is unlikely to protect the 
general public. More likely, regulators will claim that they protect 
the public by protecting the banks. That's what they do now.
    The Administration's proposal sacrifices much of the remaining 
independence of the Federal Reserve. Congress, the Administration, and 
failing banks or firms will want to influence decisions about what is 
to be bailed out. I believe that is a mistake. If we use our capital to 
avoid failures instead of promoting growth we not only reduce growth in 
living standards we also sacrifice a socially valuable arrangement--
central bank independence. We encourage excessive risk taking and moral 
hazard.
    I believe there are better alternatives than the Administration's 
proposal. First step: End TBTF. Require all financial institutions to 
increase capital more than in proportion to their increase in size of 
assets. TBTF gives perverse incentives. It allows banks to profit in 
good times and shifts the losses to the taxpayers when crises or 
failures occur.
    My proposal reduces the profits from giant size, increases 
incentives for prudent banker behavior by putting losses back to 
managements and stockholders where they belong. Benefits of size come 
from economies of scale and scope. These benefits to society are more 
than offset by the losses society takes in periods of crisis. Congress 
should find it hard to defend a system that distributes profits and 
losses as TBTF does. I believe that the public will not choose to 
maintain that system forever. Permitting losses does not eliminate 
services; failure means that management loses its position and 
stockholders take the losses. Profitable operations continue and are 
sold at the earliest opportunity.
    Second step: Require the Federal Reserve to announce a rule for 
lender-of-last-resort. Congress should adopt the rule that they are 
willing to sustain. The rule should give banks an incentive to hold 
collateral to be used in a crisis period. Bagehot's rule is a great 
place to start.
    Third step: Recognize that regulation is an ineffective way to 
change behavior. My first rule of regulation states that lawyers 
regulate but markets circumvent burdensome regulation. The Basel Accord 
is an example. Banks everywhere had to increase capital when they 
increased balance sheet risk. The banks responded by creating entities 
that were not on their balance sheet. Later, banks had to absorb the 
losses, but that was after the crisis. There are many other examples of 
circumvention from Federal Reserve history. The reason we have money 
market funds was that Fed regulation Q restricted the interest that the 
public could earn. Money market funds bought unregulated, large 
certificates of deposit. For a small fee they shared the higher 
interest rate with the public. Much later Congress agreed to end 
interest rate regulation. The money funds remained.
    Fourth step: Recognize that regulators do not allow for the 
incentives induced by their regulations. In the dynamic, financial 
markets it is difficult, perhaps impossible, to anticipate how clever 
market participants will circumvent the rules without violating them. 
The lesson is to focus on incentives, not prohibitions. Shifting losses 
back to the bankers is the most powerful incentive because it changes 
the risk-return tradeoff that bankers and stockholders see.
    Fifth step: Either extend FDICIA to include holding companies or 
subject financial holding companies to bankruptcy law. Make the holding 
company subject to early intervention either under FDICIA or under 
bankruptcy law. That not only reduces or eliminates taxpayer losses, 
but it also encourages prudential behavior.
    Other important changes should be made. Congress should close 
Fannie Mae and Freddie Mac and put any subsidy for low-income housing 
on the budget. The same should be done to other credit market 
subsidies. The budget is the proper place for subsidies.
    Congress, the regulators, and the Administration should encourage 
financial firms to change their compensation systems to tie 
compensation to sustained average earnings. Compensation decisions are 
too complex for regulation and too easy to circumvent. Decisions should 
be management's responsibility. Part of the change should reward due 
diligence by traders. We know that rating agencies contributed to 
failures. The rating problem would be lessened if users practiced 
diligence of their own.
    Three principles should be borne in mind. First, banks borrow short 
and lend long. Unanticipated large changes can and will cause failures. 
Our problem is to minimize the cost of failures to society. Second, 
remember that capitalism without failure is like religion without sin. 
It removes incentives for prudent behavior. Third, those that rely on 
regulation to reduce risk should recall that this is the age of Madoff 
and Stanford. The Fed, too, lacks a record of success in managing large 
risks to the financial system, the economy and the public. Incentives 
for fraud, evasion, and circumvention of regulation often have been far 
more powerful than incentives to enforce regulation that protects the 
public.
        RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
                      FROM SHEILA C. BAIR

Q.1. Too-Big-To-Fail--Chairman Bair, the Obama administration's 
proposal would have regulators designate certain firms as 
systemically important. These firms would be classified as Tier 
1 Financial Holding Companies and would be subject to a 
separate regulatory regime. If some firms are designated as 
systemically important, would this signal to market 
participants that the Government will not allow these firms to 
fail? If so, how would this worsen our ``too-big-to-fail'' 
problem?

A.1. We have concerns about formally designating certain 
institutions as a special class. Any recognition of an 
institution as systemically important risks invoking the moral 
hazard that accompanies institutions that are considered too-
big-to-fail. That is why, most importantly, a robust resolution 
mechanism, in addition to enhanced supervision, is important 
for very large financial organizations. A vigorous systemic 
risk regulatory regime, along with resolution authority for 
bank holding companies and systemically risky financial firms 
would go far toward eliminating ``too-big-to-fail.''

Q.2. Government Replacing Management?--In your testimony, while 
discussing the need for a systemic risk regulator to provide a 
resolution regime, you state that ``losses would be borne by 
the stockholders and bondholders of the holding company, and 
senior management would be replaced.'' Could you expand upon 
how the senior management would be replaced? Would the systemic 
risk regulator decide who needed to be replaced and who would 
replace them?

A.2. When the FDIC takes over a large insured bank and 
establishes a bridge bank, the normal business practice is to 
replace certain top officials in the bank, usually the CEO, 
plus any other senior officials whose activities were tied to 
the cause of the bank failure. The resolution authority would 
decide who to replace based on why the firm failed.

Q.3. ``Highly Credible Mechanism'' for Orderly Resolution--
Chairman Bair, in your testimony you suggest that we must 
redesign our system to allow the market to determine winners 
and losers, ``and when firms--through their own mismanagement 
and excessive risk taking--are no longer viable, they should 
fail.'' You also suggest that the solution must involve a 
``highly credible mechanism'' for orderly resolution of failed 
institutions similar to that which exists for FDIC-insured 
banks.
    Do you believe that our current bankruptcy system is 
inadequate, or do you believe that we must create a new 
resolution regime simply to fight the perception that we will 
not allow a systemically important institution to fail?

A.3. In the United States, liquidation and rehabilitation of 
most failing corporations are governed by the Federal 
bankruptcy code and administered primarily in the Federal 
bankruptcy courts. Separate treatment, however, is afforded to 
banks, which are resolved under the Federal Deposit Insurance 
Act and administered by the FDIC. \1\ The justifications for 
this separate treatment are banks' importance to the aggregate 
economy, and the serious adverse effect of their insolvency on 
others.
---------------------------------------------------------------------------
     \1\ Another exception would be the liquidation or rehabilitation 
of insurance companies, which are handled under State law.
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    Bankruptcy focuses on returning value to creditors and is 
not geared to protecting the stability of the financial system. 
When a firm is placed into bankruptcy, an automatic stay is 
placed on most creditor claims to allow management time to 
develop a reorganization plan. This can create liquidity 
problems for creditors--especially when a financial institution 
is involved--who must wait to receive their funds. Bankruptcy 
cannot prevent a meltdown of the financial system when a 
systemically important financial firm is troubled or failing.
    Financial firms--especially large and complex financial 
firms--are highly interconnected and operate through financial 
commitments. Most obtain a significant share of their funding 
from wholesale markets using short-term instruments. They 
provide key credit and liquidity intermediation functions. Like 
banks, financial firms (holding companies and their affiliates) 
can be vulnerable to ``runs'' if their short-term liabilities 
come due and cannot be rolled over. For these firms, bankruptcy 
can trigger a rush to the door, since counterparties to 
derivatives contracts--which are exempt from the automatic stay 
placed on other contracts--will exercise their rights to 
immediately terminate contracts, net out their exposures, and 
sell any supporting collateral.
    The statutory right to invoke close-out netting and 
settlement was intended to reduce the risks of market 
disruption. Because financial firms play a central role in the 
intermediation of credit and liquidity, tying up these 
functions in the bankruptcy process would be particularly 
destabilizing. However, during periods of economic instability 
this rush-to-the-door can overwhelm the market and even depress 
market prices for the underlying assets. This can further 
destabilize the markets and affect other financial firms as 
they are forced to adjust their balance sheets.
    By contrast, the powers that are available to the FDIC 
under its special resolution authority prevent the immediate 
close-out netting and settlement of financial contracts of an 
insured depository institution if the FDIC, within 24 hours 
after its appointment as receiver, decides to transfer the 
contracts to another bank or to an FDIC-operated bridge bank. 
As a result, the potential for instability or contagion caused 
by the immediate close-out netting and settlement of qualified 
financial contracts can be tempered by transferring them to a 
more stable counterparty or by having the bridge bank guarantee 
to continue to perform on the contracts. The FDIC's resolution 
powers clearly add stability in contrast to a bankruptcy 
proceeding.
    For any new resolution regime to be truly ``credible,'' it 
must provide for the orderly wind-down of large, systemically 
important financial firms in a manner that is clear, 
comprehensive, and capable of conclusion. Thus, it is not 
simply a matter of ``perception,'' although the new resolution 
regime must be recognized by firms, investors, creditors, and 
the public as a mechanism in which systemically important 
institutions will in fact fail.

Q.4. Firms Subject to New Resolution Regime--Chairman Bair, in 
your testimony, you continuously refer to ``systemically 
significant entities,'' and you also advocate for much broader 
resolution authority. Could you indicate how a ``systemically 
significant entity'' would be defined? Will the list of 
systemically significant institutions change year-to-year? Do 
you envision it including nonfinancial companies such as GM?
    Would all financial and ``systemically significant 
entities'' be subject to this new resolution regime? If not, 
how would the market determine whether the company would be 
subject to a traditional bankruptcy or the new resolution 
regime?
    Why do we need a systemic risk regulator if we are going to 
allow institutions to become ``systemically important''?

A.4. We would anticipate that the Systemic Risk Council, in 
conjunction with the Federal Reserve would develop definitions 
for systemic risk. Also, mergers, failures, and changing 
business models could change what firms would be considered 
systemically important from year-to-year.
    While not commenting on any specific company, nonfinancial 
firms that become major financial system participants should 
have their financial activities come under the same regulatory 
scrutiny as any other major financial system participant.

Q.5. Better Deal for the Taxpayer--Chairman Bair, you advocate 
in your testimony for a new resolution mechanism designed to 
handle systemically significant institutions. Could you please 
cite specific examples of how this new resolution regime would 
have worked to achieve a better outcome for the taxpayer during 
this past crisis?

A.5. A proposed new resolution regime modeled after the FDIC's 
existing authorities has a number of characteristics that would 
reduce the costs associated with the failure of a systemically 
significant institution.
    First and foremost, the existence of a transparent 
resolution scheme and processes will make clear to market 
participants that there will be an imposition of losses 
according to an established claims priority where stockholders 
and creditors, not the Government, are in the first loss 
position. This will provide a significant measure of cost 
savings by imposing market discipline on institutions so that 
they are less likely to get to the point where they would have 
otherwise been considered too-big-to-fail.
    Also, the proposed resolution regime would allow the 
continuation of any systemically significant operations, but 
only as a means to achieve a final resolution of the entity. A 
bridge mechanism, applicable to the parent company and all 
affiliated entities, would allow the Government to preserve 
systemically significant functions. Also, for institutions 
involved in derivatives contracts, the new resolution regime 
would provide an orderly unwinding of counterparty positions as 
compared to the rush to the door that can occur during a 
bankruptcy. In contrast, since counterparties to derivatives 
contracts are exempt from the automatic stay placed on other 
contracts under the Bankruptcy Code, they will exercise their 
rights to immediately terminate contracts, net out their 
exposures, and sell any supporting collateral, which serves to 
increase the loss to the failed institution.
    In addition, the proposed resolution regime enables losses 
to be imposed on market players who should appropriately bear 
the risk, including shareholders and unsecured debt investors. 
This creates a buffer that can reduce potential losses that 
could be borne by taxpayers.
    Further, when the institution and its assets are sold, this 
approach creates the possibility of multiple bidders for the 
financial organization and its assets, which can improve 
pricing and reduce losses to the receivership.
    The current financial crisis led to illiquidity and the 
potential insolvency of a number of systemically significant 
financial institutions during 2008. Where Government assistance 
was provided on an open-institution basis, the Government 
exposed itself to significant loss that would otherwise have 
been mitigated by these authorities proposed for the resolution 
of systemically significant institutions. A new resolution 
regime for firms such as Lehman or AIG would ensure that 
shareholders, management, and creditors take losses and would 
bar an open institution bail-out, as with AIG. The powers of a 
receiver for a financial firm would include the ability to 
require counterparties to perform under their contracts and the 
ability to repudiate or terminate contracts that impose 
continuing losses. It also would have the power to terminate 
employment contracts and eliminate many bonuses.
                                ------                                


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

Q.1. You discussed regulatory arbitrage in your written 
statements and emphasized the benefits of a Council to minimize 
such opportunities. Can you elaborate on this? Should standards 
be set by individual regulators, the Council, or both? Can a 
Council operate effectively in emergency situations?

A.1. One type of regulatory arbitrage is regulatory capital 
arbitrage. It is made possible when there are different capital 
requirements for organizations that have similar risks. For 
instance, banks must hold 10 percent total risk-based capital 
and a 5 percent leverage ratio to be considered well-
capitalized, while large broker-dealers (investment banks) were 
allowed to operate with as little as 3 percent risk-based 
capital. Thus for similar assets, a bank would have to hold $5 
for every $100 of assets, a broker dealer would only be 
required to hold $3 of capital for every $100 of the same 
assets. Obviously, it would be more advantageous for broker 
dealers to accumulate these assets, as their capital 
requirement was 40 percent smaller than for a comparable bank.
    The creation of a Systemic Risk Council with authority to 
harmonize capital requirements across all financial firms would 
mitigate this type of regulatory capital arbitrage. Although 
the capital rules would vary somewhat according to industry, 
the authority vested in the Council would prevent the types of 
disparities in capital requirements we have recently witnessed.
    Some have suggested that a council approach would be less 
effective than having this authority vested in a single agency 
because of the perception that a deliberative council such as 
this would need additional time to address emergency situations 
that might arise from time to time. Certainly, some additional 
thought and effort will be needed to address any dissenting 
views in council deliberations, but a vote by Council members 
would achieve a final decision. A Council will provide for an 
appropriate system of checks and balances to ensure that 
appropriate decisions are made that reflect the various 
interests of public and private stakeholders. In this regard, 
it should be noted that the board structure at the FDIC, with 
the participation of outside directors, is not very different 
than the way the council would operate. In the case of the 
FDIC, quick decisions have been made with respect to systemic 
issues and emergency bank resolutions on many occasions. Based 
on our experience with a board structure, we believe that 
decisions could be made quickly by a deliberative council while 
still providing the benefit of arriving at consensus decisions.

Q.2. What do you see as the key differences in viewpoints with 
respect to the role and authority of a Systemic Risk Council? 
For example, it seems like one key question is whether the 
Council or the Federal Reserve will set capital, liquidity, and 
risk management standards. Another key question seems to be who 
should be the Chair of the Council: the Secretary of the 
Treasury or a different Senate-appointed Chair. Please share 
your views on these issues.

A.2. The Systemic Risk Council should have the authority to 
impose higher capital and other standards on financial firms 
notwithstanding existing Federal or State law and it should be 
able to overrule or force actions on behalf of other regulatory 
entities to raise capital or other requirements. Primary 
regulators would be charged with enforcing the requirements set 
by the Council. However, if the primary regulators fail to act, 
the Council should have the authority to do so. The standards 
set by the Council would be designed to provide incentives to 
reduce or eliminate potential systemic risks created by the 
size or complexity of individual entities, concentrations of 
risk or market practices, and other interconnections between 
entities and markets.
    The Council would be uniquely positioned to provide the 
critical linkage between the primary Federal regulators and the 
need to take a macroprudential view and focus on emerging 
systemic risk across the financial system. The Council would 
assimilate information on economic conditions and the condition 
of supervised financial companies to assess potential risk to 
the entire financial system. The Council could then direct 
specific regulatory agencies to undertake systemic risk 
monitoring activities or impose recommended regulatory measures 
to mitigate systemic risk.
    The Administration proposal includes eight members on the 
Council: the Secretary of the Treasury (as Chairman); the 
Chairman of the Federal Reserve Board; the Director of the 
National Bank Supervisor; the Director of the Consumer 
Financial Protection Agency; the Chairman of the Securities and 
Exchange Commission; the Chairman of the Commodities Futures 
Trading Commission; the Chairman of the FDIC; and the Director 
of the Federal Housing Finance Agency.
    In designing the role of the Council, it will be important 
to preserve the longstanding principle that bank regulation and 
supervision are best conducted by independent agencies. For 
example, while the OCC is an organization within the Treasury 
Department, there are statutory safeguards to prevent undue 
involvement of the Treasury in regulation and supervision of 
National Banks. Given the role of the Treasury in the Council 
contemplated in the Administration's plan, careful attention 
should be given to the establishment of appropriate safeguards 
to preserve the political independence of financial regulation.
    Moreover, while the FDIC does not have a specific 
recommendation regarding what agencies should compose the 
Council, we would suggest that the Council include an odd 
number of members in order to avoid deadlocks. One way to 
address this issue that would be consistent with the importance 
of preserving the political independence of the regulatory 
process would be for the Treasury Chair to be a nonvoting 
member, or the Council could be headed by someone appointed by 
the President and confirmed by the Senate.

Q.3. What are the other unresolved aspects of establishing a 
framework for systemic risk regulation?

A.3. With an enhanced Council with decision-making powers to 
raise capital and other key standards for systemically related 
firms or activities, we are in general agreement with the 
Treasury plan for systemic risk regulation, or the Council 
could be headed by a Presidential appointee.

Q.4. How should Tier 1 firms be identified? Which regulator(s) 
should have this responsibility?

A.4. As discussed in my testimony, the FDIC endorses the 
creation of a Council to oversee systemic risk issues, develop 
needed prudential policies and mitigate developing systemic 
risks. Prior to the current crisis, systemic risk was not 
routinely part of the ongoing supervisory process. The FDIC 
believes that the creation of a Council would provide a 
continuous mechanism for measuring and reacting to systemic 
risk across the financial system. The powers of such a Council 
would ultimately have to be developed through a dialogue 
between the banking agencies and Congress, and empower the 
Council to oversee unsupervised nonbanks that present systemic 
risk. Such nonbanks should be required to submit to such 
oversight, presumably as a financial holding company under the 
Federal Reserve. The Council could establish what practices, 
instruments, or characteristics (concentrations of risk or 
size) that might be considered risky, but would not identify 
any set of firms as systemic.
    We have concerns about formally designating certain 
institutions as a special class. Any recognition of an 
institution as systemically important, however, risks invoking 
the moral hazard that accompanies institutions that are 
considered too-big-to-fail. That is why, most importantly, a 
robust resolution mechanism, in addition to enhanced 
supervision, is important for very large financial 
organizations.

Q.5. One key part of the discussion at the hearing is whether 
the Federal Reserve, or any agency, can effectively operate 
with two or more goals or missions. Can the Federal Reserve 
effectively conduct monetary policy, macroprudential 
regulation, and consumer protection?

A.5. The Federal Reserve has been the primary Federal regulator 
for State chartered member institutions since its inception and 
has been the bank holding company supervisor since 1956. With 
the creation of the Consumer Financial Protection Agency and 
the Systemic Risk Council, the Federal Reserve should be able 
to continue its monetary policy role as well as remain the 
prudential primary Federal regulator for State chartered member 
institutions and bank holding companies.

Q.6. Under the Administration's plan, there would be heightened 
supervision and consolidation of all large, interconnected 
financial firms, including likely requiring more firms to 
become financial holding companies. Can you comment on whether 
this plan adequately addresses the ``too-big-to-fail'' problem? 
Is it problematic, as some say, to identify specific firms that 
are systemically significant, even if you provide disincentives 
to becoming so large, as the Administration's plan does?

A.6. The creation of a systemic risk regulatory framework for 
bank holding companies and systemically important firms will 
address some of the problems posed by ``too-big-to-fail'' 
firms. In addition, we should develop incentives to reduce the 
size of very large financial firms.
    However, even if risk-management practices improve 
dramatically and we introduce effective macroprudential 
supervision, the odds are that a large systemically significant 
firm will become troubled or fail at some time in the future. 
The current crisis has clearly demonstrated the need for a 
single resolution mechanism for financial firms that will 
preserve stability while imposing the losses on shareholders 
and creditors and replacing senior management to encourage 
market discipline. A timely, orderly resolution process that 
could be applied to both banks and nonbank financial 
institutions, and their holding companies, would prevent 
instability and contagion and promote fairness. It would enable 
the financial markets to continue to function smoothly, while 
providing for an orderly transfer or unwinding of the firm's 
operations. The resolution process would ensure that there is 
the necessary liquidity to complete transactions that are in 
process at the time of failure, thus addressing the potential 
for systemic risk without creating the expectation of a 
bailout.
    Under a new resolution regime, Congress should raise the 
bar higher than existing law and eliminate the possibility of 
open assistance for individual failing entities. The new 
resolution powers should result in the shareholders and 
unsecured creditors taking losses prior to the Government, and 
consideration also should be given to imposing some haircut on 
secured creditors to promote market discipline and limit costs 
potentially borne by the Government.
                                ------                                


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

Q.1. A recent media article (New York Times, June 14th) states 
there have been strong disagreements between the FDIC and the 
OCC over whether the proposal to impose new insurance fees on 
banks is unfair to the largest banks, with the FDIC arguing 
that the largest banks contributed to the current crisis and 
should have to pay more. Can you elaborate on your rationale 
for requiring big banks to pay more than community banks?

A.1. The New York Times article referred to the emergency 
special assessment, adopted on May 22, 2009, which imposes a 5-
basis point special assessment rate on each insured depository 
institution's assets minus Tier 1 capital as of June 30, 2009.
    The Federal Deposit Insurance Reform Act of 2005 requires 
the FDIC to establish and implement a restoration plan if the 
reserve ratio falls below 1.15 percent of insured deposits. On 
October 7, 2008, the FDIC established a Restoration Plan for 
the Deposit Insurance Fund. The Restoration Plan was amended on 
February 27, 2009, and quarterly base assessment rates were set 
at a range of 12 to 45 basis points beginning in the second 
quarter of 2009. However, given the FDIC's estimated losses 
from projected institution failures, these assessment rates 
were determined not to be sufficient to return the fund reserve 
ratio to 1.15 percent. On May 22, 2009, therefore, the FDIC 
Board of Directors adopted a final rule establishing a 5 basis 
point special assessment on each insured depository 
institution's assets minus Tier 1 capital as of June 30, 2009. 
The special assessment is necessary to strengthen the Deposit 
Insurance Fund and promote confidence in the deposit insurance 
system.
    The adoption of the final rule on the special assessment 
followed a request for comment that generated over 14,000 
responses. The final rule implemented several changes to the 
FDIC's special assessment interim rule, including a reduction 
in the rate used to calculate the special assessment and a 
change in the base used to calculate the special assessment.
    The assessment formula is the same for all insured 
institutions--big and small. However, it produces higher 
assessments for institutions that rely more on nondeposit 
liabilities. These institutions do tend to be the larger 
institutions. The FDIC considers this appropriate as in the 
event of the failure of institutions with significant amounts 
of secured debt, the FDIC's loss is often increased without any 
compensation in the form of increased assessment revenue.
    The amount of the special assessment for any institution, 
however, will not exceed 10 basis points times the 
institution's assessment base for the second quarter 2009 risk-
based assessment. We believe that the special assessment 
formula provides incentives for institutions to hold long-term 
unsecured debt, and for smaller institutions to hold high 
levels of Tier 1 capital--both good things in the FDIC's view.
                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
                      FROM SHEILA C. BAIR

Q.1. Many proposals call for a risk regulator that is separate 
from the normal safety and soundness regulator of banks and 
other firms. The idea is that the risk regulator will set rules 
that the other regulators will enforce. That sounds a lot like 
the current system we have today, where different regulators 
read and enforce the same rules different ways. Under such a 
risk regulator, how would you make sure the rules were being 
enforced the same across the board?

A.1. The significant size and growth of unsupervised financial 
activities outside the traditional banking system--in what is 
termed the shadow financial system--has made it all the more 
difficult for regulators or market participants to understand 
the real dynamics of either bank credit markets or public 
capital markets. The existence of one regulatory framework for 
insured institutions and a much less effective regulatory 
scheme for nonbank entities created the conditions for 
arbitrage that permitted the development of risky and harmful 
products and services outside regulated entities.
    We have proposed a Systemic Risk Council composed of the 
principal prudential regulators for banking, financial markets, 
consumer protection, and Treasury to look broadly across all of 
the financial sectors to adopt a ``macroprudential'' approach 
to regulation. The point of looking more broadly at the 
financial system is that reasonable business decisions by 
individual financial firms may, in aggregate, pose a systemic 
risk. This failure of composition problem cannot be solved by 
simply making each financial instrument or practice safe.
    Rules and restrictions promulgated by the proposed Systemic 
Risk Council would be uniform with respect to institutions, 
products, practices, services, and markets that create 
potential systemic risks. Again, a distinction should be drawn 
between the direct supervision of systemically significant 
financial firms and the macroprudential oversight and 
regulation of developing risks that may pose systemic risks to 
the U.S. financial system. The former appropriately calls for 
the identification of a prudential supervisor for any potential 
systemically significant holding companies or similar 
conglomerates. Entities that are already subject to a 
prudential supervisor, such as insured depository institutions 
and financial holding companies, should retain those 
supervisory relationships. In addition, for systemic entities 
not already subject to a Federal prudential supervisor, this 
Council should be empowered to require that they submit to such 
oversight, presumably as a financial holding company under the 
Federal Reserve--without subjecting them to the activities 
restrictions applicable to these companies.
    We need to combine the current microprudential approach 
with a macroprudential approach through the Council. The 
current system focuses only on individual financial instruments 
or practices. Each agency is responsible for enforcing these 
regulations only for their institutions. In addition, there are 
separate regulatory schemes used by the SEC and the CFTC as 
well as the State level regulation of insurance companies. The 
macroprudential oversight of systemwide risks requires the 
integration of insights from a number of different regulatory 
perspectives--banks, securities firms, holding companies, and 
perhaps others. Thus, the FDIC supports the creation of a 
Council to oversee systemic risk issues, develop needed 
prudential policies, and mitigate developing systemic risks.

Q.2. Before we can regulate systemic risk, we have to know what 
it is. But no one seems to have a definition. How do you define 
systemic risk?

A.2. We would anticipate that the Systemic Risk Council, in 
conjunction with the Federal Reserve would develop definitions 
for systemic risk. Also, mergers, failures, and changing 
business models could change what firms would be considered 
systemically important from year-to-year.

Q.3. Assuming a regulator could spot systemic risk, what 
exactly is the regulator supposed to do about it? What powers 
would they need to have?

A.3. The failure of some large banks and nonbanks revealed that 
the U.S. banking agencies should have been more aggressive in 
their efforts to mitigate excessive risk concentrations in 
banks and their affiliates, and that the agencies' powers to 
oversee systemically important nonbanks require strengthening.
    As discussed in my testimony, the FDIC endorses the 
creation of a Council to oversee systemic risk issues, develop 
needed prudential policies, and mitigate developing systemic 
risks. For example, the Council could ensure capital standards 
are strong and consistent across significant classes of 
financial services firms including nonbanks and GSEs. Prior to 
the current crisis, systemic risk was not routinely part of the 
ongoing supervisory process. The FDIC believes that the 
creation of a Council would provide a continuous mechanism for 
measuring and reacting to systemic risk across the financial 
system. The powers of such a Council would ultimately have to 
be developed through a dialogue between the banking agencies 
and Congress, and empower the Council to ensure appropriate 
oversight of unsupervised nonbanks that present systemic risk. 
Such nonbanks should be required to submit to such oversight, 
presumably as a financial holding company under the Federal 
Reserve.

Q.4. How do you propose we identify firms that pose systemic 
risks?

A.4. The proposed Systemic Risk Council could establish what 
practices, instruments, or characteristics (concentrations of 
risk or size) that might be considered risky, but should not 
identify any set of firms as systemic. We have concerns about 
formally designating certain institutions as a special class. 
We recognize that there may be very large interconnected 
financial entities that are not yet subject to Federal 
consolidated supervision, although most of them are already 
subject to such supervision as a result of converting to banks 
or financial holding companies in response to the crisis. Any 
recognition of an institution as systemically important, 
however, risks invoking the moral hazard that accompanies 
institutions that are considered too-big-to-fail. That is one 
reason why, most importantly, a robust resolution mechanism, in 
addition to enhanced supervision, is important for very large 
financial organizations.

Q.5. Any risk regulator would have access to valuable 
information about the business of many firms. There would be a 
lot of people who would pay good money to get that information. 
How do we protect that information from being used improperly, 
such as theft or an employee leaving the regulator and using 
his knowledge to make money?

A.5. The FDIC, as deposit insurer and supervisor of over 5,000 
banks, prides itself on maintaining confidentiality with our 
stakeholders. We have a corporate culture that demands strict 
confidentiality with regard to bank and personal information. 
Our staff is trained extensively on the use, protection, and 
disclosure of nonpublic information as well as expectations for 
the ethical conduct. Disclosure of nonpublic information is not 
tolerated and any potential gaps are dealt with swiftly and 
disclosed to affected parties. The FDIC's Office of Inspector 
General has a robust process for dealing with improper 
disclosures of information both during and postemployment with 
FDIC.
    These ethical principles are supported by criminal statutes 
which provide that Federal officers and employees are 
prohibited from the disclosure of confidential information 
generally (18 U.S.C. 1905) and from the disclosure of 
information from a bank examination report (18 U.S.C. 1906).
    All former Federal officers and employees are subject to 
the postemployment restrictions (18 U.S.C. 207), which prohibit 
former Government officers and employees from knowingly making 
a communication or appearance on behalf of any other person, 
with the intent to influence, before any officer or employee of 
any Federal agency or court in connection with a particular 
matter in which the employee personally and substantially 
participated, which involved a specific party at the time of 
the participation and representation, and in which the U.S. is 
a party or has a direct and substantial interest.
    In addition, an officer or employee of the FDIC who serves 
as a senior examiner of an insured depository institution for 
at least 2 months during the last 12 months of that 
individual's employment with the FDIC may not, within 1 year 
after the termination date of his or her employment with the 
FDIC, knowingly accept compensation as an employee, officer, 
director, or consultant from the insured depository 
institution; or any company (including a bank holding company 
or savings and loan holding company) that controls such 
institution (12 U.S.C. 1820(k).
                                ------                                


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

Q.1. I appreciate the FDIC's desire to provide clarity around 
the process of private investors investing in failed banks that 
have been taken over by the FDIC. We need to make sure that the 
final rule doesn't deter private capital from entering the 
banking system, leaving the FDIC's insurance fund and, 
ultimately, the taxpayers with the final bill. Are you open to 
modifying some of the proposed requirements, such as the 15 
percent capital requirement?

A.1. The Federal Deposit Insurance Corporation is aware of the 
need for additional capital in the banking system and the 
potential contribution that private equity capital could make 
to meet this need. At the same time, the FDIC is sensitive to 
the need for all investments in insured depository 
institutions, regardless of the source, to be consistent with 
protecting the Deposit Insurance Fund and the safety and 
soundness of insured institutions.
    In light of the increased number of bank and thrift 
failures and the consequent increase in interest by potential 
private capital investors, the FDIC published for comment on 
July 9, 2009, a Proposed Statement of Policy on Qualifications 
for Failed Bank Acquisitions (Proposed Policy Statement). The 
Proposed Policy Statement provided guidance to private capital 
investors interested in acquiring the deposit liabilities, or 
the liabilities and assets, of failed insured depository 
institutions. It included specific questions on the important 
issues surrounding nontraditional investors in insured 
financial institutions including the level of capital required 
for the institution that would be owned by these new entrants 
into the banking system and whether these owners can be a 
source of strength. We sought public and industry comment to 
assist us in evaluating the policies to apply in deciding 
whether a nontraditional investor may bid on a failed 
institution.
    On August 26, 2009, the FDIC's Board of Directors voted to 
adopt the Final Statement of Policy on Qualifications for 
Failed Bank Acquisitions (Final Policy Statement), which was 
published in the Federal Register on September 2, 2009. The 
Final Policy Statement takes into account the comments 
presented by the many interested parties who submitted 
comments. Although the final minimum capital commitment has 
been adjusted from 15 percent Tier 1 leverage to 10 percent 
Tier 1 common equity, key elements of the earlier proposed 
statement remain in place: cross-support, prohibitions on 
insider lending, limitations on sales of acquired shares in the 
first 3 years, a prohibition on bidding by excessively opaque 
and complex business structures, and minimum disclosure 
requirements.
    Importantly, the Final Policy Statement specifies that it 
does not apply to investors who do not hold more than 5 percent 
of the total voting powers and who are not engaged in concerted 
actions with other investors. It also includes relief for 
investors if the insured institution maintains a Uniform 
Financial Institution composite rating of 1 or 2 for 7 
consecutive years. The FDIC Board is given the authority to 
make exceptions to its application in special circumstances. 
The Final Policy Statement also clearly excludes partnerships 
between private capital investors and bank or thrift holding 
companies that have a strong majority interest in the acquired 
banks or thrifts.
    In adopting the Final Policy Statement, the FDIC sought to 
strike a balance between the interests of private investors and 
the need to provide adequate safeguards for the insured 
depository institutions involved. We believe the Final Policy 
Statement will encourage safe and sound investments and make 
the bidding more competitive and robust. In turn, this will 
limit the FDIC's losses, protect taxpayers, and speed the 
resolution process. As a result, the Final Policy Statement 
will aid the FDIC in carrying out its mission.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
                      FROM SHEILA C. BAIR

Q.1. Chairwoman Bair, you recently released a proposal which, I 
believe, asks private equity to maintain a 15 percent Tier 1 
capital ratio while well-capitalized banks only maintain a 5 
percent ratio and newly established banks an 8 percent ratio. 
In May, the FDIC announced the successful purchase of Bank 
United which allowed almost $1 billion of private investment 
come in and successfully take over the bank's management. By 
all reports this has been a successful arrangement for both the 
FDIC and private investment company. Although I understand your 
policy concerns, I think that the current proposal goes too far 
in several respects. I am concerned that the FDIC's proposed 
policy deters private capital from entering the banking system, 
leaving the FDIC's insurance fund and, ultimately, the 
taxpayers with the final bill. With bank failures mounting this 
year, I would have liked see more private investment able to 
participate in cleaning up these troubled banks.
    What can the FDIC do to ensure that more private equity 
comes in to stem the tide of bank failures?

A.1. On August 26, 2009, the FDIC's Board of Directors voted to 
adopt the Final Statement of Policy on Qualifications for 
Failed Bank Acquisitions (Final Policy Statement), which was 
published in the Federal Register on September 2, 2009. The 
Final Policy Statement takes into account the comments 
presented by the many interested parties who submitted 
comments. Although the final minimum capital commitment has 
been adjusted from 15 percent Tier 1 leverage to 10 percent 
Tier 1 common equity, key elements of the earlier proposed 
statement remain in place: cross-support, prohibitions on 
insider lending, limitations on sales of acquired shares in the 
first 3 years, a prohibition on bidding by excessively opaque 
and complex business structures, and minimum disclosure 
requirements.
    Importantly, the Final Policy Statement specifies that it 
does not apply to investors who do not hold more than 5 percent 
of the total voting powers and who are not engaged in concerted 
actions with other investors. It also includes relief for 
investors if the insured institution maintains a Uniform 
Financial Institution composite rating of 1 or 2 for 7 
consecutive years. The FDIC Board is given the authority to 
make exceptions to its application in special circumstances. 
The Final Policy Statement also clearly excludes partnerships 
between private capital investors and bank or thrift holding 
companies that have a strong majority interest in the acquired 
banks or thrifts.
    In adopting the Final Policy Statement, the FDIC sought to 
strike a balance between the interests of private investors and 
the need to provide adequate safeguards for the insured 
depository institutions involved. We believe the Final Policy 
Statement will encourage safe and sound investments and make 
the bidding more competitive and robust. In turn, this will 
limit the FDIC's losses, protect taxpayers, and speed the 
resolution process. As a result, the Final Policy Statement 
will aid the FDIC in carrying out its mission.

Q.2. Are you concerned that without attracting private capital, 
the FDIC's deposit insurance fund and, ultimately, taxpayers 
will foot the entire bill for the looming bank failures?

A.2. We do not see a taxpayer exposure as a result of upcoming 
bank failures. Our latest publicly released information shows 
that the FDIC ended the second quarter of 2009 with a DIF 
balance of $10.4 billion and an additional $32 billion reserve 
for expected future failure losses. Updates to these numbers 
show the FDIC estimates that it ended the third quarter of 2009 
with a negative fund balance. The contingent loss reserve for 
expected future losses from failures has grown, however.
    To date, the FDIC has required a special assessment to 
rebuild the DIF and we recently issued a notice of proposed 
rule making to require the prepayment of assessments for 3 
years. Current projections are that assessment income will 
exceed expected losses from bank failures over the next several 
years. However, there is a timing problem as the bulk of bank 
failures are expected to occur in 2009 and 2010, while most 
assessment income will be booked in later years. Therefore, 
although the prepayment of assessments will not immediately 
rebuild the fund balance, it will provide the FDIC with the 
liquidity needed to fund projected bank failures. Further, even 
if it became necessary for the FDIC to borrow from the U.S. 
Treasury, any potential borrowing would be repaid by insured 
depository institutions.

Q.3. If private equity does come in, what could the savings be 
to the deposit insurance fund?

A.3. If, as expected, the FDIC increases the overall number of 
potential bidders for failed financial institutions by 
including more private equity firms, it would increase 
competition and potentially improve the quality of the bids.

Q.4. Do you agree with the Secretary's assessment that the FDIC 
was created to address resolving small banks and thrifts and 
does not have the appropriate resources to deal with the 
failure of a major bank?

A.4. The FDIC has substantial experience resolving large, 
complex, internationally active insured depository 
institutions. Continental Illinois National Bank and Trust, 
which required FDIC assistance in 1984 was the seventh largest 
commercial bank in the country at the time. More recently, in 
September 2008, the FDIC dealt with the failure of Washington 
Mutual Bank which had total assets of $307 billion. This was 
the fifth largest bank in the country at that time.
    This experience with conservatorships and receiverships has 
significant parallels for systemically important holding 
companies and for other types of financial companies, enabling 
the FDIC to take advantage of its experience in acting as 
receiver for thousands of insured depository institutions. 
Also, much of the Administration's special resolution authority 
proposal is based on the FDIC's current statutory authority. 
Therefore, expanding the FDIC's activities to systemically 
significant institutions will be consistent in many respects to 
its current scope of activities.

Q.5. If there are limits on the FDIC's expertise and resources 
would keep the FDIC from resolving the biggest banks in the 
country, what are they?

A.5. We believe the FDIC is prepared to handle the resolution 
of an insured depository institution of any size and 
complexity. Our testimony outlines limitations of our current 
resolution authority and recommends, on page 7 [see Page 66 of 
this hearing], principles to guide Congress in adopting a 
process that ensures an orderly and comprehensive resolution 
mechanism for systemically important financial firms.

Q.6. What are the impediments, if any, that the FDIC would face 
in resolving the depository institutions associated with Bank 
of America or Citi?

A.6. Although I cannot comment on supervisory matters involving 
open institutions, any large depository institution can pose 
special challenges. They typically have extensive foreign 
operations, higher-than-normal levels of uninsured deposits, 
expansive branch networks that can span multiple time zones and 
usually are heavily involved in derivative financial 
instruments. Further, the largest insured depository 
institutions are owned by holding companies that own other 
related entities. These holding companies manage operations by 
business line with little regard to the legal entities 
involved. The intertwined nature of the operations of a large 
bank holding company will present its own set of challenges. 
This is one reason it is important for the FDIC to have 
receivership authority over the entire financial services 
holding company, not just the insured depository institution.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
                     FROM MARY L. SCHAPIRO

Q.1. Identify Systemic Risk in Advance?--I believe we can all 
agree that very few if anyone was able to effectively identify 
where the systemic risk resided in our economy prior to our 
current financial difficulties. While we had regulatory efforts 
in effect to combat these risks in commercial bank and thrift 
institutions, the real risk was shown to be outside of this 
area.
    Chairman Schapiro, what about the structure proposed by the 
Obama administration gives you confidence that this new 
regulatory body will succeed where so many others failed?

A.1. While there is no guarantee, the one proposed by the 
Administration represents a number of improvements over the 
current regulatory landscape in terms addressing gaps in 
regulatory oversight and minimizing incentives for regulatory 
arbitrage. For example, the Administration's proposal seeks to 
address the importance of and strengthen consolidated 
supervision of large financial conglomerates, including 
supervision of previously unregulated subsidiaries.
    Critical elements of a successful systemic risk regulation 
program also include strong support of functional regulators. 
The Council and SRR should complement and augment the role of 
functional regulators by leveraging their specialized knowledge 
and expertise and should take action in contravention of 
functional regulators' standards if necessary when those 
standards are less stringent than those advocated by the 
Council or SRR. Indeed, functional regulators' standards are 
the first line of defense, as functional regulators understand 
the markets, products and activities of their regulated 
entities.
    The effective implementation of a systemic risk regulation 
program is critical to its success. Because the process of 
identifying emerging risks heavily relies on the analysis of 
significant amounts of information and reporting gathered from 
firms and regulators, a successful program must be 
appropriately resourced, employing an adequate number of staff 
with appropriate skill sets. It is important that the 
competencies of monitoring and inspection staff are equal to 
those of the firm's personnel regarding the relevant topic. 
Having a staff that is multidisciplinary and equipped with the 
proper skill sets to review and analyze the information 
obtained is critical. Generalists with substantial experience 
across the breadth of issues and firm relationships should 
complement their skills with those of experts in relevant 
quantitative specialties.

Q.2. SEC as Systemic Risk Regulator--Chairman Schapiro, the 
SEC's Consolidated Supervised Entity program, a program that 
existed without the benefit of statutory authorization, 
collapsed as its firms failed, were taken over, or shifted to 
regulation as bank holding companies.
    How does the SEC's experience with the CSE program inform 
the model for regulation of systemic risk that you are 
advocating today?

A.2. Between 2004 and 2008, the SEC was recognized as the 
consolidated supervisor for the five large independent 
investment banks under its Consolidated Supervised Entity or 
``CSE'' program. The CSE program was created as a way for U.S. 
global investment banks that lacked a consolidated holding 
company supervisor to voluntarily submit to consolidated 
regulation by the SEC. In connection with the establishment of 
the CSE program, the largest U.S. broker-dealer subsidiaries of 
these entities were permitted to utilize an alternate net 
capital computation (ANC). \1\ Other large broker-dealers, 
whose holding companies are subject to consolidated supervision 
by banking authorities, were also permitted to use this ANC 
approach. \2\
---------------------------------------------------------------------------
     \1\ In 2004, the SEC amended its net capital rule to permit 
certain broker-dealers subject to consolidated supervision to use their 
internal mathematical models to calculate net capital requirements for 
the market risks of certain positions and the credit risk for OTC 
derivatives-related positions rather than the prescribed charges in the 
net capital rule, subject to specified conditions. These models were 
thought to more accurately reflect the risks posed by these activities, 
but were expected to reduce the capital charges and therefore permit 
greater leverage by the broker-dealer subsidiaries. Accordingly, the 
SEC required that these broker-dealers have, at the time of their ANC 
approval, at least $5 billion in tentative net capital (i.e., ``net 
liquid assets''), and thereafter to provide an early warning notice to 
the SEC if that capital fell below $5 billion. This level was 
considered an effective minimum capital requirement.
     \2\ Currently six broker-dealers utilize the ANC regime and all 
are subject to consolidated supervision by banking authorities.
---------------------------------------------------------------------------
    Under the CSE regime, the holding company had to provide 
the Commission with information concerning its activities and 
exposures on a consolidated basis; submit its nonregulated 
affiliates to SEC examinations; compute on a monthly basis, 
risk-based consolidated holding company capital in general 
accordance with the Basel Capital Accord, an internationally 
recognized method for computing regulatory capital at the 
holding company level; and provide the Commission with 
additional information regarding its capital and risk 
exposures, including market, credit and liquidity risks.
    It is important to note that prior to the CSE regime, the 
SEC had no jurisdiction to regulate these holding companies. 
\3\ Accordingly, these holding companies previously had not 
been subject to any consolidated capital requirements. This 
program was viewed as an effort to fill a significant gap in 
the U.S. regulatory structure. \4\
---------------------------------------------------------------------------
     \3\ The Gramm-Leach-Bliley Act had created a voluntary program for 
the oversight of certain investment bank holding companies (i.e., those 
that did not have a U.S. insured depository institution affiliate). The 
firms participating in the CSE program did not qualify for that program 
or did not opt into that program. Only one firm (Lazard) has ever opted 
for this program.
     \4\ See, e.g., Testimony by Erik Sirri, Director of the Division 
of Trading and Markets, Before the Senate Subcommittee on Securities, 
Insurance and Investment, Senate Banking Committee, March 18, 2009. 
http://www.sec.gov/news/testimony/2009/ts031809es.htm.
---------------------------------------------------------------------------
    During the financial crisis many of these institutions 
lacked sufficient liquidity to operate effectively. During 
2008, these CSE institutions failed, were acquired, or 
converted to bank holding companies which enabled them to 
access Government support. The CSE program was discontinued in 
September 2008. Some of the lessons learned are as follows:
    Capital Adequacy Rules Were Flawed and Assumptions 
Regarding Liquidity Risk Proved Overly Optimistic. The 
applicable Basel capital adequacy standards depended heavily on 
the models developed by the financial institutions themselves. 
All models depend on assumptions. Assumptions about such 
matters as correlations, volatility, and market behavior 
developed during the years before the financial crisis were not 
necessarily applicable for the market conditions leading up to 
the crisis, nor during the crisis itself.
    The capital adequacy rules did not sufficiently consider 
the possibility or impact of modeling failures or the limits of 
such models. Indeed, regulators worldwide are reconsidering how 
to address such issues in the context of strengthening the 
Basel regime. Going forward, risk managers and regulators must 
recognize the inherent limitations of these (and any) models 
and assumptions--and regularly challenge models and their 
underlying assumptions to consider more fully low probability, 
extreme events.
    While capital adequacy is important, it was the related, 
but distinct, matter of liquidity that proved especially 
troublesome with respect to CSE holding companies. Prior to the 
crisis, the SEC recognized that liquidity and liquidity risk 
management were critically important for investment banks 
because of their reliance on private sources of short-term 
funding.
    To address these liquidity concerns, the SEC imposed two 
requirements: First, a CSE holding company was expected to 
maintain funding procedures designed to ensure that it had 
sufficient liquidity to withstand the complete loss of all 
short term 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 (a 
``haircut''). Second, each CSE holding company was expected to 
maintain a substantial ``liquidity pool'' that was composed of 
unencumbered highly liquid and creditworthy assets that could 
be used by the holding company or moved to any subsidiary 
experiencing financial stress.
    The SEC assumed that these institutions, even in stressed 
environments, would continue to be able to finance their high-
quality assets in the secured funding markets (albeit perhaps 
on less favorable terms than normal). In times of stress, if 
the business were sound, there might be a number of possible 
outcomes: For example, the firm might simply suffer a loss in 
capital or profitability, receive new investment injections, or 
be acquired by another firm. If not, the sale of high quality 
assets would at least slow the path to bankruptcy or allow for 
self-liquidation.
    As we now know, these assumptions proved much too 
optimistic. Some assets that were considered liquid prior to 
the crisis proved not to be so under duress, hampering their 
ability to be financed in the repo markets. Moreover, during 
the height of the crisis, it was very difficult for some firms 
to obtain secured funding even when using assets that had been 
considered highly liquid.
    Thus, the financial institutions, the Basel regime, and the 
CSE regulatory approach did not sufficiently recognize the 
willingness of counterparties to simply stop doing business 
with well-capitalized institutions or to refuse to lend to CSE 
holding companies even against high-quality collateral. Runs 
could sometimes be stopped only with significant Government 
intervention, such as through institutions agreeing to become 
bank holding companies and obtaining access to Government 
liquidity facilities or through other forms of support.
    Consolidated Supervision Is Necessary but Not a Panacea. 
Although large interconnected institutions should be supervised 
on a consolidated basis, policy makers should remain aware of 
the limits of such oversight and regulation. This is 
particularly the case for institutions with many subsidiaries 
engaging in different, often unregulated, businesses in 
multiple countries.
    Before the crisis, there were many different types of large 
interconnected institutions subject to consolidated supervision 
by different regulators. During the crisis, many consolidated 
supervisors, including the SEC, saw large interconnected, 
supervised entities seek Government liquidity or direct 
assistance.
    Systemic Risk Management Requires Meaningful Functional 
Regulation, Active Enforcement, and Transparent Markets. While 
a consolidated regulator of large interconnected firms is an 
essential component to identifying and addressing systemic 
risk, a number of other tools must also be employed. These 
include more effective capital requirements, strong 
enforcement, functional regulation, and transparent markets 
that enable investors and other counterparties to better 
understand the risks associated with particular investment 
decisions. Given the complexity of modern financial 
institutions, it is essential to have strong, consistent 
functional regulation of individual types of institutions, 
along with a broader view of the risks building within the 
financial system.

Q.3. SEC's Endorsement of Treasury's Approach--Chairman 
Schapiro, you chose to testify today on your own behalf. I 
suspect that if you had submitted your testimony for a 
Commission vote, you might have met some resistance since you 
endorse an approach that envisions the creation of a systemic 
risk regulator that will have authority over firms within the 
SEC's jurisdiction. Although cast as a second set of eyes to 
back up the front line financial regulators, the systemic risk 
regulator could complicate the SEC's job.
    Are you concerned that the addition of a new regulatory 
body will water down your regulatory authority over firms that 
you oversee?

A.3. While a SRR should play a critical role in assessing 
emerging systemic risks by setting standards for liquidity, 
capital and risk management practices, in my view it is vital 
that its role be complemented by the creation of a strong and 
robust Council. I believe the Council should have authority to 
identify institutions, practices, and markets that create 
potential systemic risks, and also should be authorized to set 
policies for liquidity, capital and other risk management 
practices at firms whose failure could pose a threat to 
financial stability due to their combination of size, leverage, 
and interconnectedness. The Council also would provide a forum 
for analyzing and recommending harmonization of certain 
standards at other significant financial institutions.
    In most times, I would expect the Council and SRR to work 
with and through primary regulators of systemically important 
institutions. The primary regulators understand the markets, 
products and activities of their regulated entities. The SRR, 
however, can provide a second layer of review from a 
macroprudential perspective. If differences arise between the 
SRR/Council and the primary regulator regarding the capital or 
risk management standards of systemically important 
institutions, I strongly believe that the higher (more 
conservative) standard should govern. The systemic risk 
regulatory structure should serve as a ``brake'' on a 
systemically important institution's riskiness; it should never 
be an ``accelerator.''
    In emergency situations, the SRR/Council may need to 
overrule a primary regulator (for example, to impose higher 
standards or to stop or limit potentially risky activities). 
However, to ensure that authority is checked and decisions are 
not arbitrary, the Council should be where general policy is 
set, and only then to implement a more rigorous policy than 
that of a primary regulator. This should reduce the ability of 
any single regulator to ``compete'' with other regulators by 
lowering standards, driving a race to the bottom.

Q.4. SEC as Systemic Risk Regulator--Chairman Schapiro, under 
the plan the Administration set forth, a so-called ``Tier 1 
Financial Holding Company'' (Tier 1 FHC) and its subsidiaries 
would be subject to examination by the Federal Reserve. Thus, a 
broker-dealer subsidiary of a Tier 1 FHC would be subject to 
examination by the Fed and the SEC.
    Should we be concerned that, rather than clarifying 
regulatory responsibility, this arrangement could blur lines of 
regulatory responsibility?

A.4. A similar arrangement exists today for broker-dealers 
subsidiaries within a Bank Holding Company. At its core, the 
mission of the SEC is to protect investors, maintain fair, 
orderly, and efficient markets, and facilitate capital 
formation. Accordingly, rigorous financial responsibility 
requirements apply to all U.S. broker-dealers, which are 
designed to ensure that broker-dealers operate in a manner that 
permits them to meet all obligations to customers and 
counterparties. The first of these requirements is the net 
capital rule, which, among other things, requires the broker-
dealer to maintain a level of liquid assets in excess of all 
unsubordinated liabilities to enable the firm to absorb 
business losses and, if necessary, finance an orderly self-
liquidation. The second is the customer protection rule, which 
requires the firm to safeguard customer cash and securities by 
segregating these assets from its proprietary business 
activities. The third prong is comprised of recordkeeping and 
financial reporting requirements that require the broker-dealer 
to make and maintain records and file reports that detail its 
net capital positions and document the segregation of customer 
assets.
    To ensure an equal playing field among the large and small, 
all broker-dealers should be subject to the same regulation, 
but additional review and holding company supervision can also 
take place. The SRR/Council could serve as a second set of eyes 
upon those larger institutions whose failure might put the 
system at risk, with the mandate of monitoring the entire 
financial system for systemwide risks and forestalling 
emergencies.

Q.5. Too-Big-To-Fail--Chairman Schapiro, your testimony 
correctly recognizes that one type of systemic risk is that we 
create a system that favors large institutions over their 
``smaller, more nimble competitors.'' Your testimony also 
suggests that a Financial Stability Oversight Council could 
prevent the formation of institutions that are too-big-to-fail.
    How would this work in practice?

A.5. The Council, SRR, and primary regulators all should have a 
role in addressing the risks posed by large interconnected 
financial institutions. One of most important regulatory 
arbitrage risks is the potential perception that large 
interconnected financial institutions are too-big-to-fail and 
will therefore benefit from Government intervention in times of 
crisis. This perception can lead market participants to favor 
large interconnected firms over smaller firms of equivalent 
creditworthiness, fueling greater risk. To address these 
issues, policy makers should consider the following:
    Strengthen Regulation and Market Transparency. Given the 
financial crisis and the Government's unprecedented response, 
it is clear that large, interconnected firms present unique and 
additional risks to the system. To minimize the systemic risks 
posed by these institutions, policy makers should consider 
using all regulatory tools available--including supplemental 
capital, transparency and activities restrictions--to reduce 
risks and ensure a level playing field for large and small 
institutions. A strong Council could provide a forum for 
examining regulatory standards across markets, ensuring that 
capital and liquidity standards are in place and being enforced 
and that those standards are adequate and appropriate for 
systemically important institutions and the activities they 
conduct. The Council and SRR would be primarily responsible for 
setting standards at the holding company level.
    Establish a Resolution Regime. In times of crisis when a 
systemically important institution may be teetering on the 
brink of failure, policy makers have to immediately choose 
between two highly unappealing options: (1) providing 
Government assistance to a failing institution (or an acquirer 
of a failing institution), thereby allowing markets to continue 
functioning but creating moral hazard; or (2) not providing 
Government assistance but running the risk of market collapses 
and greater costs in the future. Markets recognize this dilemma 
and can fuel more systemic risk by ``pricing in'' the 
possibility of a Government backstop of large interconnected 
institutions. This can give such institutions an advantage over 
their smaller competitors and make them even larger and more 
interconnected.
    A credible resolution regime can help address these risks 
by giving policy makers a third option: a controlled unwinding 
of a large, interconnected institution over time. Structured 
correctly, such a regime could force market participants to 
realize the full costs of their decisions and help reduce the 
``too-big-to-fail'' dilemma. Structured poorly, such a regime 
could strengthen market expectations of Government support, 
thereby fueling ``too-big-to-fail'' risks.
                                ------                                


         RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED
                     FROM MARY L. SCHAPIRO

Q.1. You discussed regulatory arbitrage in your written 
statement and emphasized the benefits of a Council to minimize 
such opportunities. Can you elaborate on this? Should standards 
be set by individual regulators, the Council, or both? Can a 
Council operate effectively in emergency situations?

A.1. Establishing a robust and multidisciplinary Financial 
Services Oversight Council (Council) would be an important step 
toward closing regulatory gaps. Because financial participants 
currently can use different vehicles or jurisdictions from 
which to engage in the same activity, participants can 
sometimes ``choose'' their regulatory framework. This choice 
can sometimes result in a race to the bottom among competing 
regulators and jurisdictions, lowering standards and increasing 
systemic risk.
    A strong Council could provide a forum for examining and 
discussing regulatory standards across markets, ensuring that 
adequate and appropriate capital and liquidity standards for 
financial institutions in the marketplace and the activities 
they conduct are in place and being enforced. In addition, the 
Council would have the role of identifying risks across the 
system, harmonizing rules to minimize systemic risk, and 
helping to ensure that future regulatory gaps--and arbitrage 
opportunities--are minimized or avoided. In general, all 
regulatory tools available should be considered, including 
strong enforcement, additional measures to improve 
transparency, and appropriate activities restrictions. The 
Council should set policy if necessary to ensure that more 
rigorous standards than those of a primary regulator and/or the 
systemic risk regulator (SRR) are implemented. The Council 
should provide a different, impartial perspective relative to a 
single regulator having a daily oversight role.
    In general, I would expect the Council and SRR to work with 
and through the primary regulators. The primary regulators 
understand the markets, products, and activities of their 
regulated entities. The SRR can provide a second layer of 
review over the activities, capital, and risk management 
procedures of systemically important institutions from a 
macroprudential perspective, considering risk to the system as 
a whole. If differences arise between the SRR/Council and the 
primary regulator regarding the capital or risk management 
standards of systemically important institutions, I strongly 
believe that the higher (more conservative) standard should 
govern.
    In emergency situations, the SRR/Council may need to 
overrule a primary regulator (for example, to impose higher 
standards or to stop or limit potentially risky activities). 
However, to ensure that authority is checked and decisions are 
not arbitrary, general policy should be set by the Council, and 
only then to implement a more rigorous policy than that of a 
primary regulator.
    The Council's responsibilities, lines of authority, and 
consultations with other regulators during both emergency and 
nonemergency situations should be explicitly delineated. 
Voting, quorum, and other governance requirements, including 
consultations with other regulators, should be carefully 
considered in advance for exigencies such as the ability to 
invoke resolution authority or overrule a primary regulator--as 
well as for designating systemically important institutions or 
setting policies as a matter of course.

Q.2. What factors should Congress consider as it weighs the 
benefits and drawbacks of expanding the Federal Reserve's 
authority to oversee the safety and soundness of systemically 
important payment, clearing, and settlement systems? Would it 
interfere with the SEC's authority over any of these systems?

A.2. While we believe it is appropriate for Congress to 
establish a single SRR to focus on macroprudential oversight 
and to identify systemic risk, it is important for Congress to 
consider the existing framework for the regulation and 
oversight of clearing agencies under the Exchange Act. 
Accordingly, we believe that any expansion of the Federal 
Reserve's authority should supplement rather than replace the 
existing regulatory framework for clearing agencies.
    Confidence that the financial markets are both safe and 
fair is promoted by the risk management standards applicable to 
clearing agencies under Section 17A of the Exchange Act, 
including that clearing agencies must provide for the 
safeguarding of securities and funds and for the prompt and 
accurate clearance and settlement of securities transactions. 
The current risk management procedures for clearing agencies 
have shown remarkable robustness and resiliency both 
historically and through the recent period of financial stress. 
For example, no clearing agency incurred a loss following the 
Lehman bankruptcy last year. Furthermore, in the event of a 
participant default, one of a clearing agency's primary lines 
of defense is its substantial collateral pool, or clearing 
fund, that is comprised of substantial contributions from its 
participants. As a result, participants have a strong incentive 
to ensure the clearing agency maintains highly effective risk 
management policies and procedures.
    In addition to the requirements regarding risk management, 
Section 17A also imposes a number of requirements to facilitate 
a national system for clearance and settlement of securities 
transactions. The regulation of the securities markets is 
inextricably tied to the regulation of the entities that 
provide clearance and settlement services. Clearance and 
settlement has an effect on almost every facet of the 
securities markets, including: characteristics of the products 
traded, trading partners, competition among trading venues, 
proxy and dividend distributions, and collaterization of 
ongoing transactions such as repurchase agreements and stock 
lending. In addition, regulation of many aspects of the 
securities market, such as the monitoring and regulation of 
``short selling,'' is accomplished through use of the clearance 
and settlement infrastructure. The standards that promote 
fairness and innovation in the securities markets have elements 
related to risk management, such as participant eligibility for 
clearing services, and could be compromised if another 
regulator could simply ignore the investor protections 
available under Section 17A or other laws. For these reasons, 
there should be a coordinated approach between the Council, 
functional regulators, and SRR in order to fully utilize the 
expertise and experience of all regulators and maintain the 
existing standards that are crucial to supporting the 
securities markets.

Q.3. What do you see as the key differences in viewpoints with 
respect to the role and authority of a Systemic Risk Council? 
For example, it seems like one key question is whether the 
Council or the Federal Reserve will set capital, liquidity, and 
risk management standards. Another key question seems to be who 
should be the Chair of the Council, the Secretary of the 
Treasury or a different Senate-appointed Chair. Please share 
your views on these issues.

A.3. Please see my response to your first question.

Q.4. What are the other unresolved aspects of establishing a 
framework for systemic risk regulation?

A.4. The Administration's white paper on Financial Regulatory 
Reform and recent legislation extensively address the 
additional supervisory, capital, leverage, and other 
requirements to which Tier 1 Financial Holding Companies (FHCs) 
would be subject. Consistent with the need to minimize 
regulatory arbitrage and close regulatory loopholes, attention 
is also due to firms that would not be considered Tier 1 FHCs 
and are not supervised as bank holding companies but 
nonetheless have a substantial presence in the securities 
markets or carry substantial customer assets. The failure of 
such ``Tier 2'' firms could have a disruptive or harmful impact 
on orderly and efficient markets and on customers, even if not 
necessarily at a global level. Moreover, it may be appropriate 
to impose graduated limits and capital charges, as well as 
increased supervisory attention, on these financial 
institutions as they grow.

Q.5. How should Tier 1 FHCs be identified? Which regulator(s) 
should have this responsibility?

A.5. The Council should have the authority to identify Tier 1 
FHCs whose failure would pose a threat to the financial system 
due to their combination of size; leverage; interconnectedness; 
amount and nature of financial assets; nature of liabilities 
(such as reliance on short-term funding); importance as a 
source of credit for households, businesses, and Government; 
amount of cash, securities, or other types of customer assets 
held; and other factors the Council deems appropriate. One 
possible way to identify Tier 1 FHCs would be to use a process 
similar to that used to select participants in the Treasury 
Department and Federal Reserve's Supervisory Capital Assessment 
Program, or stress tests, conducted in 2009.

Q.6. One key part of the discussion at the hearing is whether 
the Federal Reserve, or any agency, can effectively operate 
with two or more goals or missions. Can the Federal Reserve 
effectively conduct monetary policy, macroprudential 
regulation, and consumer protection?

A.6. I believe the approach laid out above, where policy is set 
by a strong Council and implemented through functional 
regulators with a SRR overlay, would help address limitations 
associated with any individual regulators' mission or 
expertise.

Q.7. Under the Administration's plan, there would be heightened 
supervision and consolidation of all large, interconnected 
financial firms, including likely requiring more firms to 
become financial holding companies. Can you comment on whether 
this plan adequately addresses the ``too-big-to-fail'' problem? 
Is it problematic, as some say, to identify specific firms that 
are systemically significant, even if you provide disincentives 
to becoming so large, as the Administration's plan does?

A.7. Large financial institutions may enjoy a competitive 
advantage in the form of a lower cost of capital because the 
possibility of a Government backstop has been priced in. 
Accordingly, some have suggested that appropriate financial and 
risk management requirements be imposed on these large 
institutions to level the playing field for smaller competitors 
and to provide additional protection against their failure. I 
agree with the effort to establish a mechanism for 
macroprudential oversight and consolidated supervision of 
systemically important firms. Moreover, to minimize the 
systemic risks posed by these institutions, policy makers 
should consider using all regulatory tools available--including 
supplemental capital, transparency, and activities 
restrictions--to reduce risks and ensure a level playing field 
for large and small institutions.
    A credible resolution regime can also help address these 
risks by giving policy makers the option of a controlled 
unwinding of a large, interconnected institution over time.
                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
                     FROM MARY L. SCHAPIRO

Q.1. Many proposals call for a risk regulator that is separate 
from the normal safety and soundness regulator of banks and 
other firms. The idea is that the risk regulator will set rules 
that the other regulators will enforce. That sounds a lot like 
the current system we have today, where different regulators 
read and enforce the same rules in different ways. Under such a 
risk regulator, how would you make sure the rules were being 
enforced the same across the board?

A.1. Any risk regulator's role should be in conjunction with a 
strong Financial Services Oversight Council (Council). The 
Council would promote greater uniformity by providing a forum 
for examining and discussing regulatory standards across 
markets, ensuring that capital and liquidity standards are in 
place and being enforced, and that those standards are adequate 
and appropriate for systemically important institutions and the 
activities they conduct. In addition, the Council would have 
the role of identifying risks across the system, harmonizing 
rules to minimize systemic risk, and helping to ensure that 
future regulatory gaps--and arbitrage opportunities--are 
minimized or avoided. The Council would set policy if necessary 
to ensure that more rigorous standards than those of a primary 
regulator and/or the systemic risk regulator (SRR) are 
implemented. Such an approach would provide the best structure 
to ensure clear accountability for systemic risk, enable a 
strong, nimble response should adverse circumstances arise, and 
benefit from the broad and differing perspectives needed to 
best identify developing risks and minimize unintended 
consequences.

Q.2. Before we can regulate systemic risk, we have to know what 
it is. But no one seems to have a definition. How do you define 
systemic risk?

A.2. In my view, systemic risk is the concentration of risk in 
a single firm or a collective accumulation of risk across firms 
that creates a risk of sudden, near-term systemic seizures in 
markets or cascading failures of other entities. In addressing 
systemic risk it is important that we are careful that our 
efforts to protect the system from near-term systemic seizures 
do not inadvertently result in a long-term systemic imbalance 
that unintentionally favors large systemically important 
institutions over smaller firms of equivalent creditworthiness, 
fueling greater risk.

Q.3. Assuming a regulator could spot systemic risk, what 
exactly is the regulator supposed to do about it? What powers 
would they need to have?

A.3. A systemic risk regulator should be empowered, among other 
things, with broad information-gathering authority to obtain 
adequate reporting from firms that are or may pose a risk to 
the financial system and from other regulators. Using the 
information obtained, the systemic risk regulator would 
identify emerging risks--whether market-oriented, 
infrastructure-related, or entity-specific. For example, 
concentrations in particular businesses or asset classes and 
off-balance sheet or other activities that may not be readily 
transparent to the public or primary regulators should be of 
particular concern.
    Given the breadth of the task, however, the Council, SRR, 
and primary regulators all have a role in identifying and 
addressing such risks. The Council and the SRR would need to 
rely heavily on primary regulators to implement policies. In 
that regard, the Council should play a key role in facilitating 
and emphasizing coordination among the SRR and primary 
regulators.
    Moreover, while a consolidated regulator of large 
interconnected firms is an essential component to identifying 
and addressing systemic risk, a number of other tools must also 
be employed. These include more effective capital requirements, 
strong enforcement, and transparent markets that enable 
investors and other counterparties to better understand risks, 
established and maintained in coordination with primary 
regulators. Given the complexity of modern financial 
institutions, it is essential to have strong, consistent 
functional regulation of individual types of institutions, 
along with a broader view of the risks building within the 
financial system.

Q.4. How do you propose we identify firms that pose systemic 
risks?

A.4. The Council should have the authority to identify firms 
whose failure would pose a threat to the financial system due 
to their combination of size; leverage; interconnectedness; 
amount and nature of financial assets; nature of liabilities 
(such as reliance on short-term funding); importance as a 
source of credit for households, businesses, and Government; 
amount of cash, securities, or other types of customer assets 
held; and other factors the Council deems appropriate. One 
possible way to identify these firms would be to use a process 
similar to that used to select participants in the Treasury 
Department and Federal Reserve's Supervisory Capital Assessment 
Program, or stress tests, conducted earlier in 2009.

Q.5. All of the largest financial institutions have 
international ties, and money can flow across borders easily. 
AIG is probably the best known example of how problems can 
cross borders. How do we deal with the risks created in our 
country by actions somewhere else, as well as the impact of 
actions in the U.S. on foreign firms?

A.5. Globally active financial services firms may be 
geographically dispersed, but as we saw during this financial 
crisis, the holding company can become crippled by the failure 
of any one of its many material subsidiaries. Our experience 
has confirmed the need for cross-border coordination and 
dialogue, as well as for sound regulatory regimes for principal 
subsidiaries of international holding companies. These 
regulatory regimes should of course include capital and 
liquidity standards that are adequate, appropriate, and 
enforced for the type of financial institutions affected, as 
well as measures to address operational and reputational risks. 
The global nature of financial conglomerates such as AIG makes 
capital and liquidity standards appropriate topics for 
international coordination and cooperation. In general, the 
financial crisis has highlighted the need for regulators to 
work more closely together to better understand the risks posed 
by international financial companies and global market risks.

Q.6. Any risk regulator would have access to valuable 
information about the business of many firms. There would be a 
lot of people who would pay good money to get that information. 
How do we protect that information from being used improperly, 
such as theft or an employee leaving the regulator and using 
his knowledge to make money?

A.6. This same issue exists in our current regulatory regime 
and there is an established framework of regulation to 
safeguard against the misuse of confidential information. It is 
a criminal violation to disclose confidential information 
generally. See 18 U.S.C. 1905, Disclosure of confidential 
information generally, which provides that any officer or 
employee of the United States or any of its department or 
agency who, in the course of his employment or official duties, 
discloses confidential information (unless authorized by law) 
will be subject to fines, imprisonment, or both and will be 
removed from office or employment.
    There also are express standards of ethical conduct for 
employees or executives of any executive agency of the United 
States (such as the Securities and Exchange Commission) that 
provide, among other things, that an employee shall not engage 
in financial transactions using nonpublic Government 
information or allow the improper use of such information to 
further any private interest. See 5 CFR Section 2635.101(b)(3); 
see also 5 CFR Section 2635.703(a), which states that ``[a]n 
employee shall not engage in a financial transaction using 
nonpublic information, nor allow the improper use of nonpublic 
information to further his own private interest or that of 
another, whether through advice or recommendation, or by 
knowing unauthorized disclosure.''
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
                     FROM MARY L. SCHAPIRO

Q.1. Thank you for responding back to my letter that was signed 
by Senators Bunning, Martinez, Vitter, and Enzi about the need 
to make sure that any decision on short selling will be made 
based on empirical data. Has the SEC Office of Economic 
Analysis undertaken any independent analysis to determine if 
there would be a net benefit from imposing an additional short-
selling restriction so that any final decision will be able to 
withstand scrutiny and cost-benefit analysis?

A.1. The Commission's Office of Economic Analysis (OEA), now 
part of the newly created Division of Risk, Strategy, and 
Financial Innovation, has performed independent analysis of the 
uptick rule and various other types of short sale restrictions. 
For example, OEA analysis includes (1) a major empirical study 
based on a pilot rule change prior to the elimination of Rule 
10a-1 in 2007; (2) subsequent analyses to determine how various 
forms of uptick rules would have operated during the financial 
crisis; and (3) numerous studies of how Regulation SHO and its 
subsequent amendments have impacted delivery failures. OEA also 
has reviewed and analyzed many other publicly available 
empirical studies of short sale restrictions, including studies 
conducted both before and after the recent financial crisis. 
Collectively, these studies provide a wealth of empirical 
evidence relevant to understanding the costs and benefits of 
short sale regulation. In addition, the public has had many 
opportunities to present additional commentary, analysis, and 
empirical evidence bearing on short sale restrictions as a part 
of the rule-making process. OEA has assisted the Commission in 
reviewing studies and evidence raised through the public 
comment process.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
                     FROM MARY L. SCHAPIRO

Q.1. Ms. Schapiro, in recent months, you stated that the SEC is 
undertaking a comprehensive reexamination of rule 12b-1 fees. 
Can you please explain why, when the SEC has so many other 
important issues facing it, you are directing the SEC's 
resources to a review of these fees which exist to help 
millions of small investors have access to ongoing professional 
financial advice and service?

A.1. I have directed the staff to undertake a comprehensive 
reexamination of rule 12b-1 to help the Commission better 
understand the impact the rule has on investors and funds and 
to make recommendations to the Commission regarding the rule. 
Rule 12b-1, which permits funds to use their assets to pay for 
distribution costs, was adopted 30 years ago and has not been 
substantively revised since that time. As a result, certain 
provisions of the rule likely are outdated and no longer 
relevant to the way the rule is used today.
    The amount of 12b-1 fees that shareholders pay through 
mutual funds has risen from a few million dollars per year in 
the early 1980s to over $13 billion in 2008. The expanded use 
and amount of the fees paid pursuant to rule 12b-1 have been a 
source of concern and controversy for many years. As you note, 
supporters of the rule argue that 12b-1 fees help small 
investors to access ongoing professional financial advice and 
services, and help spur innovation and fund growth. Others, 
however, have argued that the rule has, among other concerns, 
led to complex fee structures that make it difficult for 
investors to evaluate and compare overall costs and services.
    The results of the staff's reexamination of rule 12b-1 will 
better inform the Commission as it considers potential updating 
and reform of this rule that has a substantial impact on fund 
investors.
                                ------                                


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

Q.1. AIG--Governor Tarullo, I am very concerned that the Fed 
currently has too many responsibilities. The Fed's bail out of 
AIG has put the Fed in the position of having to unwind one of 
the world's largest and most complex financial institutions. 
Resolving AIG without imposing losses on the U.S. taxpayer is 
proving to be a time-consuming and difficult task. It could 
even potentially distract the Fed from its core mission of 
monetary policy.
    Approximately how many hours have you personally dedicated 
to overseeing the Fed's investments in AIG?
    How does this compare with the number of hours you have 
spent on monetary policy issues?
    What assurance can you provide that the Fed is devoting 
enough time and attention to both AIG and monetary policy?

A.1. I joined the Board at the end of January 2009 and thus was 
not involved in matters involving the American International 
Group, Inc. (AIG) before that date. While we do not have 
records of the exact number of hours I have spent addressing 
AIG matters since I joined the Board, these matters do not 
occupy a significant part of my ongoing workload and do not 
detract from my other responsibilities as a member of the 
Board, including the conduct of monetary policy.
    The oversight of the Federal financial assistance provided 
to AIG is shared by the Federal Reserve, which has provided 
several credit facilities designed to stabilize AIG, and the 
Treasury Department, which holds equity interests in the 
company. The day-to-day oversight of the Federal Reserve credit 
facilities is carried out by a team ofstaff at the Federal 
Reserve Bank of New York and the Board of Governors, assisted 
by expert advisers we have retained. In our role as a creditor 
of AIG, the Federal Reserve oversight staff makes sure that we 
are adequately informed on such matters as funding, cash flows, 
liquidity, earnings, risk management, and progress in pursuing 
the company's divestiture plan, so that we can protect the 
interests of the System and the taxpayers in repayment of the 
credit extended. With respect to the credit facilities extended 
to special purpose entities that purchased assets connected 
with AIG operations, the staff's oversight activities consist 
primarily of monitoring the portfolio operations of each of the 
entities, which are managed by a third-party investment 
manager. The Federal Reserve staff involved in the ongoing 
oversight of AIG periodically report to the Board of Governors 
about material developments regarding the administration of 
these credit facilities.
    The Federal Reserve oversight staff for AIG works closely 
with the Treasury staff who oversee and manage the Treasury's 
relationship with AIG. As the holder of significant equity 
interests in the company, Treasury plays an important role in 
stabilizing AIG's financial condition, overseeing the execution 
of its divestiture plan, and protecting the taxpayers' 
interests.
    With respect to time expended by the Reserve Bank members 
of the Federal Open Market Committee, the President of the New 
York Reserve Bank devotes significant attention to AIG. 
However, as noted above, day-to-day responsibility for 
overseeing the Bank's interests as lender to AIG has been 
delegated to a team of senior Bank managers. The President 
regularly consults with the AIG team--in particular he receives 
a daily morning briefing on AIG as well as other significant 
Bank activities, receives updates throughout the day on an ad 
hoc basis circumstances warrant, and occasionally intervenes 
personally on particular issues. The President believes that he 
is able to adequately balance the time and resources he 
allocates to AIG with the other Bank activities that warrant 
his personal attention, including his responsibilities as a 
voting member of the FOMC.

Q.2. Safety and Soundness Regulation--Governor Tarullo, in your 
testimony you state that there are synergies between monetary 
policy and systemic risk regulation. In order to capture these 
synergies, you argue that the Fed should become a systemic risk 
regulator. Yesterday, Chairman Bernanke testified that he 
believed there are synergies between prudential bank regulation 
and consumer protection. This argues in favor of establishing 
one consolidated bank regulator.
    In your judgment, is it on the whole better to have 
prudential supervision and consumer protection consolidated in 
one agency, or separated into two different agencies?

A.2. There are important connections and complementarities 
between consumer protection and prudential supervision. For 
example, sound underwriting benefits consumers as well as the 
relevant financial institution, and strong consumer protections 
can add certainty to the markets and reduce risks to the 
institutions. Moreover, the most effective and efficient 
consumer protection requires the in-depth understanding of bank 
practices that is gained through the prudential supervisory 
process. Indeed, the Board's separate divisions for consumer 
protection and prudential supervision work closely in 
developing examination policy and industry gnidance. Both types 
of supervision benefit from this close coordination, which 
allows for a broader perspective on the quality of management 
and the risks facing a financial organization. Thus, placing 
consumer protection rule writing, examination, and enforcement 
activities in a separate organization that does not have 
prudential supervisory responsibilities would have costs, as 
well as benefits.
    Achieving the synergies between prudential supervision and 
consumer protection does not require that responsibility for 
both functions and for all banking organizations to be 
concentrated in a single, consolidated bank regulator. Under 
the current framework for bank supervision, the Board has 
prudential supervisory responsibilities for a substantial 
cross-section of banking organizations in the United States, as 
well as rule-writing, examination, and enforcement authority 
for consumer protection. Likewise, the other Federal banking 
agencies all have both prudential supervisory authority for 
certain types of banking organizations and consumer protection 
examination and enforcement responsibilities for these 
organizations.
    Moreover, as I indicated in my July 23rd testimony to the 
Committee, the United States needs a comprehensive agenda to 
contain systemic risk and address the problem of ``too-big-to-
fail'' financial institutions. We should seek to marshal and 
build on the individual and collective expertise and resources 
of all financial supervisors in the effort to contain systemic 
risks within the financial system, rather than rely on a single 
``systemic risk regulator.'' This means new or enhanced 
responsibilities for a number of Federal agencies and 
departments, including the Securities and Exchange Commission, 
the Commodity Futures Trading Commission, and the Federal 
Deposit Insurance Corporation.
    One important aspect of such an agenda is ensuring that all 
systemically important financial institutions--and not just 
those that own a bank--are subject to a robust framework for 
supervision on a consolidated or groupwide basis, thereby 
closing an important gap in the current regulatory framework. 
The Federal Reserve already serves as the consolidated 
supervisor of all bank holding companies, including a number of 
the largest and most complex banking organizations and a number 
of very large financial firms--such as Goldman Sachs, Morgan 
Stanley, and American Express--that became a bank holding 
company during the financial crisis. This expertise, as well as 
the information and perspective that the Federal Reserve has as 
a result of its central bank responsibilities, makes the 
Federal Reserve well suited to serve as consolidated supervisor 
for all systemically important financial firms.
    As Chairman Bernanke recently noted, there are substantial 
synergies between the Federal Reserve's role as prudential 
supervisor and its other central bank responsibilities. Price 
stability and financial stability are closely related policy 
goals. The benefits of maintaining a Federal Reserve role in 
supervision have been particularly evident in the recent 
financial crisis. Over the past 2 years, supervisory expertise 
and information have helped the Federal Reserve to better 
understand the emerging pressures on financial firms and to use 
monetary policy and other tools to respond to those pressures. 
This understanding contributed to more timely and decisive 
monetary policy actions and proved invaluable in helping us to 
address potential systemic risks involving specific financial 
institutions and markets. More broadly, our supervisors' 
knowledge of interbank lending markets and other sources of 
bank funding contributed to the development of new tools to 
address financial stress.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
                    FROM VINCENT R. REINHART

Q.1.a. Removing Bank Regulation From the Fed--Dr. Reinhart, 
Governor Tarullo claims that there are synergies between 
systemic risk regulation and monetary policy.
    As the former Director of the Division of Monetary Affairs 
at the Fed, do you believe that the Fed's ability to conduct 
monetary policy would be compromised if the Fed no longer 
regulated any financial institutions?

A.1.a. Absolutely not. The Fed's monetary policy responsibility 
requires a high-level understanding of the aggregate economy. 
Fed officials need an expertise in the workings of markets, 
industries, and sectoral behavior. They can get an aggregate 
understanding without being a supervisor. As for markets, no 
one wants to strip the Fed of its responsibility of managing 
the Fedwire and book-entry systems--the backbone to how funds 
and Treasury securities are transferred. As long as it provides 
those fundamental market utilities, the Fed will always have a 
window into markets and large firms, independent of its 
supervisory responsibilities. Fed officials frequently boast 
that their lending involves little risk because it is highly 
collateralized. If so, why do they need the information that 
comes from being the regulator of those firms? The Fed should 
focus on its core responsibility and work with the Congress to 
protect the information flows it deems essential.

Q.1.b. Would banking regulation improve if it was consolidated 
under one regulator?

A.1.b. Absolutely yes. Financial firms are too complicated to 
supervise or for markets to discipline. One reason is that they 
can search among multiple regulators for the most conducive 
(i.e., lax) environment. Eliminate regulatory arbitrage by 
consolidating regulators.

Q.2. Politicization of the Fed--Dr. Reinhart, Professor Meltzer 
asserts in his testimony that the Administration's proposal to 
make the Fed responsible for systemic risk would ultimately 
sacrifice the independence of the Fed. As the primary Federal 
regulator, the Fed's views would have great sway over whether a 
firm facing insolvency is rescued. Professor Meltzer points out 
that banks, future Administrations, and Congress will therefore 
seek to exert political influence over the Fed's decisions on 
which firms receive bail outs.
    Do you agree with Professor Meltzer that making the Fed 
responsible for systemic risk regulation may cause the Fed to 
become politicized?

A.2. Monetary policy is abstract and about the national 
economy. Aiding a failing firm is concrete and about specific 
States and districts. All politics is local. If the Fed is 
responsible for systemic risk, it will be enmeshed in politics 
and its core responsibility will suffer.
                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
                    FROM VINCENT R. REINHART

Q.1. I doubt we can create a regulator that will be able to see 
and stop systemic risk. It seems to me a more practical and 
effective way to limit the damage firms can do is to limit 
their size and exposure to other firms. That also has the 
benefit of allowing the free markets to operate, but within 
reasonable limits. Do you agree with that?

A.1. Financial firms have gotten too complicated and too 
interconnected. This is related to, but not completely 
explained by, the size of a firm. In March 2008, for instance 
and much to my regret, financial authorities were unwilling to 
let market forces determine the fate of the mid-sized 
investment bank, Bear Stearns, because of concerns about its 
interconnectedness. My preferred solution is to combat 
complexity directly by enforcing strict consolidation of 
balance sheets and requiring different activities within a 
holding company to be chartered and capitalized separately. If 
a firm's balance sheet is transparent, then the market can 
exert meaningful discipline.

Q.2. Many proposals call for a risk regulator that is separate 
from the normal safety and soundness regulator of banks and 
other firms. The idea is that the risk regulator will set rules 
that the other regulators will enforce. That sounds a lot like 
the current system we have today, where different regulators 
read and enforce the same rules different ways. Under such a 
risk regulator, how would we make sure the rules were being 
enforced the same across the board?

A.2. Management by committee never works well. Introducing 
layers of supervision invites turf wars among the regulators, 
the search for regulatory gaps among the regulated, and mutual 
finger-pointing after the fact of failure.

Q.3. Before we can regulate systemic risk, we have to know what 
it is. But no one seems to have a definition. How do you define 
systemic risk?

A.3. Systemic risk refers to the possibility that there will be 
a widespread withdrawal from risk taking that does not 
discriminate across borrowers.

Q.4. Assuming a regulator could spot systemic risk, what 
exactly is the regulator supposed to do about it? What powers 
would they need to have?

A.4. Systemic risk is a contagion. The most effective response 
is to isolate the source. Before the fact, regulated entities 
should be required to keep a simple balance-sheet structure 
that limits interconnections. This reduces the risk of 
contagion. In the event, weak firms should be allowed to fail. 
If there are activities of the firm that pose system risk, they 
should be isolated and protected--after sufficient haircuts--
and the rest of the firm left to fail.

Q.5. How would we identify firms that pose systemic risks?

A.5. A systemic threat is posed by any firm with large gross 
exposures, relative to its capital, to many different firms 
with no effective netting regime.

Q.6. All of the largest financial institutions have 
international ties, and money can flow across borders easily. 
AIG is probably the best known example of how problems can 
cross borders. How do we deal with the risks created in our 
country by actions somewhere else, as well as the impact of 
actions in the U.S. on foreign firms?

A.6. We can best protect our national interest by requiring 
that any firm operating in the United States have a transparent 
balance sheet and sufficient capital for each of its 
independent lines of business.

Q.7. As you probably have heard, many are calling for an audit 
of the Fed. Chairman Bernanke and others are opposed to that 
idea because they fear it will lead to Congressional 
interference with monetary policy. What can be done to improve 
transparency at the Fed? What should not be done? Is there any 
information on Fed discussions and the data that goes into them 
that would compromise the Fed's independence or ability to do 
its job if made public?

A.7. There are limits to transparency. A requirement that the 
Fed disclose more information sooner would probably push 
decision making more outside organized meetings, to the 
detriment of openness. There are two areas where the Fed could 
volunteer improvement. First, it could make a numeric summary 
of its staff forecast public with its minutes. The forecast is 
influential among FOMC participants. If they find it useful, 
would not the public? Second, the transcripts could be released 
sooner than the current 5-year lag, and probably substantially 
so.

Q.8. Do you have any suggestions for ways to improve the Fed's 
ability to carry out its core mission of monetary policy? Do 
you have any other comments about the Fed generally?

A.8. The Fed would be far better off if it focused on its core 
responsibility of monetary policy and hardened the wall of 
independence around it. Shed bank supervision, which it did not 
do well. Collect and share more data to compensate for the lack 
of supervision. Articulate a long-run inflation goal to anchor 
the public's understanding. The Fed's unwillingness to engage 
the Congress in a meaningful dialogue about the appropriate 
role of the central bank is a mistake.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                    FROM PAUL SCHOTT STEVENS

Q.1. Creating a New Systemic Regulator--Mr. Stevens, your 
testimony pointed out the importance of clearly defining the 
relationship between any new systemic regulator and existing 
primary financial regulators.
    What are the potential consequences of failing to draw 
clear lines?

A.1. Failure to clearly delineate the relationship between any 
systemic risk regulator and the existing primary financial 
regulators could have several adverse consequences, 
particularly if the systemic risk regulator is not constituted 
as a council of existing primary regulators. It would increase 
the chances that the systemic risk regulator and one or more 
primary regulators might find themselves working at cross 
purposes with respect to a given issue. If each believes that 
it has responsibility over a particular area, each could adopt 
regulations that are inconsistent, particularly if the 
regulators have distinct regulatory philosophies and different 
types of expertise. If the respective responsibilities of the 
systemic risk regulator and the primary regulators are not 
well-defined, there will be no clear avenue for resolving these 
sorts of conflicts. As a result, there could be delays in 
addressing the issue at hand.
    Alternatively, the absence of clear lines could result in 
the systemic risk regulator and primary regulators duplicating 
each other's efforts, which would be inefficient and 
potentially create additional regulatory burdens for financial 
institutions. Or, the systemic risk regulator and relevant 
primary regulator may each mistakenly believe that the other is 
responsible for a particular matter, and the identification and 
resolution of issues could fall through the cracks.
    A related point is the need to place explicit limits on the 
authority granted to the systemic risk regulator and to 
identify areas in which the systemic risk regulator and the 
primary regulators should work together. I believe it would be 
most unfortunate if the systemic risk regulator were to 
marginalize the primary regulator, thus potentially leading to 
the loss of specialized expertise that the primary regulator is 
in the best position to offer.

Q.2. Tier 1 Financial Holding Companies--Mr. Stevens, as you 
noted, the Administration's proposal would vest the Federal 
Reserve with the ultimate authority to designate a firm as a 
Tier 1 Financial Holding Company (Tier 1 FHC). A Tier 1 FHC is 
defined as a firm the failure of which would pose a threat to 
financial stability due to its size, leverage, and 
interconnectedness. Some of your larger members could 
potentially be swept up by that definition.
    How do you anticipate that could change the way in which 
large mutual funds are regulated and could the designation of a 
large fund complex as a Tier 1 FHC create an uneven playing 
field for smaller firms without that designation?

A.2. As a threshold matter, it is useful to note the potential 
range of financial firms that could be designated as Tier 1 
Financial Holding Companies (Tier 1 FHCs). In its white paper 
on financial services regulatory reform, and in the ``Findings 
and Purposes'' section of its draft legislation, the 
Administration describes a Tier 1 FHC as a firm the failure of 
which would pose a threat to financial stability due to its 
size, degree of leverage, and interconnectedness. Elsewhere in 
the draft legislation is a standard that governs Tier 1 FHC 
designations, and it is much more expansive. In particular, the 
Federal Reserve need not find all three factors to be present 
in order to determine that a firm should be designated a Tier 1 
FHC--rather, the legislation would require that the Federal 
Reserve consider these and other enumerated factors, in 
addition to any other factors that the agency in its discretion 
deems appropriate.
    The degree of discretion that the Administration seeks to 
vest in the Federal Reserve is further illustrated by the 
Administration's proposal to authorize that agency to require 
certain financial companies to submit ``such information as 
[the Federal Reserve] may reasonably require'' for purposes of 
making Tier 1 FHC designations. Under the draft legislation, 
this authority would extend to any financial company having (1) 
$10 billion or more in assets, (2) $100 billion or more in 
assets under management, or (3) $2 billion or more in gross 
annual revenue. These thresholds are low enough to capture 
potentially a wide array of companies in the fund industry.
    Under such an open-ended framework, it is certainly 
possible that a large mutual fund (typically organized as a 
corporation or business trust under state law) or a family of 
such funds collectively could be designated a Tier 1 FHC. The 
same might be true for a mutual fund investment adviser and its 
affiliated companies. Perhaps most likely, a mutual fund 
adviser that is part of an integrated financial services firm 
could be swept into the Tier 1 FHC regime. These scenarios are 
discussed below.

Mutual funds

    Designating a large mutual fund or family of funds as a 
Tier 1 FHC would not, in my view, be likely to serve the stated 
purposes of the Administration's proposal. Mutual funds are 
already subject to comprehensive regulation under the Federal 
securities laws including, in particular, the Investment 
Company Act of 1940 (ICA). Perhaps most relevant for this 
purpose are the ICA's strict limitations on leverage to which 
mutual funds must adhere. Other core areas of fund regulation, 
including daily valuation of fund shares, separate custody of 
fund assets, affiliated transaction prohibitions, 
diversification requirements, and extensive disclosure and 
transparency requirements, are part of an extensive regulatory 
framework that has protected fund investors and proven 
resilient in difficult market conditions.
    Importantly, the Federal Reserve has long viewed a mutual 
fund as being controlled by its independent board and not by 
its investment adviser or by a company that provides the fund 
with administrative, brokerage, and other services. Consistent 
with this longstanding view, the Federal Reserve would 
presumably need to conclude that the relevant risk 
characteristics of a mutual fund or fund family themselves 
warrant designating the fund or fund family as a Tier 1 FHC, 
and it would not take into account the activities of the fund 
adviser and/or the adviser's affiliates in making this 
determination. As discussed above, designating a fund or fund 
family as a Tier 1 FHC would appear unnecessary given the 
comprehensive ICA regulatory scheme, including its strict 
limits on leverage.
    Under the Administration's proposal, Tier 1 FHC status 
might be applied to certain kinds of funds such as money market 
funds, which seek to offer investors stability of principal, 
liquidity, and a market-based rate of return, all at a 
reasonable cost. These funds have been comprehensively 
regulated by the Securities and Exchange Commission (SEC) not 
only under the ICA provisions outlined above, but also through 
a specialized and highly prescriptive rule, Rule 2a-7, for 30 
years. For the reasons described below, any concerns that a 
large money market fund or family of such funds could present 
the potential for systemic risk should be addressed by SEC 
reforms and other pending initiatives, and not by designating 
such fund(s) as a Tier 1 FHC.
    In March, ICI's Money Market Working Group issued a 
comprehensive report outlining a range of measures to 
strengthen the liquidity and credit quality of money market 
funds and ensure that money market funds will be better 
positioned to sustain prolonged and extreme redemption 
pressures. \1\ Consistent with the Working Group's 
recommendations, the Administration, in its white paper, 
specifically directed the SEC to move forward with plans to 
strengthen the money market fund regulatory framework to reduce 
the credit and liquidity risk profile of individual money 
market funds and to make the money market fund industry as a 
whole less susceptible to runs. In so doing, the Administration 
recognized that the SEC, as the primary regulator for money 
market funds, is uniquely qualified to evaluate and implement 
potential changes to the existing scheme of money market fund 
regulation. The SEC already has proposed such amendments, many 
of which are similar to the Working Group's recommendations, 
and is currently reviewing the comments it has received from 
ICI and others on the proposal. \2\ In addition, the 
President's Working Group on Financial Markets is considering 
whether any other reforms are needed to further strengthen the 
resiliency of money market funds to certain short-term market 
risks.
---------------------------------------------------------------------------
     \1\ See ``Report of the Money Market Working Group'', Investment 
Company Institute (March 17, 2009), available at http://www.ici.org/
pdf/ppr_09_mmwg.pdf.
     \2\ See ``Money Market Fund Reform'', SEC Release No. IC-28807 
(June 30, 2009), 74 FR 32688 (July 8, 2009), available on the SEC's Web 
site at http://sec.gov/rules/proposed/2009/ic-28807.pdf.
---------------------------------------------------------------------------
    Finally, whether the designation of a large fund or fund 
family as a Tier 1 FHC could create an uneven playing field for 
smaller funds without that designation is difficult to say. It 
is conceivable that investors might perceive such a designation 
as providing some kind of assurance or advantage and, thus, 
that a Tier 1 designation could have a positive influence on 
their investment decisions, especially in times of market 
stress. But it seems more likely that a Tier 1 FHC 
designation--and its potential effects on how funds are 
regulated--would put those funds at a competitive disadvantage 
as compared to their peers that are not so designated.

Investment Advisers

    Bringing a mutual fund investment adviser--most likely, one 
that is part of an integrated financial services firm--within 
the proposed supervisory and regulatory scheme for Tier 1 FHCs 
would impose an additional layer of substantive regulation on 
the adviser that would be fundamentally different from, and 
could be at odds with, the regulatory schemes to which fund 
advisers have long been subject.
    Generally speaking, a Tier 1 FHC and its subsidiaries--
regardless of whether those subsidiaries are already regulated 
by a ``functional'' regulator such as the SEC--would be subject 
to supervisory and regulatory authority of the Federal Reserve. 
Such supervision is intended to be ``macroprudential'' in 
focus, combining ``enhanced forms'' of the Federal Reserve's 
normal supervisory tools that are focused on safety and 
soundness with rigorous assessments of how the firm's overall 
activities and risk exposures potentially impact other Tier 1 
firms, critical markets, and the broader financial system. A 
firm designated as a Tier 1 FHC would need to meet strict 
prudential standards, including risk-based capital standards, 
leverage limits, liquidity requirements, and overall risk 
management requirements. Following a transition period, the 
firm also would have to conform to the restrictions on 
nonfinancial activities in the Bank Holding Company Act, even 
if the firm did not control an insured depository institution.
    In a sharp departure from current law, the Federal Reserve 
would be given authority to impose and enforce prudential 
requirements on a fund adviser, upon consultation in some cases 
with the SEC. This would be true regardless of whether the 
adviser is named a Tier 1 FHC in its own right or is part of an 
integrated financial services firm that is designated as a Tier 
1 FHC. In either case, it is not clear how prudential 
requirements such as capital standards, which make considerable 
sense in ensuring the safety and soundness of an insured 
depository institution and its holding company, would be 
applied to investment advisers. There would be other ways in 
which prudential regulation by the Federal Reserve may conflict 
with the regulatory requirements to which investment advisers 
already are subject, and it is unclear at this point how such 
differences in regulatory requirements would be reconciled.
    Lastly, it is important to recognize that, unlike the SEC, 
the Federal Reserve does not have an investor protection 
mandate. Instead, its bottom-line objective is to promote the 
safety and soundness of financial institutions. In pursuing 
their respective missions, the two agencies follow distinct 
regulatory approaches, they have different regulatory tools at 
their disposal, and each has its particular areas of expertise. 
The difficulties likely to result from superimposing Federal 
Reserve supervisory and regulatory authority onto comprehensive 
SEC regulation of mutual fund advisers should not be 
underestimated.

Q.3. Independent Board Versus Independent Council--Mr. Stevens, 
you argue that the creation of an independent board, as opposed 
to a council of existing regulators, could lead to incentives 
to justify its existence by finding systemic risks even where 
they do not exist.
    What aspects of the Council's design would prevent its 
staff from falling prey to the same pressure to justify the 
Council's existence?

A.3. I believe that several aspects of the design of a Systemic 
Risk Council (as I have described it in my written testimony) 
would make it highly unlikely that the Council or its staff 
would feel pressured to find systemic risks merely to justify 
the Council's existence.
    As the leaders of the core financial regulatory agencies, 
all standing members of the Council would already have critical 
``day jobs,'' ones that make them ultimately responsible for 
the regulation of financial firms, activities, and markets 
within their spheres of expertise. It is precisely these 
roles--as Secretary of the Treasury or as Chairman of the SEC, 
for example--that would well position the Council members to 
distinguish between regulatory matters best handled by the 
appropriate primary regulator(s) and those matters that cut 
across regulatory lines and present the potential for harm that 
could spread throughout the financial system. In these latter 
cases, the Council would be required to make a formal 
determination that the matter is of such nature and import as 
to require the Council's involvement, both in developing a 
series of responses to the identified risks and in directing 
the appropriate primary regulator(s) to implement those 
responses. I do not believe that the Council members would come 
to such a conclusion lightly.
    Moreover, the Council would not just be tasked with the 
prevention and mitigation of systemic risk--it would also be 
the body responsible for policy coordination and information 
sharing across the various federal financial regulators. The 
time and energies of the Council and its independent staff, and 
in particular the knowledge gleaned from their continuous 
monitoring of conditions and developments in the financial 
markets, would be leveraged for both purposes. This is 
significant because not all of the issues and risks that they 
identify will involve threats to overall financial stability. 
Through the collaborative Council process, these ``lesser'' 
issues and risks can get the attention that they deserve, 
presumably by the appropriate primary regulator(s).
    Finally, as regards the staff, I have proposed that a small 
but diverse group of highly experienced individuals should be 
sufficient to support the work of the Council. Many of these 
individuals should be seconded from the financial regulatory 
agencies represented on the Council and thus, like the Council 
members themselves, be well positioned to identify risks that 
are truly systemic in nature. And the staff, while independent, 
will follow an agenda that is determined by the Council. All of 
these factors, in my view, would appropriately focus the 
staff's efforts.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                      FROM ALICE M. RIVLIN

Q.1. Super Regulators--Ms. Rivlin, you state in your testimony 
that it would be ``a mistake to give the Federal Reserve 
responsibility for consolidated prudential regulation'' of 
systemically important institutions as the Obama administration 
has proposed. You note that if the Fed acquires this additional 
responsibility it will need leaders with regulatory skills--
lawyers, not economists like Volcker, Greenspan, and Bernanke.
    Is it realistic to expect that any one person can be an 
expert in all of the areas falling under the Fed's 
jurisdiction?
    As a former Vice-Chair of the Fed, do you think that the 
Fed was an effective bank regulator in the run up to this 
crisis?

A.1. Answer not received by time of publication.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING
                      FROM ALICE M. RIVLIN

Q.1. I doubt we can create a regulator that will be able to see 
and stop systemic risk. It seems to me a more practical and 
effective way to limit the damage firms can do is to limit 
their size and exposure to other firms. That also has the 
benefit of allowing the free markets to operate, but within 
reasonable limits. Do you agree with that?

A.1. Answer not received by time of publication.

Q.2. Many proposals call for a risk regulator that is separate 
from the normal safety and soundness regulator of banks and 
other firms. The idea is that the risk regulator will set rules 
that the other regulators will enforce. That sounds a lot like 
the current system we have today, where different regulators 
read and enforce the same rules different ways. Under such a 
risk regulator, how would we make sure the rules were being 
enforced the same across the board?

A.2. Answer not received by time of publication.

Q.3. Before we can regulate systemic risk, we have to know what 
it is. But no one seems to have a definition. How do you define 
systemic risk?

A.3. Answer not received by time of publication.

Q.4. Assuming a regulator could spot systemic risk, what 
exactly is the regulator supposed to do about it? What powers 
would they need to have?

A.4. Answer not received by time of publication.

Q.5. How would we identify firms that pose systemic risks?

A.5. Answer not received by time of publication.

Q.6. All of the largest financial institutions have 
international ties, and money can flow across borders easily. 
AIG is probably the best known example of how problems can 
cross borders. How do we deal with the risks created in our 
country by actions somewhere else, as well as the impact of 
actions in the U.S. on foreign firms?

A.6. Answer not received by time of publication.

Q.7. As you probably have heard, many are calling for an audit 
of the Fed. Chairman Bernanke and others are opposed to that 
idea because they fear it will lead to Congressional 
interference with monetary policy. What can be done to improve 
transparency at the Fed? What should not be done? Is there any 
information on Fed discussions and the data that goes into them 
that would compromise the Fed's independence or ability to do 
its job if made public?

A.7. Answer not received by time of publication.

Q.8. Do you have any suggestions for ways to improve the Fed's 
ability to carry out its core mission of monetary policy? Do 
you have any other comments about the Fed generally?

A.8. Answer not received by time of publication.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
                     FROM ALLAN H. MELTZER

Q.1. Lessons of Fed History--Professor Meltzer, you are in the 
process of completing your book on the History of the Federal 
Reserve. I understand that you have been working on this 
project for more than a decade. This research gives you a 
unique perspective about the strengths and weaknesses of the 
Fed.
    In your examination of its history, has the Fed 
demonstrated that it is inherently better at identifying 
systemic risks than any other regulator?

A.1. No. If anyone could forecast crises, they would either be 
very rich or they could prevent them. We need to choose 
policies that reduce the risk of crises. My answers to some of 
Senator Bunning's questions suggest some ways of reducing 
failures and the public's cost of failures.

Q.2. What are the problems that are likely to occur if the Fed 
is given authority to regulate systemic risk?

A.2. The Fed will not be able to do much because we do not know 
how to forecast systemic risks. The Fed will be more engaged in 
political decisions than is consistent with independence.
                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
                     FROM ALLAN H. MELTZER

Q.1. I doubt we can create a regulator that will be able to see 
and stop systemic risk. It seems to me a more practical and 
effective way to limit the damage firms can do is to limit 
their size and exposure to other firms. That also has the 
benefit of allowing the free markets to operate, but within 
reasonable limits. Do you agree with that?

A.1. Yes, very much. I propose to limit size by making banks 
increase their reserves (capital) more than in proportion to 
the increase in the size of assets. That shifts the cost from 
the public to the stockholders, changes bankers' incentives, 
and protects the public. That should accompany an end to ``too-
big-to-fail'' and a lender of last resort rule that Congress 
and the Federal Reserve agree to follow.

Q.2. Many proposals call for a risk regulator that is separate 
from the normal safety and soundness regulator of banks and 
other firms. The idea is that the risk regulator will set rules 
that the other regulators will enforce. That sounds a lot like 
the current system we have today, where different regulators 
read and enforce the same rules different ways. Under such a 
risk regulator, how would we make sure the rules were being 
enforced the same across the board?

A.2. Again, you are right. The central point of difference 
between a risk regulator and increased bank capital lies in who 
bears the residual risk. You and I want it to be management and 
stockholders. Those favoring a risk regulator leave the public 
bearing the risk.

Q.3. Before we can regulate systemic risk, we have to know what 
it is. But no one seems to have a definition. How do you define 
systemic risk?

A.3. I don't think there is an all-purpose definition. I do not 
need to define it because I do not want a risk regulator to 
decide. If costs are borne by the banks, they will have an 
incentive to be more prudent. We cannot prevent all failures 
because banks lend long and borrow short. We can prevent 
failures from becoming crises.
    The lender of last resort should lend only to those that 
have quality collateral. That puts the incentives where they 
should be.

Q.4. Assuming a regulator could spot systemic risk, what 
exactly is the regulator supposed to do about it? What powers 
would they need to have?

A.4. See above. I can't see how we can get a definition. If the 
opportunity arises every member of congress would claim that a 
large failure in their district is systemic. And their 
constituents would expect that.

Q.5. How would we identify firms that pose systemic risks?

A.5. I would not. I would make them hold capital to safeguard 
the rest of us.

Q.6. All of the largest financial institutions have 
international ties, and money can flow across borders easily. 
AIG is probably the best known example of how problems can 
cross borders. How do we deal with the risks created in our 
country by actions somewhere else, as well as the impact of 
actions in the U.S. on foreign firms?

A.6. Yes, a big problem. We allow failures of the companies we 
charter. If foreign governments want to rescue the subs in 
their jurisdiction, why is that a problem for us?

Q.7. As you probably have heard, many are calling for an audit 
of the Fed. Chairman Bernanke and others are opposed to that 
idea because they fear it will lead to Congressional 
interference with monetary policy. What can be done to improve 
transparency at the Fed? What should not be done? Is there any 
information on Fed discussions and the data that goes into them 
that would compromise the Fed's independence or ability to do 
its job if made public?

A.7. Independence of central banks began under the gold 
standard. Fed actions were restricted and no one expected long-
term inflation. These restrictions have gone away. We need new 
restrictions that Congress can monitor. That means we must 
adopt a quasi-rule that allows limited discretion. The Fed 
should announce its inflation and unemployment targets. If it 
misses the target substantially, it should offer an explanation 
and a resignation. The President can accept the explanation or 
the resignation. My proposal relates responsibility to 
authority. Several countries have adopted variants of it.
    Congressman Paul's proposal is too much concerned with 
procedure. More important is outcome--inflation and 
unemployment. From about 1985 to 2003, we had low inflation and 
good growth. The Fed must be made to repeat or improve on that 
performance.

Q.8. Do you have any suggestions for ways to improve the Fed's 
ability to carry out its core mission of monetary policy? Do 
you have any other comments about the Fed generally?

A.8. See the previous question. We need to limit discretion 
without putting the Fed in a straight jacket. We need to end 
``too-big-to-fail.'' We need to agree on lender of last resort 
policy. We need better--more effective--Congressional 
oversight.
