[Senate Hearing 111-407]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-407


       STRENGTHENING AND STREAMLINING PRUDENTIAL BANK SUPERVISION

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

                                HEARING

                               before the

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

 STRENGTHENING AND STREAMLINING PRUDENTIAL BANK SUPERVISION TO BETTER 
 PROVIDE THE SAFETY, SOUNDNESS, AND STABILITY OF THE FINANCIAL MARKETS

                               __________

                    AUGUST 4 AND SEPTEMBER 29, 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                 JUDD GREGG, New Hampshire
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

              William D. Duhnke, Republican Staff Director

                      Amy S. Friend, Chief Counsel

                   Dean V. Shahinian, Senior Counsel

                   Charles Yi, Senior Policy Adviser

                Brian Filipowich, Legislative Assistant

                       Deborah Katz, OCC Detailee

                      Matthew Green, FDIC Detailee

                      Mark Jickling, CRS Detailee

                Mark Oesterle, Republican Chief Counsel

                    Jim Johnson, Republican Counsel

                Andrew J. Olmem, Jr., Republican Counsel

               Jeffery L. Stoltzfoos, Republican Counsel

              Heath P. Tarbert, Republican Special Counsel

            Chad Davis, Republican 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

                              ----------                              

                        TUESDAY, AUGUST 4, 2009

                                                                   Page

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

Opening statements, comments, or prepared statements of:
    Senator Johnson
        Prepared statement.......................................    43
    Senator Reed
        Prepared statement.......................................    43

                               WITNESSES

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation..     2
    Prepared statement...........................................    44
    Responses to written questions of:
        Senator Bunning..........................................    79
John C. Dugan, Comptroller of the Currency, Office of the 
  Comptroller of the Currency....................................     4
    Prepared statement...........................................    48
    Responses to written questions of:
        Senator Bunning..........................................    82
Daniel K. Tarullo, Member, Board of Governors of the Federal 
  Reserve
  System.........................................................     5
    Prepared statement...........................................    66
    Responses to written questions of:
        Senator Bunning..........................................    89
John E. Bowman, Acting Director, Office of Thrift Supervision....     7
    Prepared statement...........................................    72
    Responses to written questions of:
        Senator Bunning..........................................    90

                              ----------                              

                      TUESDAY, SEPTEMBER 29, 2009

Opening statement of Chairman Dodd...............................    99
    Prepared statement...........................................   132

                               WITNESSES

Eugene A. Ludwig, Chief Executive Officer, Promontory Financial 
  Group, LLC.....................................................   101
    Prepared statement...........................................   132
Martin N. Baily, Senior Fellow, Economic Studies, The Brookings 
  Institution....................................................   104
    Prepared statement...........................................   144
Richard S. Carnell, Associate Professor, Fordham University 
  School of Law..................................................   107
    Prepared statement...........................................   153
Richard J. Hillman, Managing Director, Financial Markets and 
  Community Investment Team, Government Accountability Office....   109
    Prepared statement...........................................   159

 
       STRENGTHENING AND STREAMLINING PRUDENTIAL BANK SUPERVISION

                              ----------                              


                        TUESDAY, AUGUST 4, 2009

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

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. The Committee will come to order. Let me 
welcome our guests who are in the hearing room this morning, as 
well as to welcome our very distinguished panel of witnesses, 
and we thank the four of you and the second panel that is going 
to come as well.
    I have informed our colleagues already, those who are here, 
and others, we are under some time constraints. We have a 
couple of votes around 10:30 that are coming up on the floor of 
the Senate. There is a meeting that we are going to have that 
begins a little after noon that many of us are going to have to 
attend later. So we are not going to make any opening 
statements, including the Chairman and the Ranking Member. We 
have agreed this morning just to get right to our witnesses.
    I know my colleague from Tennessee would like that 
precedent, I tell you. He has been dying for that moment for 2 
years.
    [Laughter.]
    Senator Shelby. Mr. Chairman, when he was mayor, nobody 
spoke.
    Chairman Dodd. No, no. Just the mayor spoke. We are not 
setting precedent here, but we are certainly going to, this 
morning, move in that direction.
    So let me thank again everyone for being with us this 
morning. Obviously, strengthening and streamlining prudential 
bank supervision is a major subject matter. We have had I do 
not know how many hearings. What is the number? Twenty-eight 
hearings since January on this subject matter of financial 
modernization regulations. And, obviously, this is a very 
critical piece to the extent we are going to have consolidation 
of our financial regulators.
    And so I welcome our witnesses here this morning. Many--
well, all of you have been before us on numerous occasions to 
talk about the various aspects of the financial troubles our 
Nation has been in over the last number of years. And I just 
want to make one point, and I know all of you at the table 
pretty well, and I know you understand this because I believe 
you care about this as well. Our job, obviously, here is not to 
protect regulators. Our job is, obviously, to protect the 
people who count on us and you and the system to provide the 
safety and soundness and the stability of the financial 
markets. That is what this is all about. And I know you get 
that and understand that, but I sometimes think we need to 
clear the air a little bit to make sure people understand what 
we are talking about as we describe the structure and the 
architecture that will provide that sense of stability and 
safety and soundness that we are looking for.
    So, with that, let me just turn directly, if I can, to you, 
Sheila, to start in on this. I will ask you to try and be 
brief. Again, all the documents and all of my colleagues' 
opening statements will be included in the record at this point 
here.
    We will try and be a little more careful on the clock than 
we might otherwise be because of time constraints.
    Jim, I am just explaining we have got some votes in an hour 
and a half or so. We are going to try and move along to the 
extent possible.
    Sheila, we thank you again for being with us.

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

    Ms. Bair. Thank you, Senator Dodd, Ranking Member Shelby, 
and Members of the Committee. Today you have asked us to 
address the regulatory consolidation aspects of the 
Administration's proposal and whether there should be further 
consolidation.
    The yardstick for any reform should be whether it deals 
with the fundamental causes of the current crisis and helps 
guard against future crises. Measured by that yardstick, we do 
not believe the case has been made for regulatory consolidation 
of State and Federal charters.
    Among the many causes of the current crisis, the ability to 
choose between a State and Federal charter was not one of them. 
As a consequence, we see little benefit to regulatory 
consolidation and the potential for great harm and its 
disruptive impact and greater risk of regulatory capture and 
dominance by large banking organizations.
    The simplicity of a single bank regulator is alluring. 
However, such proposals have rarely gained traction in the past 
because prudential supervision of FDIC-insured banks has, in 
fact, worked well compared to the regulatory structures used 
for other U.S. financial sectors and to those used overseas. 
Indeed, this is evidenced by the fact that large swaths of the 
so-called ``shadow banking sector'' have collapsed back into 
the healthier insured sector.
    And U.S. banks, notwithstanding the current problems, 
entered this crisis with stronger capital positions and less 
leverage than their international competitors.
    A significant cause of the crisis was the exploitation of 
regulatory gaps between banks and the shadow nonbank financial 
system and virtually no regulation of the over-the-counter 
derivatives contracts. There were also gaps in consumer 
protection. To address these problems, we have previously 
testified in support of a systemic risk council that would help 
assure coordination and harmonization of prudential standards 
among all types of financial institutions.
    And a council would address regulatory arbitrage among the 
various financial sectors.
    We also support a new consumer agency to assure strong 
rules and enforcement of consumer protection across the board. 
However, we do not see merit or wisdom in consolidating all 
Federal banking supervision. The risk of weak or misdirected 
regulation would be exacerbated by a single Federal regulator 
that embarked on a wrong policy course. Prudent risk management 
argues strongly against putting all your regulatory and 
supervisory eggs in one basket.
    One of the advantages of multiple regulators is that it 
permits diverse viewpoints to be heard. For example, during the 
discussion of Basel II, the FDIC voiced deep and strong 
concerns about the reduction in capital that would have 
resulted. Under a unified regulator, the advanced approaches of 
Basel II could have been implemented much more quickly and with 
fewer safeguards, and banks would have entered this crisis with 
much lower levels of capital.
    Also, there is no evidence that shows a single financial 
regulatory structure was better at avoiding the widespread 
economic damage of the past 2 years. Despite their single-
regulator approach, the financial systems in other countries 
have all suffered during the crisis.
    Moreover, a single-regulator approach would have serious 
consequences for two mainstays of the American financial 
system: the dual banking system and deposit insurance. The dual 
banking system and the regulatory competition and diversity 
that it generates is credited with spurring creativity and 
innovation in financial products and the organization of 
financial activities. State-chartered institutions tend to be 
community-oriented and very close to the small businesses and 
customers they serve. They provide the funding that supports 
economic growth and job creation, especially in rural areas. 
Main Street banks also are sensitive to market discipline 
because they know they are not too big to fail and that they 
will be closed if they become insolvent.
    A unified supervisory approach would inevitably focus on 
the largest banks to the detriment of community banking. In 
turn, this could cause more consolidation in the banking 
industry at a time when efforts are underway to reduce systemic 
exposure to very large financial institutions and to end ``too 
big to fail.''
    Concentrating examination authority in a single regulator 
also could hurt bank deposit insurance. The loss of an ongoing 
and significant supervisory role would greatly diminish the 
effectiveness of the FDIC's ability to perform a congressional 
mandate. It would hamper our ability to reduce systemic risk 
through risk-based premiums and to contain the costs of deposit 
insurance by identifying, assessing, and taking actions to 
mitigate risk to the Deposit Insurance Fund.
    To summarize, the regulatory reforms should focus on 
eliminating the regulatory gaps I have just outlined. Proposals 
to create a unified supervisor would undercut the many benefits 
of our dual banking system and would reduce the effectiveness 
of deposit insurance, and, most importantly, they would not 
address the fundamental causes of the current crisis.
    Thank you.
    Chairman Dodd. Thank you very much, and I apologize, 
Sheila, for not properly introducing you here as the 
Chairperson of the Federal Deposit Insurance Corporation. I 
kind of assume everybody knows who you are, so I kind of jumped 
into that, and I apologize.
    John Dugan is the Comptroller of the Currency, and we thank 
you very much, a well-known figure to this Committee, having 
served on this side of the dais for a number of years and now 
at the OCC. So we thank you, John.

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

    Mr. Dugan. Thank you very much, Mr. Chairman.
    Chairman Dodd, Ranking Member Shelby, and Members of the 
Committee, I appreciate this opportunity to discuss the 
Administration's proposal for regulatory reform.
    The OCC supports many elements of the proposal, including 
the establishment of a council of financial regulators to 
identify and monitor systemic risk and enhanced authority to 
resolve systemically significant financial firms. We also 
believe it would be appropriate to establish a consolidated 
supervisor of all systemically significant financial firms.
    The Federal Reserve already plays this role for the largest 
bank holding companies, but during the financial crisis, the 
absence of a comparable supervisor for large securities and 
insurance firms proved to be an enormous problem. The proposal 
would fill this gap by extending the Federal Reserve's holding 
company regulation to such firms, which we believe would be 
appropriate.
    However, one aspect of the proposal goes much too far, 
which is to grant broad new authority to the Federal Reserve to 
override the primary banking supervisor on standards, 
examination, and enforcement applicable to the bank. Such 
override power would fundamentally undermine the authority and 
accountability of the banking supervisor.
    We also support the proposal to effectively merge the OTS 
into the OCC with a phase-out of the Federal Thrift Charter. My 
written testimony responds in detail to the Chairman's 
questions about options for additional banking agency 
consolidation by: first, establishing either the Federal 
Reserve or the FDIC as the single Federal agency responsible 
for regulating State-chartered banks; second, establishing a 
single prudential supervisor to supervise all national and 
State banks; and, third, transferring all holding company 
regulation from the Federal Reserve to the prudential 
supervisor.
    While there are significant potential benefits to be gained 
from all three proposals, there are also potential costs, 
especially with removing the Federal Reserve altogether from 
the holding company regulation of systemically important 
companies.
    Finally, we support enhanced consumer financial protection 
standards and believe that a dedicated consumer protection 
agency could help to achieve that goal. However, we have 
significant concerns with the parts of the proposed CFPA that 
would consolidate all financial consumer protection 
rulewriting, examination, and enforcement in a single agency 
which would completely divorce these functions from safety and 
soundness regulation.
    It makes sense to consolidate all consumer protection 
rulewriting in a single agency with the rules applying to all 
financial providers of a product, both bank and nonbank. But we 
believe the rules must be uniform and that banking supervisors 
must have meaningful input into formulating them. 
Unfortunately, the proposed CFPA falls short on both counts.
    First, the rules would not be uniform because the proposal 
would expressly authorize States to adopt different rules for 
all financial firms, including national banks, by repealing the 
Federal preemption that has always allowed national banks to 
operate under uniform Federal standards. This repeal of a 
uniform Federal standards option is a radical change that will 
make it far more difficult and costly for national banks to 
provide financial services to consumers in different States 
having different rules, and these costs will ultimately be 
borne by the consumer. The change will also undermine the 
national banking charter and the dual banking system that have 
served us well for nearly 150 years.
    Second, the rules do not afford meaningful input from 
banking supervisors, even on real safety and soundness issues, 
because in the event of any disputes, the proposed CFPA would 
always win. The new agency needs to have a strong mechanism for 
ensuring meaningful bank supervisor input into CFPA rulemaking.
    Finally, the CFPA should not take examination and 
enforcement responsibilities away from the banking agencies. 
The current bank supervisory process works well where the 
integration of consumer compliance and safety and soundness 
supervision provides real benefits for both functions. 
Moreover, moving bank examination and enforcement functions to 
the CFPA would only distract it from its most important and 
daunting implementation challenge--that is, establishing an 
effective enforcement regime for the shadow banking system of 
the literally tens of thousands of nonbank providers that are 
currently unregulated or lightly regulated, like mortgage 
brokers and originators. The CFPA's resources should be focused 
on this fundamental regulatory gap rather than on already 
regulated depository institutions.
    Thank you very much.
    Chairman Dodd. Thank you very much.
    Dan Tarullo, from the Federal Reserve Board, we thank you, 
Dan, once again for coming before the Committee. Happy to hear 
your testimony.

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

    Mr. Tarullo. Thank you, Mr. Chairman, Ranking Member 
Shelby, and other Members of the Committee.
    Before the final history of the financial crisis is 
written, I am certain that supervisory shortcomings in all 
kinds and sizes of financial institutions, will have been 
revealed. The crisis has also shown that the framework for 
prudential supervision and regulation has not kept pace changes 
in the structure, activities, and interrelationships of the 
financial sector.
    In my prepared testimony, I have suggested and tried to 
elaborate the elements of an effective framework for prudential 
supervision, including a number of recommendations for 
legislative actions. Knowing of your time constraints this 
morning, let me confine these introductory remarks to three 
quick points.
    First, prudential supervision must be required for all 
systemically important institutions. It is noteworthy that a 
number of the firms at the heart of the crisis had not been 
subject to mandatory prudential supervision of any sort. 
Improving the quality of supervision will fall short of 
realizing the maximum potential gains for financial stability 
if important institutions can escape the rules and requirements 
associated with the supervisory process.
    Second, there must be effective supervision of the 
companies that own insured depository institutions, a task that 
is distinct from the supervision of the banks themselves. Large 
organizations increasingly manage their businesses on an 
integrated basis, with little regard for the corporate 
boundaries that typically define the jurisdiction of individual 
functional supervisors. There is need for close scrutiny of the 
linkages between the banks and other affiliates within a 
holding company--not just straightforward financial or 
contractual ties, but also managerial, operational, and 
reputational linkages. The premise of so-called ``functional 
regulation''--that risks within a diversified organization can 
be successfully evaluated and controlled through supervision 
within each individual firm--has been belied by the experience 
of the financial crisis.
    Third, it is important to emphasize that much of what needs 
to be done to improve and adapt our system of prudential 
supervision lies within the existing authorities of the 
agencies represented at this table. Together, we have acted to 
shut down the practice of converting charters in order to 
escape enforcement actions or adverse supervisory ratings. We 
are working together in international fora to assure that all 
internationally active financial institutions are subject to 
effective regulation. The Federal Reserve is adjusting its 
approach to prudential supervision, particularly of the largest 
banking organizations.
    Building on the experience of the unprecedented Supervisory 
Capital Assessment Program, or SCAP, we are expanding our use 
of horizontal examinations to assess key operations, risks, and 
risk management of large institutions. We are creating an 
enhanced quantitative surveillance mechanism that will draw on 
a multidisciplinary group of economists and other experts to 
create and evaluate scenarios that cross large firms. These 
top-down analyses will provide an independent supervisory 
perspective on the bottom-up work of supervisory teams. The two 
perspectives will be joined in a well-coordinated process 
involving both the supervisory teams and Washington staff.
    Thank you all for your attention. I look forward to 
discussing both agency and congressional initiatives to 
strengthen further our prudential supervisory system.
    Chairman Dodd. Thank you very much, Governor.
    I will now turn to our last witness, John Bowman, who is 
the Acting Director of the Office of Thrift Supervision. John, 
we welcome you once again to the Committee.

STATEMENT OF JOHN E. BOWMAN, ACTING DIRECTOR, OFFICE OF THRIFT 
                          SUPERVISION

    Mr. Bowman. Good morning, Chairman Dodd, Ranking Member 
Shelby, and other Members of the Committee. Thank you for the 
opportunity to testify on the Administration's proposal for 
financial regulatory reform. It is my pleasure to address this 
Committee for the first time in my role as Acting Director of 
the Office of Thrift Supervision. I will begin my testimony by 
outlining the core principles I believe are essential to 
accomplishing true and lasting reform. Then I will address 
specific questions you asked regarding the Administration's 
proposal.
    Let me start with the four principles.
    One, ensure that changes to the financial regulatory system 
address real problems. We all agree that the system has real 
problems and needs real reform. What we must determine, as we 
consider each proposed change, is whether the proposal would 
fix what is broken. In the rush to address what went wrong, let 
us not try to fix nonexisting problems or try to fix real 
problems with flawed solutions.
    Two, ensure uniform regulation. One of the biggest lessons 
learned from the current economic crisis is that all entities 
offering financial products to consumers must be subject to the 
same rules. Underregulated entities competing in the financial 
marketplace have a corrosive, damaging impact on the entire 
system. Also, complex derivative products such as credit 
default swaps should be regulated.
    Three, ensure that systemically important firms are 
effectively supervised and, if necessary, wound down in an 
orderly manner. No provider of financial products should be too 
big to fail, achieving through size and complexity an implicit 
Federal Government guarantee to prevent its collapse. The U.S. 
economy operates on the principle of healthy competition. 
Enterprises that are strong, industrious, well managed, and 
efficient succeed and prosper. Those that fall short of the 
mark struggle or fail, and other stronger enterprises take 
their places. Enterprises that become too big to fail subvert 
the system. When the Government is forced to prop up failing 
systemically important computers, it is, in essence, supporting 
poor performance and creating a moral hazard.
    Let me be clear. I am not advocating a cap on size, just 
effective, robust authority for properly regulating and 
resolving the largest and most complex financial institutions.
    Number four, ensure that consumers are protected. A single 
agency should have the regulation of financial products as its 
central mission. That agency should establish the rules and 
standards for all consumer financial products, regardless of 
the issuer of those products, rather than having multiple 
agencies with fragmented authority and a lack of singular 
accountability.
    Regarding feedbacks on the questions the Committee asked, 
the OTS does not support the Administration's proposal to 
eliminate the Office of the Comptroller of the Currency and the 
Office of Thrift Supervision, transferring the employees of 
each into a national bank supervisory agency or for the 
elimination of the Federal Thrift Charter. Failures by insured 
depository institutions have been no more severe among thrifts 
than among institutions supervised by other Federal banking 
regulators.
    If you look at the numbers of failed institutions, most 
have been State-chartered banks whose primary Federal regulator 
is not the OTS.
    If you look at the size of failed institutions, you see 
that the Federal Government prevented the failures of the 
largest banks that collapsed by authorizing open bank 
assistance. These too-big-to-fail institutions are not and were 
not regulated by the OTS.
    The argument about bank shopping for the most lenient 
regulator is also without merit. Most financial institutions 
and more assets have converted away from OTS supervision in the 
last 10 years than have converted to OTS supervision.
    In the same way the thrift charter is not part of the 
problem, we do not see any reason to cause major disruptions 
with the hundreds of legitimate, well-run financial businesses 
that are operating successfully with the thrift charter and 
making credit available to American consumers. My written 
testimony contains detailed information you requested about the 
proposed elimination of the exceptions in the Bank Holding 
Company Act for thrifts and certain special-purpose banks and 
about the Federal Reserve System's prudential supervision of 
holding companies.
    Thank you again, Mr. Chairman, and I would be happy to 
answer any questions.
    Chairman Dodd. Thank you very much, Mr. Bowman.
    Let me ask the clerk to put the clock on here for about 6 
minutes per Member, and I have two questions I want to raise 
with you, if time permits, and then I will turn to Senator 
Shelby.
    First of all, for decades--and I have been on this 
Committee for a number of years, and we have had commissions 
and think tanks and regulators, presidents, Banking Committee 
Chairs. John, you will remember sitting behind us back here at 
that table with parties recommending the consolidation of 
Federal banking supervision. Bill Proxmire, who sat in this 
chair for a number of years, proclaimed the U.S. system of 
regulation to be, and I quote, ``the most bizarre and tangled 
financial regulatory system in the world.''
    Former FDIC Chairman, Sheila, Chairman William Seidman, 
called it ``complex, inefficient, outmoded, and archaic.''
    In the wake of the last bank and thrift crisis, when 
hundreds of institutions failed, the Clinton administration 
urged Congress to consolidate the Federal banking regulators 
into a single prudential regulator. So here we have seen 
Administrations, Chairs of this Committee, and others over the 
years, all at various times, in the wake of previous crises, 
call for consolidation, and yet we did not act after those 
crises. We sat back and basically left pretty much the system 
we have today intact. And as a result, we have had some real 
costs ranging from inefficiencies and redundancies to the lack 
of accountability and regulatory laxity. We are now paying a 
very high price for those shortcomings.
    So my first question is--the Administration, as you all 
know and you have commented on, has proposed the consolidation 
of the OCC and OTS, but leaves in place the three Federal bank 
regulators. My question is simply: Putting the safety and 
soundness of the banking system first, is the Administration 
proposal really enough? Or should we not be listening to the 
admonition of previous Administrations? And people have sat in 
this chair who have recommended greater consolidation that 
ought to be the step taken.
    Sheila, we will begin with you.
    Ms. Bair. As I indicated in my opening statement, we do not 
think that the ability to choose between the Federal and State 
charter was any kind of a significant driver or had any kind of 
an impact at all on the activities that led to this current 
crisis. The key problems were arbitrage between more heavily 
regulated banks and nonbanks, and then the OTC derivatives 
sector, which was pretty much completely unregulated.
    I do support merging OCC and OTS. That is reflective of 
market conditions, but that doesn't need to be about whether 
there is a weak regulator or strong regulator. I think that is 
just a reflection of the market and the lack of current market 
interest in a specialty charter to do just mortgage lending or 
heavily concentrate on mortgage lending. In fact, some of the 
restrictions on the thrift charter perhaps have impeded the 
ability of those thrifts to undertake additional 
diversification.
    So, Mr. Chairman, I would have to respectfully disagree in 
terms of drivers of what went on this time around. I really do 
not see that as a symptom of the fact that you have four 
different regulators overseeing different charters for FDIC-
insured institutions. And I do think that the banks held up 
pretty well compared to the other sectors. They did have higher 
capital standards and more extensive regulation.
    Chairman Dodd. Let me just ask you and the other panelists 
to comment on this. Clearly, we are looking back in the 
rearview mirror as to what happened, and that is certainly a 
motivation here. But it is not the sole motivation. It is not 
just a question of addressing the problems that occurred, but 
going forward, in the 21st century, in a very different time, 
in a global economy today--we saw the implications of what 
happened not only here in this country but around the world. 
The idea that we would maintain the same architecture we have 
for decades is not only a question about what has occurred and 
whether or not the system responded well enough to it, but 
looking forward as to whether or not this architecture and 
structure is going to be sufficient to protect the safety and 
soundness in a very different economic environment than existed 
at the time these agencies emerged through the process of 
growth over the years. It seems to me that is just as important 
question as looking back.
    Ms. Bair. I think it is a very important question, and I am 
very glad you are having these hearings. But I do not think 
that this is going to solve the problems that led to this 
crisis. Looking at the performance of other models in European 
countries that have a single regulator, the performance is not 
particularly good.
    I do think there is a profound risk of regulatory capture 
by very large institutions if you collapse regulatory oversight 
into one single entity. I think having multiple voices is 
beautiful. We testified before this Committee on the Advanced 
Approaches under Basel II. We resisted that, and we slowed it 
down. And because of that, our banks--commercial banks, FDIC-
insured banks--had not transitioned into that new system, which 
would have significantly lowered the amount of capital they 
would have had going into this crisis, unlike what happened in 
Europe and with investment banks.
    So we think having multiple voices can actually strengthen 
regulation and guard against regulatory capture. If you have a 
single monopoly regulator, there is not going to be another 
regulator out there saying, ``We are going to have a higher 
standard,'' ``We are going to be stronger,'' or ``We are going 
to question that.'' I think you lose that with a single 
regulator. So you should look carefully at the European models 
and how they functioned during the crisis.
    Chairman Dodd. We are talking here--John, let me ask you, 
we are talking about a consumer financial product safety 
agency. Obviously, the Fed is very much here. We are talking 
about that as well and having a prudential regulator. Why is 
that not necessarily the kind of checks and balances we are 
talking about in the system?
    Mr. Dugan. I cannot really defend the current system of so 
many regulators. As one of my predecessors used to say, it does 
not work in theory, but we have worked hard to make it work in 
practice.
    And having said that, I think there is more you could do if 
you were so inclined, and you have gone from four regulators to 
three prudential regulators in the proposal. You could go the 
next step to have a single regulator for State-chartered 
institutions, which would bring you down to two. You could go 
to one regulator for the banks, and you could even bring in the 
holding company regulation to the prudential supervisor.
    As I mentioned in my testimony, there are advantages and 
disadvantages in each of those steps. I think at the end of the 
day, if you put everything all in one place, it would be 
probably too much. And so I think that is probably a bridge too 
far, but there are things that you could do that would simplify 
things for the future.
    I do not believe, and agree with Sheila, that this was a 
principal contributing cause of this crisis. But I think going 
forward we do have to think hard about what is the best system 
for the future, and giving those matters real thought is a good 
thing.
    Chairman Dodd. Dan and John, some quick responses to my 
question.
    Mr. Tarullo. Mr. Chairman, among the many reasons why 
Members of this Committee will not be unhappy to see the summer 
recess come is they will not have to listen to me say, for 
about the third hearing in a row, that each proposal that comes 
before us is going to have some advantages and some 
disadvantages.
    I do think, as John and Sheila have suggested, that nobody 
would sit down and write the system we have now if they were 
starting from scratch. But the system having been in place, you 
have seen that there are some advantages to splitting bank 
supervision. I personally think it would be a very bad idea not 
to have the deposit insurer have a bank examination function, 
so that the deposit insurer understands how banks are 
functioning before they fail, and thus be better able to 
resolve them.
    I also think that it is important for the Federal Reserve, 
as the central bank and as the holding company supervisor, to 
have a window into how banks function.
    Would there be efficiency gains in some sense from having a 
single regulator? There probably would be, but I think my 
colleagues to my right have already pointed out some of the 
disadvantages as well.
    Chairman Dodd. John.
    Mr. Bowman. I would agree with some of the disadvantages 
that have been pointed out. I think the other question that we 
would have is the form that the current system holds, a 
multiple of regulators, really the cause of the issue we are 
dealing with today? And I would suggest that, in fact, the 
principal cause, as the Administration says in its proposal--
high-cost loans, only 6 percent of the high-cost loans provided 
American consumers were provided by depository institutions 
that were regulated under the current system; 94 percent were 
provided by the so-called ``shadow banking regulator.''
    That is why we would suggest the focus really should be on 
filling the regulatory gaps that exist today and that really 
need to be filled.
    Chairman Dodd. Senator Shelby.
    Senator Shelby. Mr. Chairman, just for the record, just my 
observation, I would think that if you look at the record here 
of the failure of the regulatory bodies, that all roads seem to 
lead to the Federal Reserve. They don't lead to the FDIC. They 
don't lead to the Comptroller. They don't lead to the Community 
Bank Supervisor. But just about all of them lead to the Fed, 
and let us be honest about it.
    I want to get into something else. Chairman Bernanke has 
testified before this Committee that this crisis has revealed 
that our Nation's ``too-big-to-fail'' problem is much worse 
than many thought. After the bailouts of Bear Stearns, AIG, 
Chrysler, and GM, our markets now have good reason to expect 
that the Federal Government will bail out any prominent company 
that gets into financial trouble, perhaps.
    My question to you is, what steps need to be taken to 
restore market discipline and minimize the moral hazard created 
by the bailouts over the past year? Is this a problem that will 
not be solved until the Federal Government actually allows 
several prominent institutions to fail? In other words, we are 
going down a road, a dead-end road on the ``too-big-to-fail'' 
thing.
    Sheila.
    Ms. Bair. Well, we very much agree with you, Senator, and 
that is why when I have testified before this Committee 
previously our priority focus has been on resolution authority. 
We need a mechanism that can resolve very large financial 
organizations in a way that is orderly, that protects the rest 
from any systemic implications, but makes sure that their 
creditors and shareholders take losses. We don't have that 
right now and I don't think we are going to get that restored 
market discipline until Congress puts something like that in 
place.
    Senator Shelby. John.
    Mr. Dugan. I agree that we need a better mechanism to have 
more orderly resolutions of companies that get into trouble so 
that you can have more instances where you don't have threats 
to the system just by resolving them. I think you need to do 
more up front by way of capital requirements and liquidity 
requirements so they don't get into that position. And I think 
you will have more circumstances where larger institutions can 
be failed in an orderly manner.
    I do think, however, that you have to preserve some 
flexibility for the Government----
    Senator Shelby. Sure.
    Mr. Dugan. ----in emergency circumstances where the entire 
system is threatened, like we were last fall, to be able to 
address that concern, and I know that is hard, but I think you 
really need to do that.
    Senator Shelby. Governor.
    Mr. Tarullo. Senator, I certainly agree with the utility of 
the resolution mechanism, but when you ask about market 
discipline, I think there is more that we need to do. The 
resolution mechanism comes at the end of the day. It comes at 
the time of failure. It would be better to create additional 
incentives that preclude the failure. We surely need more 
transparency and disclosure by financial institutions, 
particularly the largest.
    And as I have indicated a couple of times in prepared 
testimony, I think we also need to be looking at alternative 
requirements for the capital structure of at least large 
institutions. There are a number of ideas out there that would 
require certain kinds of convertible debt to be in the capital 
structure of a company. That is good because there is market 
discipline as long as it is a debt instrument. The debt holders 
want to be paid. And they know if the financial institution 
gets into trouble, that that debt will be converted into 
equity. It will provide a buffer against loss and they will be 
subject to loss.
    So I think that market discipline has a number of different 
avenues that we should pursue, and market discipline itself 
should be pursued alongside of some other regulatory 
mechanisms.
    Senator, if I could, you know I was not at the Federal 
Reserve up until a few months ago, and as I have said 
repeatedly, I really do believe here is plenty of blame to go 
around everywhere. But I don't honestly think that all roads 
lead to the Fed on this. I mean, Bear Stearns----
    Senator Shelby. Well, which don't lead to them?
    [Laughter.]
    Mr. Tarullo. I would say, Senator, Bear Stearns, AIG, 
Lehman, Fannie and Freddie. There were a lot of problems in 
this system, and as I said earlier, I think before this crisis 
is over, we are going to have seen a lot of failures in a lot 
of kinds of institutions. I don't say that to try to deflect 
any responsibility. In fact, I think part of what I was trying 
to say in my prepared remarks and in the introductory remarks 
was that I and everybody on the Board takes seriously where 
things didn't get regulated as well as they should have and 
where the structure needs work, and that is why we started to 
make the changes we are already making.
    Senator Shelby. Just for the record, and we all know this, 
but who is the regulator, the primary regulator of the holding 
companies, the big banks that got into trouble? You know it is 
your Federal Reserve, and you are now--you weren't, but you are 
now a member of the Board of Governors. Let us be honest about 
it.
    Mr. Tarullo. Well, that is absolutely true, Senator. In 
some cases, the bank is regulated by other regulatory agencies 
and there are also entities----
    Senator Shelby. But the primary regulator of the----
    Mr. Tarullo. Of the holding companies, right.
    Senator Shelby. ----is the Federal Reserve.
    I haven't got much time, but I want to pick up on a couple 
of things. Today's Wall Street Journal had a tough article 
dealing with Secretary Geithner when he met with a bunch of 
you, where he told the financial regulators that they should 
stop--can you imagine the gall here of the Secretary--that they 
should stop criticizing the Obama administration regulatory 
reform plan. My gosh. I hope you won't quit. I think your 
honesty and your candor here is very important.
    We recognize the role of the Treasury to set some policy 
for financial regulation. But ultimately, it is going to be the 
Congress up here. This Committee, both sides of the aisle, and 
the House is going to set the tone and create the laws. And I 
appreciate you bringing this independent perspective with all 
kinds of pressure placed on you.
    Does the testimony that you have given here today, that you 
have provided, is that your own views, such as it was, not in 
any way influenced by Secretary Geithner's tirade against you 
the other day? It is a serious question. Is this your----
    Chairman Dodd. Who are you asking the question of here? 
Which one of these----
    Senator Shelby. I was asking all of them.
    Mr. Dugan. Yes, it is our own testimony. Congress requires 
and prohibits the Treasury Department from intervening in any 
legislative view we express to the Committee. We do not clear 
our statements through the Treasury Department and we take that 
independent function very, very seriously.
    Senator Shelby. Sheila.
    Ms. Bair. Yes. I don't think anybody thinks we are not 
independent. It was absolutely our testimony.
    Senator Shelby. We hope you are going to stay independent.
    Ms. Bair. I will.
    Senator Shelby. Governor.
    Mr. Tarullo. Absolutely, Senator. The only people I 
discussed this with are my fellow members of the Board and the 
staff of the Federal Reserve.
    Senator Shelby. Mr. Bowman.
    Mr. Bowman. Senator Shelby, I think our testimony speaks 
for itself and we do take exception to the Administration's 
approval, and yes, we are independent.
    Senator Shelby. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Senator Brown.
    Senator Brown. Thank you. I was a little surprised by 
Senator Shelby's question, considering the positions that you 
have all taken.
    Let me look at this in kind of a different way. The public 
has a general understanding. The investing public and the 
victims of this financial disaster, which is my whole State and 
most of this country, has a general understanding that 
regulation of financial institutions, putting it mildly, fell 
far short. Some have the belief that the most, I think the most 
egregious institutions found an agency that was too easy on 
them. In Washington, we call that regulator shopping. They just 
think that the Government, for whatever reason, was too easy on 
Wall Street greed.
    And I hear each of you. There may be some turf issues, and 
that may be a cynical way to look at it and I apologize if that 
is the way you take it, but I hear the--I see the President's 
plan, the President's proposed bank supervision framework. I 
hear each of you disputing major parts of it. How would you 
explain to the American public what the next step is? How do we 
fill the financial gaps in our financial regulatory system if 
consolidation of regulators is not the best move? How do you 
explain to the public why four very smart people playing very 
important roles in our financial institution regulatory system 
and an Administration that, I think, has equally smart people 
that understand this, why is there not more agreement?
    How do you explain in understandable terms, if you were 
talking directly to the American people now, not to this 
Committee, what we should do to fill these gaps so these kinds 
of egregious, awful things don't happen again? I will start 
with you, Ms. Bair.
    Ms. Bair. Well, I think there was arbitrage, but it was 
between the bank and the nonbank sectors. It was excess 
leverage with investment banks and hedge funds and other types 
of vehicles versus the higher leverage in risk-based capital 
requirements that we had for commercial banks.
    On consumer protection, it was third-party mortgage 
originators that were not affiliated with insured depository 
institutions originating loans being funded by Wall Street 
funding vehicles. The third-party mortgage originators were 
pretty much outside of any type of prudential or consumer 
protection standards that were within the purview of the 
banking regulators.
    So I think it is unfortunate the word ``bank'' is used for 
just about every institution, but in my world, a bank is an 
FDIC-insured institution. While we all made mistakes, the 
insured depository institution sector has held up pretty well. 
This is why you saw in December so many financial companies 
fleeing to become bank holding companies and trying to grow 
their insured institutions, because that was the sector that 
was left standing, which is hard for the FDIC because our 
exposure has increased significantly. We have tried to do the 
things we need to do to stabilize the system. But, this has 
increased our exposure significantly.
    As I have testified before, the arbitrage is between the 
banks and the nonbanks. Having a consumer agency with a focus 
especially on examination and enforcement of the nonbank sector 
and having a Systemic Risk Council that would have the 
authority to define systemic issues or systemic institutions, 
whether or not they voluntarily want to come in under the more 
stringent regulatory regime we have for banks and bank holding 
companies.
    The arbitrage was between the bank and the nonbank sectors. 
It was not among different types of bank charters, and 
certainly not between the choice of a State or Federal charter. 
There are 8,000 community banks in this country. Most of them 
have a State charter, so consequently, we regulate about 5,000 
banks. I don't think they contributed to this, but you have 
seen traditional resistance among community banks to regulatory 
consolidation for fear, frankly, which I share, that inevitably 
there would be a regulatory viewpoint that would be dominated 
by the larger institutions if everyone was lumped in together.
    There is a valid reason for State charters. The community 
banks and State-chartered community banks tend to be more local 
in their interest and how they conduct their lending. To try to 
draw that issue into the much larger problems we had with 
arbitrage between banks and nonbanks and then the lack of 
regulation of derivatives, I think, is misguided and is not 
where you should be focusing your efforts or the American 
public should be focusing its efforts.
    Senator Brown. Mr. Dugan, your thoughts?
    Mr. Dugan. I agree with everything Sheila just said. I 
would point out that we also regulate about a quarter of the 
Nation's community banks, so we do all different sizes of 
institutions. And most of the problems did not take place 
inside of the insured depository institutions that we 
supervise, which are the most extensively regulated parts of 
the system.
    Of course, we did make some mistakes and there were some 
problems. I am not discounting that. But that is not where most 
of them were.
    The second thing I would say is I think there are a number 
of very sound and strong proposals in the Administration's 
reform proposal, which I do support, as I testified. There are 
just some places where we think it should be shaped 
differently, and carrying out our duty to provide our views 
independently, that is what we are trying to suggest.
    With the CFPA, for example, we agree that a strong Federal 
consumer protection rulewriter to provide a single set of rules 
that applies to everybody is a very powerful change. But we 
think taking that same step and applying it to the enforcement 
and examination of the depository institutions should stay with 
the bank regulators where it works well, and instead, all of 
that effort should go to the examination, enforcement, and 
implementation of the nonbanking sector where there were very 
substantial problems that have led to disproportionately higher 
levels of foreclosures, for example, in your State and many of 
the States represented in this room.
    Senator Brown. Thank you.
    Governor Tarullo.
    Mr. Tarullo. Thank you, Senator. If you are asking, what 
should the public be focused on, my suggestion would be too big 
to fail. That is not the only problem by a long shot, but to 
me, it continues to be the central problem--the ability to 
avoid the moral hazard that comes with ``too-big-to-fail'' 
institutions. As I said a moment ago, I think we need a variety 
of supervisory and regulatory tools to contain that problem, 
whether it is resolution, bringing systemically important 
institutions into the perimeter of regulation, making sure that 
the kinds of capital and liquidity requirements that 
systemically important institutions have will truly contain 
untoward risk taking.
    I think we are going to need a broad set of activities. 
``Too big to fail'' was not the only cause, but it was at the 
center of this crisis and that is, I think, what we all need to 
focus on.
    The only other thing I would say harks back to a colloquy 
you and I had a couple of weeks ago when I was testifying. You 
and I were talking about attitudes and orientation and how 
people in the Congress and the regulatory agencies and the 
Administration think about issues and problems. It is not easy 
to ensure against people losing interest in issues. But I think 
that is a role that, in a system of Government that has a lot 
of checks and balances, we have to think about.
    How do we try to institutionalize skepticism and critical 
thinking, to look at developments in the financial world so 
that we don't just say, well, that is just another market 
development; it must be benign. But instead, we must begin to 
distinguish intelligently between benign, useful innovations on 
the one hand and building problems on the other.
    Senator Brown. Thank you.
    Mr. Bowman.
    Mr. Bowman. Thank you, sir. One of the advantages of being 
last on a panel like this is you usually get to agree and sort 
of dispel the notion that we disagree on so many things. I 
agree with what my colleagues have said, but I would also like 
to focus on the arbitrage position between banks and nonbanks.
    I think the CFPA provision of the Administration's bill 
goes a long ways toward dealing with that situation. The 
difference is that you don't get to sell a product at a 
nonregulated entity under different terms and conditions, a 
different regulatory structure, than you would if you were 
doing so in a depository institution or otherwise regulated 
entity. I think that is one of the critical components of this 
Administration's proposal to fix that gap.
    Senator Brown. Thank you. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator Brown.
    Senator Corker.
    Senator Corker. Mr. Chairman, thank you, and as always, I 
thank each of you for your testimony.
    I also, like I am sure most people did, read the story this 
morning in the Wall Street Journal regarding the meeting on 
Friday, and generally speaking, did it capture the essence of 
the attitude in the meeting?
    Ms. Bair. Who is going to take that one?
    [Laughter.]
    Senator Corker. Very briefly. I just want to move on to 
other----
    Mr. Dugan. Senator, it was a candid conversation about our 
agencies' different views on the different subjects and----
    Senator Corker. It was a generally fair article?
    Mr. Dugan. A lot of it was true.
    Senator Corker. OK. So here is----
    [Laughter.]
    Senator Corker. I guess what I would like to get at, it is 
my understanding that the original draft had the National 
Banking Supervisor not being actually a part of Treasury. I 
think we have seen today that--and we have known for some 
time--Treasury can exercise--try to exercise influence over the 
organizations, and my understanding is that, again, in the 
beginning, the National Banking Supervisor was not a part of 
Treasury and at the last minute it was put back in.
    And I just wonder if one of the things we ought to be 
looking at is absolutely ensuring that this Banking Supervisor 
is not a part of Treasury and even more independent than has 
been laid out, very briefly.
    Mr. Dugan. May I respond to that?
    Senator Corker. Yes.
    Mr. Dugan. This may surprise you, but I was a strong 
advocate of keeping it within the Treasury but subject to the 
same firewalls that we have now, which does give the agency a 
very strong ability to operate independently. I believe that 
making it independent and creating a new board, if you have 
three other regulators still in existence and everybody has got 
boards, I think it will confuse things. It is critical, 
however, that you do have those statutory firewalls that were 
put in place. And that was a position that I advocated.
    Senator Corker. Any differing opinions from the panel?
    Ms. Bair. As an independent agency that does the types of 
supervisory functions that the OCC and OTS perform, we look to 
them to help protect the Deposit Insurance Fund through their 
front line prudential supervision of banks that we insure. So, 
I think there are some merits in making it independent. As an 
independent agency, you do want to make sure it is as insulated 
as possible from any type of influences that might not be 
focused on prudential supervision and the safety and soundness 
of the institution.
    Senator Corker. OK. Thank you.
    Mr. Tarullo, I think I have actually been very supportive 
of our Chairman of the Federal Reserve, differing from some of 
the folks on the panel. And yet at the same time, there is no 
doubt the Federal Reserve had some failings in this last go 
around.
    I read your 2005, the Federal Reserve Service Purposes and 
Function document, and it actually does, just for what it is 
worth, state that one of your responsibilities is maintain the 
stability of the financial system and containing systemic risk 
that may arise in financial markets and providing financial 
services to depository institutions. So I think it is fair to 
say that, in essence, you sort of did have responsibility 
there.
    I am wondering how harboring all of that at the Federal 
Reserve would alter, if you will, behavior. I think all of us 
understand today that we need to be more concerned about 
systemic risk. I am sure the Fed does, too. And again, I say 
this with respect for the organization, but obviously with 
concerns. I am just wondering what would be different if, in 
fact, the Fed was the systemic regulator--the systemic 
regulator.
    Mr. Tarullo. Senator, I don't think there are any proposals 
on the table that would really make the Fed a systemic risk 
regulator in the sense of being able to swoop in anywhere, 
anytime, and say, we want to do something about this. The 
proposal that we have endorsed is making the Federal Reserve 
the consolidated supervisor of systemically important 
institutions.
    I would say in direct response to your question, there is 
certainly a responsibility there, and I would be the first to 
say that responsibilities of all the financial regulators, 
including the Fed, were not exercised as effectively as they 
ought to have been. But I would also say that when you give an 
entity responsibility, you do have to make sure that you give 
it authority to achieve that responsibility, to fulfill it, and 
that you have the mechanisms that will allow it to do the job.
    And when you have a circumstance in which large 
institutions that turned out to be systemically important--I 
think in some cases to the surprise of many--and were not 
within the perimeter of regulation, it was obviously not going 
to be an easy matter to contain the activities of those 
institutions, including a lot of the wholesale funding and a 
lot of the very tightly wound, complex securitization that was 
a major contributor to these problems.
    So I would say, first, you need to make sure that the 
appropriate legal authorities are present. Second, as I have 
often said, there needs to be a reorientation of our regulatory 
approach more generally toward systemic risk. And third, the 
Federal Reserve, I think, needs to take more advantage of the 
comparative abilities that it has. That is why we wanted to 
move forward, to make use of the economic and financial 
expertise to provide a monitoring of and a check upon the on-
the-ground supervisors. That is where the advantages lie and 
that is where we ought to bring them together.
    Senator Corker. Let me just ask one last question. I know 
there are differing thoughts on ``too big to fail,'' but each 
of you feel that that is a big issue, how to deal with that. I 
know that I would like to see a resolution mechanism in place 
where they resolve much like Chairman Bair proposes.
    Mr. Dugan, I don't understand how, if you continue to give 
Treasury the ability to solve the problem with taxpayer money 
if they deem it an important thing to do, I don't understand 
how that creates any market discipline. It seems to me that 
leaving that vague line in place defeats all market discipline. 
I don't understand how you can cause those to measure up or how 
we could craft something that actually worked and caused people 
like the Senator from Ohio's constituents and mine, which I 
think are different in thinking about some things, but I think 
they would agree that that is wrong, and yet you propose 
keeping it in place and I don't understand that.
    Mr. Dugan. I think there are ways that you have to limit 
it. I think there are presumptions so that you make it more 
difficult to exercise. I think there are measures that you have 
to take up front so you don't get yourself in that position.
    My only point, though, is this: when you are in a crisis 
and you need to take action and you need to do it to protect 
the financial stability of the system, I don't think we should 
tie the hands of the Government from being able to do it in a 
moment's notice if we have to. I don't ever want to be in some 
of the weekend situations that I was in last fall, and we did 
have mechanisms that ensured a wide variety of the Government 
was involved in the decisions. People can second-guess some of 
those judgments, but I really do not think it is a good idea to 
completely forbid the ability to address systemic situations 
and crises if we have to.
    Senator Corker. Thank you.
    Chairman Dodd. Thank you very much.
    Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman. Thank you all 
for your testimony.
    I gather from the panel that, in fact, there is a sense 
that beyond maybe what the Administration is proposing, which 
is merging OTS into the OCC, there isn't a view that there 
should be any further regulatory consolidation. So my question 
is, if we don't do that, then there still seems to be the 
opportunity for regulatory arbitrage where the regulated 
companies would choose what they believe to be the most lax 
regulator.
    So what mechanisms can we put in place to prevent that, to 
prevent the shopping? For example, the Administration's 
restrictions that are proposed on the ability of a troubled 
bank to switch charters, is that enough by themselves to 
prevent a regulatory arbitrage that we want? I would like to 
hear some of your ideas on that.
    Mr. Tarullo. Senator, I will start if that is OK. Congress 
has provided some mechanisms to contain regulatory arbitrage. A 
lot of restrictions that apply to national banks are made by 
Congress to apply to State banks if they are going to get 
Federal deposit insurance. That is an important backdrop, 
number one.
    Number two, the provision you just referred to, I think is 
an important one, and it is one on which the agencies have 
already tried to act. Actually I was going to tell the Chairman 
this--we had a break in your hearing in March during which 
Chairman Bair turned to me and said, you know, we have to 
figure out a way to do something about entities trying to get 
different charters when they are under enforcement actions or 
they see an enforcement action coming. And so she launched an 
initiative among the agencies to have us all reaffirm that 
charter conversion ought not to happen unless the institution 
is sound, there are no enforcement actions pending, and it is 
not being used to avoid supervisory ratings.
    A couple of the institutions shifting charters over the 
last several years that have become reasonably well known 
engaged in that sort of flight from enforcement. So I think 
this was a very important gap to plug.
    Senator Menendez. Anything else? Is that enough?
    Mr. Dugan. I think it is very important. We have seen over 
the years, a number of situations in which people have switched 
charters to avoid supervisory action. I totally support the 
action we have taken. If we wanted to go further and put some 
of that in legislative language, I would think that might be a 
very good idea, just to make sure that we don't change it in 
the future.
    Senator Menendez. Chairman Bair.
    Ms. Bair. I would agree with that, and we indicate that in 
our written testimony. We are the insurer. We are not the 
chartering entity. So, once deposit insurance is granted, if 
the entity then decides later to shift charities, we really 
don't have a role in that decision. We particularly feel that 
it is in our interest to ensure good, strong, robust prudential 
supervision. We do not want charter conversions to, in any way, 
be used to undermine that process.
    We would also be happy to work with you. Senator Reed and I 
had a conversation a while back about putting something like 
that in the statute to make sure the provision is there.
    Senator Menendez. Well, I would join Senator Reed in that 
effort.
    Let me ask you, some big banks----
    Mr. Bowman. Senator Menendez, if I could address that 
question----
    Senator Menendez. Surely.
    Mr. Bowman. ----I think one of the charters, which I think 
is being used as an example of an arbitrage opportunity was the 
choice by Countrywide to move from regulation by the OCC and 
the Fed to regulation by the OTS. This was in March of 2007. In 
doing so, Countrywide brought approximately $92 billion in 
assets to the OTS. We undertook a very extensive coordination 
with the Fed, including the Fed Bank of San Francisco, the OCC, 
and others, as well as State regulators of various affiliates 
within the Fed's holding company jurisdiction. We granted the 
charter to Countrywide.
    But one of the facts that seemed to be sort of lost in a 
lot of the discussion is that 3 months or 4 months before 
Countrywide came to the OTS, Citibank took two historic thrift 
charters totaling approximately $232 billion in assets to the 
national bank charter from the Federal thrift charter shortly 
after Countrywide came. Cap One took approximately $17 billion 
in assets from a thrift charter to the OCC.
    I would suggest that the mere action of an entity, a 
business entity choosing to change its charter based upon its 
business plan in and of itself does not necessarily suggest 
that they fleeing a particular set of regulatory structures or 
whatever else.
    Senator Menendez. No, I appreciate that.
    Mr. Bowman. I just wanted to make myself clear on that 
point.
    Senator Menendez. I appreciate that.
    Let me ask the question, several big banks have come here 
and argued before the Committee that we shouldn't have a 
Consumer Financial Protection Agency because it is bad to 
separate safety and soundness regulations from consumer 
protection regulations. But that argue doesn't, at least to 
make, make much sense because safety and soundness regulations 
and consumer protection regulations are currently together in 
the same agencies and that very system failed miserably to 
protect middle-class American consumers.
    So if there is concern about regulators having overlapping 
responsibilities, can't that be solved by assigning clear 
responsibilities to each regulator and creating some solid 
procedures for resolving conflicts among regulators?
    Ms. Bair. On the consumer protection side, rulewriting 
traditionally has been divorced from enforcement, so the FDIC 
and the OCC have no power to write consumer rules. We examine 
and enforce, but we have never had rulewriting authority. That 
is separate already. So I think the bank regulators generally--
I do not want to speak for others--are supportive of this 
because the arbitrage, the choice, if you will, was not so much 
among bank charters, but between being a bank or being a 
nonbank. Mortgage brokers with very little regulation could 
originate loans without anybody looking over their shoulders, 
regarding undocumented income, or regressively marketing 
teaser-rate 2/28s and 3/27s.
    The value added with this new agency is providing rules 
across the board for both banks and nonbanks. And as we have 
all testified, keeping the examination and enforcement function 
with the bank regulators for the banks and having this new 
agency focus its examination and enforcement resources on the 
nonbank sector where there is not much oversight would give 
consumers protection across the board. So, whether they are 
dealing with a bank or a nonbank, they have some baseline level 
of protection and a regulator actually coming in and making 
sure those rules are being enforced and adhered to.
    Does that answer your question?
    Senator Menendez. Yes. Mr. Dugan, do you want to jump in?
    Mr. Dugan. I was just going to say I agree completely with 
everything Sheila just said, and attached to my testimony are 
examples of a number of the ways in which integrated safety and 
soundness and consumer protection supervision has found issues 
for both safety and soundness purposes and for consumer 
protection purposes that otherwise would not have been found 
under the current system. We believe that under the examination 
and supervision system currently in place, bank examiners are 
good at implementing rules that are written, and to the extent 
that a new agency writes strong rules, they will be complied 
with by banks through this function better than any other 
alternative model.
    Senator Menendez. So basically--and, Mr. Chairman, I will 
end on this. My understanding from the panel is that you are 
all in support of a consumer financial protection agency?
    Mr. Tarullo. No, Senator, that is not true. The Federal 
Reserve has not taken a position one way or another on the 
creation of the----
    Senator Menendez. Are you going to take a position?
    Mr. Tarullo. If we were specifically asked, I guess we 
would at least discuss among ourselves. I think our effort to 
this point has been to point out the virtues of integrated 
supervision and regulation of consumer products alongside the 
obvious virtues of a separate agency.
    Senator Menendez. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator Menendez.
    Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    I am very happy to see all of you here today. After you 
kissed the ring of the Secretary of the Treasury, you finally 
got out of the room, and you are here in person to testify, 
independently. It is really nice to see that.
    Mr. Tarullo, I want to go back to something that you said 
earlier. You said that the Fed would like to have the authority 
and the power to enforce. We gave you that 14 years ago--more 
than 14 years ago, actually. Now it is 15 or 16 years ago. And 
you did not write a regulation for 14 years to govern the banks 
that were under your control or the mortgage brokers that were 
under your control. I know you were not at the Fed. That is not 
the problem. The problem is the Fed had the ability to act and 
did not.
    So you might understand some of us not being agreeable to 
giving you more power when you failed in enforcing the power we 
gave you. So just for your information, you can take it back to 
Chairman Bernanke and the rest of the board and say, ``You 
know, it took you, Mr. Bernanke, 2 years after you became 
Chairman to write a regulation on mortgages. And it took 
Chairman Greenspan 12 years not to write it.'' So we are a 
little reluctant to give the Fed new additional authority. I 
just happen to agree with Chairman Bair on when the rubber hits 
the road, they are there to make something happen.
    Now, our panel is trying to figure out how to stop the 
rubber hitting the road--in other words, how to prevent 
systemic risk from becoming too big to fail. That seems to be 
the major problem.
    Senator Corker brought it up earlier today about, you know, 
we really need ideas, because we seem to have failed by not 
giving the authority to the right person or the right person 
not enforcing the authority we gave them.
    So my question to you is: What additional authority do you 
think we should give the Fed?
    Mr. Tarullo. Senator, as you know, I agree, personally--it 
is not a Board position--with you that the Fed took too long to 
use its existing authority to enact consumer protection 
associated with mortgages. I was referring a few moments ago--
and I will elaborate on it now--to the authority to provide 
consolidated supervision for any systemically important 
institution.
    As you know, a year-and-a-half ago, that statement would 
have, in practical terms, meant that a whole set of 
institutions--at that point, the five free-standing investment 
banks--would likely have been brought in by law to the 
consolidate supervision program.
    Because of the financial crisis, and the fact that a couple 
of those institutions are no longer with us and others have 
become bank holding companies, the immediate practical 
importance of the authority would not be as great as it would 
have been a year-and-a-half or 2 years ago. However, there is 
first the possibility that an institution which has become a 
bank holding company in the middle of the crisis, in an effort 
to get the imprimatur of having consolidated supervision, 
would, when things calm down, decide it does not so much like 
being a supervised entity, so it would dis-elect being a 
holding company.
    Senator Bunning. We could prevent that.
    Mr. Tarullo. You could.
    Senator Bunning. Yes.
    Mr. Tarullo. Absolutely. And, second, if in the future 
other institutions grow or activities migrate from the 
regulated sector to other institutions, we would want to make 
sure that any such institution which itself becomes 
systemically important would also be subject to consolidated 
supervision. That is what I referred to earlier.
    Senator Bunning. Sheila, could you expound on the ability 
of the FDIC to preempt, in other words, to get in front of the 
foreclosure or the shutting down of our--in other words, 
looking prior to, with your regulatory regime into banks that 
you have under the FDIC jurisdiction? In other words, 
preventing.
    Ms. Bair. I think Congress gave the FDIC helpful new 
tools--they were finalized in early 2006--to make risk-based 
adjustments to our premiums that we charge for deposit 
insurance, because at least for insured depository 
institutions, this helps us provide economic disincentives to 
high-risk behavior. This is a tool we are using and will 
continue to further refine. But, it has been helpful, I think.
    I think the big problem or the shortcoming that we have 
found is that when these larger entities get into trouble, so 
much of the activity is outside the insured depository 
institution that our traditional resolution mechanism does not 
work. We can only resolve what is in the FDIC-insured 
institution, which is why we believe it would be very helpful 
to us, at the FDIC collectively, to get ahead of this. First of 
all, it would be a strong disincentive. We need more 
regulation, clearly, of these very large institutions, but we 
also need greater market discipline and the certainty that 
investors and creditors will take losses if an institution gets 
in trouble and would have come to the Government for help. They 
will be put into a resolution regime.
    Senator Bunning. Let me ask you this simple question. If an 
entity is listed on an exchange, wouldn't the Securities and 
Exchange Commission have some kind of ability to examine all 
the aspects of that institution? I am looking at AIG, for 
instance.
    Ms. Bair. Well, generally it is the holding company.
    Senator Bunning. Correct. It is the holding company.
    Ms. Bair. It is the holding company, not the bank, that is 
listed. The SEC's regime is focused not on prudential 
supervision but on investor protection through a transparency 
regime. They do not do any kind of safety and soundness 
prudential oversight of listed companies. They are focused more 
on ensuring appropriate financial disclosure for the benefit of 
investors.
    Senator Bunning. Thank you.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you.
    Senator Tester.
    Senator Tester. Thank you, Mr. Chairman, and I thank the 
panelists for being here today. An interesting discussion. I 
think we all agree that the gaps exist. I think we all agree 
that we still have not sealed those gaps up. And so I guess 
referring to the testimony from a gentleman on the second 
panel, a former Comptroller of the Currency, Mr. Ludwig, he 
writes and, in fact, recommends to ``streamline the current 
`alphabet soup' of regulators by creating a single world-class 
financial institution-specific regulator at the Federal level 
while retaining the dual banking system,'' which is very, very 
close to what, quite honestly, I have in mind. And he goes on 
to lay out a system of critiques, and you guys have somewhat 
addressed this in some of your other questions.
    But going back to what Senator Menendez asked in that he 
wanted to know if it could be laid out to seal these gaps by 
rulemaking or some other method, I am not sure I got an answer 
to that question.
    So I want you to share your thoughts as concisely as 
possible, because each one of you could burn 4 minutes and 50 
seconds with one answer if you wanted.
    As to why significant reform in this direction is not the 
direction to go, taking off your hat as your individual 
department leaders--because I know turf does play a role. If 
somebody said, ``I am going to dissolve your farm,'' I would be 
a little upset with it. But just tell me how we can get these 
gaps closed without doing something like this and why this 
would not be a good idea.
    Go ahead, Sheila. We will just go down the line.
    Ms. Bair. Again, I think the issue was not about the choice 
among bank charters. It was between being a bank or not being a 
bank and being much less regulated in the nonbanking sphere. I 
think that is the arbitrage that needs to be addressed.
    Senator Tester. And what you are saying is that could not 
be addressed with one----
    Ms. Bair. No, it would not, because you would just be 
consolidating what we all do for insured depository 
institutions. That would not expand beyond the already heavily 
regulated sector.
    Senator Tester. Could it?
    Ms. Bair. I think with a systemic risk council it could, at 
least for risks that are systemic in nature. You would be able 
to give this new systemic risk council--which would also 
include the SEC and the CFTC--some ability to look across 
systems and to impose prudential requirements regarding capital 
and leverage where needed to mitigate systemic risk. And, yes, 
that would be across all sectors, not just for banks.
    Mr. Dugan. Senator, I believe you could do more 
streamlining. You could move more in the direction you are 
talking about. We do not have an ideal system. But as my 
testimony suggests, there are some issues you are going to have 
to confront if you want to have an effective Federal Deposit 
Insurance Corporation. If you go for long periods without 
having any bank failures, they are not going to have a lot to 
do and will not know the system very well if they do not 
supervise banks.
    Likewise, the Federal Reserve has some things to offer to 
supervision, particularly of the very largest institutions at 
the holding company level that are engaged in a lot of 
nonbanking activities. And to think that a banking supervisor 
would do all of that as well without having the benefit of 
direct supervision raises some questions.
    Senator Tester. OK.
    Mr. Tarullo. Senator, I would say, trying to be succinct, 
the two most important gaps to fill are: first, making sure 
that every systemically important institution does come within 
the perimeter of regulation; and, second, what we were 
discussing earlier, which is to say the assurance that there 
cannot be charter conversions motivated by efforts to escape 
enforcement and escape bad ratings. And just to be clear, I 
think it would be a perfectly good idea for the Congress to 
legislate on that matter so that in the unlikely event that our 
successors did not share the same view, they could not go in 
the opposite direction in which charter conversions could be 
done for the wrong reasons.
    Senator Tester. I understand that, but what you are saying, 
then, a world-class financial institution, a specific regulator 
could work.
    Mr. Tarullo. Well, I actually think, as Sheila suggested 
early in the hearing, that what we have learned in this crisis 
is that there were lots of different models of supervision and 
regulation around the world, and none of them performed 
particularly well. And that seemed to me more of a lesson than 
anything about a particular structure or anything else. None of 
them performed particularly well.
    Senator Tester. OK. Go ahead.
    Mr. Bowman. And I would also pick up on the point, your 
concept is a world-class financial institution regulator. I 
think one of the lessons that we have learned--and Sheila has 
mentioned it a couple times--is that we have banks and nonbanks 
who are providing the same kinds of services in a different 
structure. If you are a financial institution, you do have 
world-class regulators currently. If you do not, you operate in 
a less than regulated or under-regulated environment.
    One of the suggestions I would have is that if you wanted 
to close that gap, there is a process by which you can do that. 
It starts with the CFPA, the Administration's proposal. The 
difficulty is how they carry out, how they enforce the 
regulations. The Administration proposes to use the CFPA as 
that. We suggest as bank regulators we can do it more 
effectively. But that is the start, because then you have to 
start looking at things like capital requirements, capital 
structure for those who are not financial institutions.
    Senator Tester. OK. Currently, have we made any progress, 
and not necessarily--well, I think ``we'' as a general group as 
well--towards regulation of derivatives, credit default swaps, 
those kinds of things? Or are we in the same boat we were in a 
year ago? Same boat, Mr. Bowman?
    Mr. Bowman. Yes. I would say that we are.
    Senator Tester. OK. Everybody agree with that?
    Ms. Bair. Yes, and that does require legislation to fix.
    Senator Tester. Yes. OK. Are we concerned about that?
    Ms. Bair. I am. Yes, I think it is huge.
    Mr. Dugan. I think it is very important.
    Senator Tester. Mr. Chairman, have you gotten any 
recommendations from any of these folks or anybody else on how 
we should be regulating derivatives and credit default swaps?
    Chairman Dodd. What we are trying to do here is fashion, 
obviously, a piece of legislation that comprehensively deals 
with all of this, and the hope is we are going to do that when 
we get back in the fall. That is the purpose of these hearings, 
to bring these ideas together.
    Senator Tester. But has anybody given you any concrete 
ideas or----
    Chairman Dodd. Oh, there have been all sorts of suggestions 
made on how to do it, clearinghouses and so forth. We have got 
a lot of recommendations.
    Senator Tester. Well, I just think it is--as we move 
forward here, I can just real quickly----
    Chairman Dodd. In fact, I would just say, John--and I will 
leave you more time--Senator Reed and Senator Bunning, in fact, 
are working on an idea that--in fact, a number of our 
colleagues here are working on various ideas to be part of the 
larger bill. The Subcommittee is working on it.
    Senator Tester. I think it is good. It is somewhat 
distressing that, quite frankly, from my perspective--and I am 
not an expert in this field at all--we have a lot of people who 
are trying to do good work; but there are still gaps, and 
obvious gaps. And then at the banking level, we have got a 
myriad of regulators out there. Quite frankly, if I was a 
banker, I would be going crazy. I would. I would not know--I 
really would not know which person to be--knowing who I have to 
deal with, let us just put it that way, because we are coming 
at it from a lot of different angles.
    Then, you know, if you take into consideration--I think, 
Sheila, you said this. Community banks were not really a 
problem here, but yet they are getting pressed just as hard as 
anybody, from my perspective, as far as regulation goes. And I 
just think that this is an opportune time in the middle of a 
potential--not a potential--in the middle of a crisis to really 
take a lot at our regulation system and say let us simplify it, 
let us make it lean and mean and simplified. And I do not think 
that can happen unless we are willing to think outside the box 
and do things differently than we have done in the past.
    Thank you all for being here.
    Chairman Dodd. Thank you very much.
    Senator Vitter.
    Senator Vitter. Thank you, Mr. Chairman.
    Ms. Bair, I wanted to ask you a few things that are little 
bit off topic but that are important, and that has to do with 
the recent actions of the Financial Accounting Standards Board 
with regard to bringing certain things that have been off 
balance sheet, on balance sheet, and what impacts that will 
have on institutions.
    How will FDIC treat the consolidation of previously off-
balance-sheet entities? And, in particular, will the agency 
require additional capital for assets that are brought on 
balance sheet?
    Ms. Bair. Well, yes, banks must follow U.S. GAAP. So if 
those are the accounting rules, if more assets are coming on 
balance sheet, capital levels are going to be impacted 
accordingly.
    Though we still have some concerns about the timing of all 
this, we support the general direction of bringing assets back 
on balance sheet. But the timing still gives me some 
heartburn--whether they really need to be on this accelerated 
framework.
    I think it also could be very damaging to efforts to get 
the securitization market back, because the way the rules are 
written now, as I understand, even if you just retain some 
portion of interest, the whole securitization might have to 
come back on balance sheet. That also goes at cross-purposes 
with our efforts to try to get originators to have some skin in 
the game.
    There are a lot of issues and questions we have about the 
timing, but we cannot control that. FASB is not an entity that 
we have any control over. We can file comment letters and that 
is about it. But banks must follow U.S. GAAP.
    Senator Vitter. So are the capital ratios set in law, or 
are they----
    Ms. Bair. Well, yes. Prompt Corrective Action capital 
levels are set by statute, yes. There is not a lot of 
flexibility there.
    Senator Vitter. And so there is no flexibility for any 
phase-in period?
    Ms. Bair. Not very much at all, no.
    Mr. Dugan. Senator, traditionally the leverage ratio 
follows GAAP completely. The risk-based ratio has some 
variations, and at times has been more restrictive than GAAP. 
There also is some flexibility to look at this and phase it in 
over some time. This is an issue all the regulators are looking 
at now to try to address some of the issues that Chairman Bair 
just raised.
    The bottom line is this stuff is coming back on the balance 
sheet. Banks are going to have to hold capital against it. It 
is really a matter of timing and how it gets phased in.
    Senator Vitter. Well, I do not think anybody is arguing 
about the fundamental issue, but I am concerned with timing and 
phase-in because it could have negative consequences if it 
were, you know, here tomorrow overnight. So what is the current 
thinking about how that should be handled?
    Mr. Dugan. I think the regulators are still discussing how 
this affects regulatory capital. The accounting rules become 
effective at the end of this year, beginning of next year, and 
how the regulatory capital rules respond is something that we 
will be discussing and providing some notice to the public 
shortly.
    Senator Vitter. When do you think there will be fairly 
clear guidance for institutions about what to expect and what 
timetable and what phase-in, if you will?
    Mr. Dugan. If I had to guess--and this is an interagency 
process--I would say weeks, not months.
    Senator Vitter. And I assume all of the agencies and 
regulators involved are in discussions about this?
    Mr. Dugan. It is an interagency rule, as capital 
requirements like this always are. So there will be a 
discussion among the agencies.
    Senator Vitter. OK. Does anyone else have any comments 
about that?
    [No response.]
    Senator Vitter. OK. Thank you. That is all I have, Mr. 
Chairman. Thank you.
    Chairman Dodd. Thank you very much, Senator.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    Since Countrywide, was brought up, I just want to make sure 
I have got some facts right. It started off with a national 
bank subsidiary. You regulated the bank, Mr. Dugan, and the Fed 
regulated the holding company?
    Mr. Dugan. That is correct.
    Senator Reed. And under your policy and case law, a 
subsidiary mortgage company, an affiliate mortgage company was 
not subject to California law.
    Mr. Dugan. We regulated the bank, and it did a portion of 
its business inside the bank. It did most of its subprime 
lending outside the bank, not in the bank. The affiliate was 
subject to California law.
    Senator Reed. It was subject to California law.
    Mr. Dugan. Yes, but the bank itself was subject to the 
uniform Federal standards of the National Bank Act, and was not 
subject to California law. They did not do their subprime 
lending that caused a number of problems in the bank.
    Senator Reed. Just to be clear, the subprime lending was in 
an entity that was subject to California law.
    Mr. Dugan. Correct.
    Senator Reed. Attorney General review, everyone else like 
that.
    Mr. Dugan. Correct.
    Senator Reed. The Fed would have responsibility to review 
or inspect that mortgage company as an affiliate.
    Mr. Dugan. At that time, before they switched charters, 
yes.
    Senator Reed. Right. And did they do that, to your 
knowledge? Or what template did they use?
    Mr. Dugan. You would have to ask the Federal Reserve. I 
will say, as in my testimony, that philosophically, 
historically, there has been this anomaly where the bank in a 
holding company gets very heavily inspected and regulated and 
is subject to the most intensive regulation, but the holding 
company affiliates were not subject to the same requirements 
for annual inspections. And that needs to be fixed, and the 
Federal Reserve has recently been doing more in that area, but 
it is not the same, and I believe it should be the same.
    Senator Reed. Let me switch to Mr. Bowman. When Countrywide 
came into your supervision, you were the holding company's 
supervisor, and you were also the bank's--the FSB, I presume.
    Mr. Bowman. Correct.
    Senator Reed. And the company that did the bulk of the 
subprime was a California-regulated mortgage entity.
    Mr. Bowman. There were a number of State-related affiliates 
within the holding company structure. I do not remember how 
many or how many States. I do not remember the percentage of 
California State versus New York versus other States.
    Senator Reed. When you reviewed, your organization reviewed 
and inspected these holding companies, did you notice 
anything--did you inspect them or did you just inspect the FSB?
    Mr. Bowman. We actually did a number of things. We spent a 
lot of time with both the Fed and the OCC, as I mentioned 
earlier, in previewing sort of what it was that was coming our 
way.
    We also convened shortly after granting the charter. Again, 
the charter was granted March of 2007. We convened what I would 
call a ``regulators conference,'' where we invited and, in 
fact, had regulators from many, many States--I do not remember 
the exact number--come in and discuss with us some of their 
particular concerns, if any, related to the operation of the 
affiliates within the holding company structure, including New 
York, California, and others.
    Senator Reed. And did that alert you to any potential 
problems?
    Mr. Bowman. Yes, it started to. Yes, it did, sir.
    Senator Reed. OK. Thank you.
    Let me switch gears. We had a few hearings ago Mr. Meltzer 
and Dr. Rivlin, who have a long-time association with the 
Federal Reserve. And their suggestion was that the Federal 
Reserve essentially get out of the business of supervising and 
regulating entities and concentrate on the issue of the 
monetary policy and perhaps, you know, other issues.
    My question is--and I will let you answer last, Governor. I 
think you have an opinion about this. But to the other 
panelists, if the Federal Reserve following this advice by two 
very knowledgeable people and experienced people, does not 
perform the role as the supervisor for large holding companies, 
who would or should? Do we have to create another entity? What 
is your general comment about that? Then I will conclude with 
the Governor.
    Ms. Bair. The Federal Reserve is the holding company 
supervisor for the vast majority, but not all of the very 
largest institutions. So, yes, I think you would have to create 
a new agency to do it if the Federal Reserve was not doing it.
    Senator Reed. Mr. Dugan, do you have a comment?
    Mr. Dugan. I think you could put the holding company 
supervisor and the bank supervisor in the same entity. That is 
how the OTS works. You could do it. And I think, frankly, for 
smaller institutions and a lot of institutions where the only 
subsidiary of the company is the bank, there is some logic to 
that. But where you have companies, as was talked about 
earlier, where a lot of different businesses were engaged in 
nonbanking kinds of activities, that is where the particular 
expertise of the Fed--because of its closeness to the capital 
markets, its open market operations, its international central 
banking, all of that comes into play. Replicating that would be 
the most difficult challenge for any agency that tried to re-
create it, either separately or inside a prudential supervisor.
    Senator Reed. Mr. Bowman--and quickly, because I have to 
give the Governor some----
    Mr. Bowman. Yes, I would agree with that. We currently 
regulate both the holding company underlying institution. I 
think you could replicate that. The difficulty would be in 
dealing with State-chartered organizations where you did not 
already have a Federal regulator like the OCC or the OTS.
    Senator Reed. Governor Tarullo, your comments, and I might 
just throw in one other issue. If the Fed is the regulator--and 
this is a common concern of all of you--you have to be able to 
sort of work through what is now the deference to functional 
regulators, which I think we have identified as a problem. So 
you might put that into your answer, too, Governor.
    Mr. Tarullo. Thank you, Senator. People are attracted--
particularly once they get out of Government or if they have 
never been in Government--to neat solutions that look great on 
paper. I think that anybody who has dealt with this crisis and, 
indeed, dealt with financial supervision on an ongoing basis, 
will tell you that the whole point about the financial sector 
of our economy is that it reaches everywhere and it affects 
everything.
    And if one is looking to a central bank to perform the dual 
mandate given to it by the Congress of trying to maximize 
employment and achieve price stability, I do not think there is 
any way to do that effectively without paying an awful lot of 
attention to financial stability. And to achieve financial 
stability, one has to have an influence upon the major kinds of 
financial activities in the economy, which are, of course, 
largely though not exclusively being performed by the larger 
institutions. So the interrelationship between monetary policy 
aims and the goals of financial stability really undergird the 
case for our central bank, and central banks around the world, 
being involved in supervision. That is point one.
    Point two, a graphic illustration of what can happen when 
the central bank is not closely involved in supervision was 
observed a couple of years ago in the United Kingdom following 
the decision to have a single financial services authority with 
all supervisory responsibility for all kinds of financial 
institutions. The Bank of England, the central bank, was not 
involved in supervision at all, and when a significant 
financial institution--Northern Rock--failed, the Bank of 
England was not in a position to be able to make judgments 
about the failure of Northern Rock or the ripple effects within 
the system. I think it is for that reason that you have a 
robust debate in the U.K. right now as to whether they need to 
return some supervisory authority to the Bank of England, I 
would assume, to coexist with the Financial Services Authority.
    Now, there have been some proposals to put everything back 
in the Bank of England. I personally would not think that would 
be a particularly good idea.
    You raised the question, and let me just address briefly, 
the issue of ability to get information and to enforce where 
necessary. I think it is important, if you are going to ask an 
entity to perform a role of consolidated supervision, to make 
sure that they have the tools to do so.
    Now, as it happens right now there is--and I have no reason 
to expect there will not be--quite a good relationship between 
the Fed and the Comptroller with respect to banks within 
holding companies. But we need to make sure that some kinds of 
information that are not gathered in bank supervision or, for 
that matter, certainly supervision of other kinds of regulated 
entities--insurance entities or securities entities--can, if 
necessary, be obtained in order to provide the kind of 
supervisory oversight of the whole institution that you are 
asking about or looking for.
    I do not personally anticipate that there is going to be 
much utilization of such an authority, but I think you do have 
to have that kind of back-up.
    Senator Reed. I have gone way over my time and I----
    Mr. Dugan. Just very quickly----
    Senator Reed. I am abusing the----
    Mr. Dugan. Just if I could very quickly respond, just to 
that last point. On the functional regulator point, it may go 
too far the way it is now, but the way the Administration has 
proposed it has pushed it too far in the other direction so 
that you could override the authority of the primary supervisor 
and that is too much.
    Senator Reed. Pointed noted. Thank you, my colleagues.
    Chairman Dodd. Thank you.
    Senator Martinez.
    Senator Martinez. Thank you, Mr. Chairman.
    Good morning to all of you and thank you for being here. I 
want to ask a question about the proposal of the Administration 
regarding the elimination of restrictions to interstate banking 
for national and State banks. I know that a lot of community 
bankers in Florida would be greatly concerned about that and I 
wonder if aggressive branching didn't contribute to excessive 
risk taking in a desire to increase market share, which, in 
fact, may have had a lot to do with a lot of the problems we 
have seen lately.
    So would a limit on branch banking, how would it change the 
competitive landscape? Madam Chair?
    Ms. Bair. Senator, the FDIC has not taken a position on 
that particular provision. I do know that there are several 
community bankers that are concerned about it, but I am sorry, 
we don't have a corporate position on it.
    Senator Martinez. Does anyone else care to comment?
    Mr. Dugan. I do not think it would be a good idea to 
reimpose limits on interstate branching. Right now, there are 
some limits left on the first branch into a State. But 
basically, the decades-long restrictions gradually evolved over 
the years to permit interstate branching and I think it did 
permit more diversification geographically which was helpful in 
some circumstances. I personally would not be in favor of 
further limits.
    Senator Martinez. Any other thoughts on the matter? I 
guess----
    Mr. Tarullo. I would just say, Senator, that you alluded to 
circumstances in which interstate operations became a problem, 
and I think that can be the case. But that is where it is 
important to focus upon the business model of the entity in 
question. It ought not to be allowed to engage in unsafe and 
unsound practices, whether they involve excessive branching 
that is unsupported by a sound business plan or other 
practices.
    Mr. Bowman. I would just simply point out the fact that 
thrifts do currently enjoy the ability to branch interstate 
without restriction, and in terms of the impact upon the 
community banks, my impression has been that that privilege 
that thrifts currently enjoy has had some impact, but I am not 
certain how great.
    Senator Martinez. My colleague from Montana brought up the 
testimony that we have in writing from Mr. Ludwig, and I wanted 
to go into another area of his testimony that I found very 
interesting. He makes the point, and I am sure he could make it 
much better than I if he were making it, which he may get a 
chance to do later, but that he would suggest avoiding a two-
tier regulatory system that elevates the largest ``too-big-to-
fail'' institutions over smaller institutions, and he makes the 
point that perhaps there would be also two-tier regulators, the 
best regulators in one system, the others in another, and so 
anyway, he would urge not to create a ``too-big-to-fail'' 
category because it would, in fact, be contrary to what he 
thinks would be the best interest of not creating a bias in the 
system that would be in favor of those institutions considered 
too big to fail at the expense of those that were not viewed 
too big to fail. Again, could I just get a comment from each of 
you on that.
    Ms. Bair. Well, I think there are a couple of questions 
there. One is whether there should be so-called ``Tier 1'' 
entities that are officially designated as too-big-to-fail, 
regardless of who regulates them. There may be some combination 
of OCC and Federal Reserve Board oversight. And second, 
whether, as part of regulatory consolidation, you want to have 
a regulator based on size as opposed to charter.
    I think on the former, we have some concerns about 
designating institutions formally as Tier 1. I think you can 
probably say who is not, based on asset size--who may not be 
systemic. But I think to have a clear line of who is 
systemically important, does contribute to moral hazard. 
Especially if you don't have a resolution mechanism, it would 
be quite problematic. But I do believe the assumption is to 
have stronger capital and leverage constraints for those very 
large institutions than for the smaller institutions.
    In terms of bank regulation, unlike consolidated holding 
company supervision, I think you should maintain a Federal 
charter and a State charter. That generally breaks out along 
size lines, but not always. We have some fairly large State-
chartered entities. The OCC has many community banks, as well. 
But the charter choice, I think, is good to maintain--not 
different regulatory policies, but policies that are perhaps 
more reflective of local conditions. With State charters, I 
think having some sensitivity and more immediacy of being able 
to deal with a State-level banking supervisor is helpful. So I 
would maintain regulation based on State or Federal chartering 
as opposed to employing size limitations.
    Senator Martinez. I know we have a vote and I don't know 
how much time we have left, so I will leave it at that, Mr. 
Chairman.
    Chairman Dodd. Thank you very much, Senator.
    Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair.
    I wanted to start by asking, Governor, it is my 
understanding that some of the problems at Citigroup and other 
major institutions resulted from moving risky activities back 
and forth between the holding company and the national bank to 
minimize supervision. So my question is whether by creating a 
similar structure, but instead of the Fed and the OCC it would 
be the Fed and the NBS, National Bank Supervisor, whether we 
are creating the same risk in the new system of moving 
activities back and forth.
    Mr. Tarullo. Senator, I think under any approach, you must 
have a common set of requirements across the system which 
minimize the opportunities for regulatory arbitrage. That means 
within institutions, and it also means between regulated 
institutions and nonregulated institutions.
    I would say, without talking about any specific 
institution, there certainly were circumstances in which 
institutions may have taken advantage of different applicable 
capital requirements, or of bundling things in one form and 
moving them around the entity and that part of what needs to be 
done is to take regulatory steps that minimize those 
opportunities.
    Senator Vitter was asking earlier about bringing off-
balance sheet assets back onto the balance sheet. That is one 
way to combat regulatory arbitrage.
    Senator Merkley. Well, let me just ask this. Do you think 
it would make more sense to have the holding companies and the 
banks under the same regulatory agency?
    Mr. Tarullo. I don't, actually. Now, with respect to 
smaller holding companies, particularly those that have only a 
bank--it is basically a shell and there is a bank, there are no 
other entities--the amount of additional holding company 
supervision is actually quite modest. As the bank holding 
company picks up additional activities--if it does any of its 
own capital raising, if it has even a small additional 
subsidiary, if it does some management at the holding company 
level--that is when an independent scrutiny of those activities 
seems to me valuable.
    As you get to an even bigger institution, an even more 
complex institution, it does seem as though the task becomes 
more specialized because you are now looking not just at 
immediate impacts on the bank--although that is important 
because we want to protect the deposit insurance fund--you now, 
as we have learned in this crisis, also need to examine how the 
whole entity, can be creating risk in and of itself. That 
involves different kinds of activities, different kinds of 
regulated entities that are, as you say, moving things back and 
forth or acting in parallel, and that is where I think you do 
need a different approach which looks at the holding company as 
an integrated whole, supplementing and complementing the 
rigorous functional regulation that takes place in the 
subsidiaries.
    Senator Merkley. Yes. Please be very quick, because I want 
to get in my second question.
    Mr. Dugan. OK, I will. I would say the one area, as I 
mentioned earlier. I do think there are times where there are 
activities going on in the bank and the holding company that 
are the same types of activities but they are subject to 
different levels of supervision. We ought to try to fix that.
    Ms. Bair. I would just say two things. We have suggested in 
prior testimony that large institutions have their own 
resolution plans so that they could be liquidated very quickly 
if they got into trouble and that a key to this would be 
greater legal separateness of the insured depository 
institution and what is in the insured depository institution 
versus what is not. Our resolution process is very complicated 
now with these large institutions because of the 
interrelationships between the bank and the nonbank activities. 
It is hard--you are right--to sometimes tell the difference.
    There is a provision called 23(a), which is designed to 
protect banks from being used as sources of strength for the 
holding company. We are consulted by the Federal Reserve Board 
regarding requests for exceptions to the 23(a) restrictions. 
However, the Fed has the sole authority to approve these 
requests that can move more higher-risk assets into banks where 
they are funded with insured deposits. So in terms of an 
incremental step, and I think that this is no surprise to the 
Federal Reserve Board, we would very much like to have a 
statutory role in the 23(a) approval process because this does 
increase our exposure.
    Chairman Dodd. Let me interrupt here. I want to make sure I 
get Senator Bennett in before the vote.
    Senator Merkley. Not at all, Mr. Chairman.
    Chairman Dodd. I thank you very much, Senator Merkley. We 
will leave the record open for further questions, by the way, 
for all of you.
    Senator Bennett.
    Senator Bennett. Thank you very much. Probably, given the 
time, this will be more of a statement that you can ponder than 
questions that I want answers to, but I would like to get some 
answers later on.
    It will come as no surprise that I want to talk about ILCs, 
and no one has discussed the ILC charter in their written 
testimony. Let us point out that the growth of ILCs over the 
last 20 years has been one of the great successes in the 
financial services markets. They are the best capitalized and 
safest banks in the country. They were in no part a contributor 
to the financial crisis. They provide credit in places that it 
has not been available before, niche markets, a diverse set of 
products, and the Administration's proposal says, let us 
eliminate them.
    Now, I find that incredible, that something--we talk about 
Conseco, Lehman Brothers, CIT. All had ILCs, and as they were 
wound down, the ILCs were the assets that were the crown 
jewels. The ILCs were the assets that had the most value. And 
yet the proposal is, let us eliminate them. Let us eliminate 
the charter.
    Now, Mr. Tarullo, you made a comment that the center of 
this crisis is too big to fail and much of this discussion has 
been in that area of ``too big to fail.'' May I respectfully 
suggest that the center of the crisis is not ``too big to 
fail.'' ``Too big to fail'' is a manifestation that came out of 
the center of the crisis, and to put it in my very much 
layman's terms, the crisis was caused because of this game of 
musical chairs with respect to risk. And we built more and more 
risk into the system because while the music was playing, more 
and more institutions passed the risk on to somebody else 
thinking, to use the phrase that Sheila used, I have no skin in 
this game anymore, this game being this particular instrument.
    And you go with the change. It starts with the borrower. He 
has no risk whatsoever because there is no equity in the house. 
He is getting a 100 percent loan. Sometimes it is a liar loan. 
The broker who arranges the loan has no risk in the game 
because he passes it on to the lender. The lender has no risk 
in the game because he passes it on to the GSE. The GSE has no 
risk because with the rating agency that has no risk has rated 
it, and he can pass it on, securitize it, to somebody else. And 
at every step in the way, in the path, somebody makes money, on 
a fee, on a commission, whatever it might be. And when the 
music stops, it turns out that everybody had risk in the game 
because the whole thing collapses.
    And I would like to know a regulator who can focus on that 
question, not how big you are, but where are you in this chain 
of musical passing on of risk, musical chairs, if you will, 
that says somebody can say, no more loans in the beginning. No 
more liar loans. To brokers, no, you can't pass this on. You 
have to have some kind of a risk if you get involved in 
brokering this loan so you will then by market pressure do your 
job better to see to it that you don't pass it on. To the 
lender, you maintain some kind of risk as the chain goes 
forward. The GSE, you maintain some kind of risk. The rating 
agencies, you will get a risk.
    But no one had any risk and the bubble, therefore, grew and 
grew and grew because everybody was making money with no 
exposure. And that is the problem that I want to solve with 
this restructuring rather than working around some of the turf 
battles that we have talked about.
    Now I will go save the republic and you can respond to 
Chairman Warner.
    [Laughter.]
    Senator Warner [presiding]. Does anybody want to respond?
    Mr. Tarullo. I would just say a word, Senator, since this 
will be recorded. I actually agree with everything Senator 
Bennett said, except I think too-big-to-fail actually plays 
exactly into the narrative that he gave us. He was talking 
about the GSEs which were the biggest institutions of all that 
in the end were regarded ``too big to fail?'' It was the GSEs. 
It is not the only problem, but I think it is a very important 
problem.
    I should be careful about speaking for people on the panel, 
but certainly making sure that risks are properly assessed by 
entities--and I would add, making sure that compensation 
systems and entities accurately reflect the risk that employees 
are assuming--are important pieces of a reform package.
    Ms. Bair. I will just say, speaking for myself, I would 
agree that I don't to eliminate the ability to choose a State 
charter instead of a Federal charter, including an ILC charter. 
We don't think this was a driver or a contributor to this 
crisis. We were unaware that the Administration was going to 
propose that. But again, speaking for myself, I don't see that 
the ILCs were in any significant way involved in what was going 
on.
    Senator Warner. Thank you. Let me go ahead and ask my 
question and then I will call on Senator Schumer. Thank you, 
Senator Schumer.
    I want to go back to where Chairman Dodd started and 
Senator Tester went with his direction. I am still struggling 
with this question of whether we do a single end-to-end 
depository regulator. I think some of you all have raised some 
legitimate concerns. I know folks on the second panel will 
perhaps have a different view. Paul Volcker has got a different 
view. Past chairs have had a different view.
    I think, Chairman Bair, your point was valid. How do you 
make sure that you don't infringe upon your insurance function? 
I do think you could achieve that by having backup authority 
and your ability to continue to go in and check particularly 
those institutions that got into trouble, to check on your 
ongoing role both as an insurer and what Senator Corker and I 
have talked about, an expanded resolution authority. I also 
tend to think that the notion of an enhanced Systemic Risk 
Council that would include the Fed, that would include the 
Treasury, that would include the FDIC and this end-to-end bank 
regulator as well as the SEC and others would give you that 
ability to have those variety of voices heard.
    And I would also just want to raise one other point that we 
have talked a lot this morning about, the chartering and the 
ability to change charters, and perhaps prohibiting that. I 
think you all have raised appropriately those questions. But 
since each of your organizations have had a licensing division, 
there is also the question of a selection of a charter when you 
start an institution.
    I guess my first question would be, having that very nature 
of that choice at the beginning, not switching midstream, but 
that selection choice at the beginning, doesn't that create 
regulatory arbitrage? Don't you by default find out who is 
going to offer you the best deal on the front end and go to 
that, within your respective agencies, that licensing 
operation? Doesn't that create the arbitrage issue?
    Mr. Tarullo. Well, first, Senator, Sheila and I don't have 
any authority to charter institutions. The banks we supervise 
are State chartered.
    I would say, though, that--and she can respond to this 
better than I--because we have similar regulatory 
requirements----
    Senator Warner. If we could do it fairly quickly, because I 
do have another question I want to ask----
    Mr. Tarullo. Sure. Some of the regulatory requirements are 
for all institutions and the FDIC has to decide whether to 
grant insurance to each depository institution, no matter by 
whom chartered, that wants to be insured. There is a way to 
contain that kind of arbitrage while permitting the useful, 
innovative kinds of experimentation that States have engaged 
in, such as allowing creation of NOW accounts, for example.
    Senator Warner. Mr. Dugan, Mr. Bowman, do you want to----
    Mr. Dugan. I would agree. We do have a licensing function 
and I would just say that just because you have a choice when 
you begin operating, it is not necessarily arbitrage. There are 
differences that go along with the charters in terms of what 
banks can do and how they can do it, and some prefer to have 
local, State Government regulation even though we have local 
examiners on the ground. There is a choice, but the FDIC does 
grant deposit insurance to all of them.
    I don't think that is where the arbitrage issue that we 
have confronted most has been. It has been after banks have 
been in operation where someone is facing a problem and they 
seek to change their charter to avoid a downgrade or an 
enforcement action. That is the thing that I think troubles all 
of us a great deal.
    Senator Warner. Mr. Bowman.
    Mr. Bowman. Yes, I would agree with that. I mean, in terms 
of people choosing a charter at the outset, the thrift charter 
is somewhat unique in terms of some of the limitations that are 
placed upon the kinds of business that an entity would want to 
engage in. Our thought is that people choose a charter based 
upon their business plan.
    In terms of others who are attempting to switch charters 
because of some perceived favorable difference between, say, a 
State charter and a Federal charter, within the State charters 
you have got 50 to choose from, or 52 to choose from. The 
Federal charter, you have two, the Federal thrift charter and 
the national bank charter. Anyone who is looking to avoid or 
evade some kind of supervisory action or enforcement action, I 
think as we have talked about here, we as a collective group, 
interagency basis, have tried to take steps to avoid that from 
happening or to slow it down, to make sure that it doesn't 
happen for the wrong reasons.
    Senator Warner. One common theme from all of you has been--
and I think accurately--reflecting that a great deal of the 
source of the crisis has come from the nonbank financial 
sector. Another issue I am struggling with and would like to 
get all of your comments on is, assume whichever way, 
consolidating a single entity or maintaining the current 
structure, how do we get our arms around this nonbank financial 
arena? Clearly, one approach the Administration has talked 
about is on the consumer end, the consumer product end, looking 
at specific financial products coming from this array of 
institutions. Another is that if they kind of bump up to the 
level of becoming systemically risky, the Council, or in the 
Administration's proposal the Fed would have oversight.
    What I am not clear on is should these nonbank--this 
nonbank financial sector have some level of day-to-day 
prudential regulation, and I have not seen anybody propose 
where that--one, is it needed, and two, where that day-to-day 
prudential regulation in terms of safety and soundness would 
land. Comments?
    Ms. Bair. You have prudential supervision of banks because 
of deposit insurance and other vehicles as part of the safety 
net. With the nonbanks, you do not have that. They are not 
federally insured.
    Senator Warner. Should you have some?
    Ms. Bair. I don't think you need to. I don't think you need 
to go that far. I think the consumer abuses for the smaller 
entities were really more of a significant driver, the lax 
underwriting which then spilled over into the larger 
institutions because of the competitive situation it created.
    But no, I don't think you do. I think if you have the 
ability to impose prudential requirements on systemic 
institutions or systemic practices, then I don't think you need 
institutional----
    Senator Warner. So the Council up here for systemic and the 
consumer down here, but no need for----
    Ms. Bair. Yes.
    Mr. Dugan. I generally think that is a daunting challenge 
to regulate the hundreds of thousands of different financial 
providers all on a safety and soundness basis. But I think the 
Administration would do so and have the authority to do so for 
consumer protection, as you suggested. It doesn't get at what 
really is, and was, a fundamental issue. To the extent they 
engage in very banklike functions and there is a safety and 
soundness issue, like an underwriting standard or downpayment 
requirements, I would argue that is not really a consumer 
protection function in its traditional sense----
    Senator Warner. It almost goes to some of the comments 
Senator Bennett was making about making sure you have got skin 
in the game----
    Mr. Dugan. Yes. That is the consumer having skin in the 
game. But my point is, part of the mortgage legislation that 
passed the House last year had some common standards that I 
would say are prudential standards that apply. I think that 
would have been helpful for mortgage providers, but not 
necessarily all financial providers. So I think there may be 
some instances where some of that is warranted.
    Senator Warner. But wouldn't Senator Bennett's approach, 
that if you originated a product, then you have to keep it in 
there, that is not so much just protecting the consumer, but it 
may be also protecting this--putting some requirements of 
safety and soundness on the institution----
    Mr. Dugan. Absolutely.
    Senator Warner. ----quasi-prudential.
    Mr. Dugan. Absolutely.
    Mr. Tarullo. Senator, I would say a couple of things. 
First, I do think that the question of where regulation stops, 
how broadly the perimeter is cast, is an important one going 
forward. We know that we are not going to have the same 
problems as we had a few years ago. There are going to be new 
problems, and that, I think, is what everybody is addressing. 
How do we stop it?
    I would have thought that one of the important roles of a 
Council, of some sort of an interagency council, is precisely 
to attend to issues that don't seem under anybody's regulatory 
umbrella at that particular moment. If----
    Senator Warner. Beyond just being whether they are 
systemically risky, down to----
    Mr. Tarullo. Well, I think you point out the problem. You 
have systemically risky institutions addressed, you have 
regulated institutions that are already regulated, and then you 
have consumer. But if you have a practice which is troublesome, 
then there ought to be a mechanism for somebody to be making an 
evaluation of that practice. And then perhaps if the Council 
saw that one of its members had authority to regulate, it could 
suggest it. Congress could also think about giving some sort of 
default or back-up authority to the Council in the event that 
no one had----
    Senator Warner. Very quickly, because the senior Senator 
from New York is anxious.
    Mr. Bowman. I think, Senator, that you really have hit the 
nub of the issue, which is the ability to regulate or somehow 
oversee this group in between the Council and the CFPA. Trust 
me that whatever scheme might be brought up or passed into 
legislation, there are very, very creative people out there who 
are going to look at that legislation, the regulations that are 
drafted by it and they are going to find a way to get around 
it, whether it is at the State level, the Federal level, 
whatever else.
    People create businesses every day. They have a business 
model of where they want to engage in a particular activity. I 
think the preference for a lot of people is to engage in a 
particular activity with a minimum of regulation attached to 
it. So it is a very, very difficult issue.
    Senator Warner. Senator Schumer.
    Senator Schumer. Thank you, Mr. Chairman.
    I want to thank all of you for being here, very important 
subject. We have all gathered here today with one common goal, 
to make our financial regulatory system strong enough to 
prevent another severe financial crisis from happening. And I 
have read the written testimony. If I were in your shoes, I 
would probably make the same arguments. But some might argue 
there is a bit of turf protection here. That is natural, but it 
shouldn't be the dominant consideration as we move forward.
    Mr. Bowman, in all due respect, almost everyone regards the 
OTS as having failed in its responsibilities. We have seen 
institution after institution after institution poorly 
regulated, and you are saying, keep the OTS. So I think even 
though, probably again, if I were sitting where you were, with 
hard-working men and women working for you, I would say, keep 
my agency, keep all the powers, don't do any consolidation, I 
think we in the Committee have to see the testimony as coming 
from at least partially that perspective.
    So I would ask you this. There are reasons for one strong, 
powerful, efficient regulator, and I think people who are 
objective, who don't have any turf considerations, when they 
look up from on high, tend to think that should happen in the 
banking area. There is more discussion in the Systemic Risk 
Regulator. I think there is a good argument that the insurer 
should be separate from the regulator because there are 
different concerns.
    So let me ask you this, though, all of you. Here are four 
arguments for a consolidated regulator. One is that a 
consolidated regulator would prevent charter shopping, so a 
bank can't flip its charter and pick up its own regulator--
Countrywide did that, remember that, Mr. Bowman?
    A hodgepodge of different regulators adds to conflicts in 
regulation and creates confusing burdens for the banks. We have 
all heard from institutions who were told one thing by one 
regulator and another thing by another regulator, each of whom 
has authority.
    Third, a single regulator could keep better tabs of 
industry-wide risks, dangers, and developments. That is pretty 
apparent.
    And fourth, a single consolidated regulator can eliminate 
agency and regulatory arbitrage and gaps, and no bank could 
escape from being held accountable for violations or poor 
practices.
    So my question to you is, do you disagree that one 
consolidated regulator would avoid these four problems, or have 
these four benefits, even if you think other mechanisms might 
be better for other reasons? Who wants to go first?
    Mr. Tarullo. I will start, Senator.
    Senator Schumer. Thank you.
    Mr. Tarullo. I would say that each of the four things you 
mentioned is an important aim. Some of them, like avoiding 
charter conversion arbitrage, can be addressed short of a 
single regulator. That is one thing that the four of us at this 
table have tried to do already.
    The only thing I would add to what you say is there are 
also some costs to going the single regulator route. So one of 
the costs is that the Fed, for example, loses some insight into 
how banks are actually functioning, how they are moving money, 
why the volatility of money is what it is.
    I think, also, another potential cost is you have a single 
all-encompassing regulator and sometimes it loses perspective 
because it is the only game in town----
    Senator Schumer. Right. Look, I wouldn't deny there are 
arguments on the other side, but you would agree that these 
four arguments make some sense for a consolidated regulator?
    Mr. Tarullo. Right. I think a couple of them are stronger 
than others, but yes.
    Senator Schumer. Mr. Dugan is shaking his head. You agree?
    Mr. Dugan. Yes, I would agree with that. Those benefits are 
definitely there and real, I think. This is the right equation. 
You have to ask, what are the costs, and again, I think there 
are certain things that the Federal Reserve brings to the table 
in terms of closeness to the markets and expertise from the 
open market operations that would be difficult, but not 
impossible, to replicate, but that are real, and you have to 
consider that.
    And second, as I have mentioned earlier with my colleague 
for the FDIC, it is hard to be----
    Senator Schumer. Yes.
    Mr. Dugan. ----good at it if you are not doing it all the 
time, and so you have to take those things into account.
    Senator Schumer. Ms. Bair.
    Ms. Bair. Yes. I think on the monitoring, if you look at 
the jurisdictions that had a single regulator, they really 
weren't any better. If you have a single monopoly regulator, 
that can contribute to regulatory laxity as opposed to having 
competition among regulators.
    Also, regarding regulatory arbitrage it is not just a 
matter of picking bank charters. If you don't include 
securities firms, derivatives dealers, hedge funds, and 
insurance companies, you still have the ability to choose a 
business model, on a legal model that would fall outside of the 
existing regulatory regime. So unless you include all of the 
various types of financial firms, I think you are going to 
still have some degree of arbitrage.
    Senator Schumer. Right. Mr. Bowman.
    Mr. Bowman. Yes, Senator Schumer. I would agree that the 
single form of regulator really hasn't proven to be any more 
effective in terms of what we have now. And I would also be 
remiss to point if I did not point out that since 2008, 79 
financial institutions, State chartered financial institutions 
have failed----
    Senator Schumer. Yes.
    Mr. Bowman. ----15 national banks, and 11 thrifts. I think 
I also need to point out that OTS chartered Countrywide in 
March of 2007. We had the market impact in August of 2007, and 
5 months later, Countrywide was sold to Bank of America. The 
ability of we as the regulator to impact the events at 
Countrywide in a 10-month period was very, very limited.
    Senator Schumer. OK. I have another question if I might, 
Mr. Chairman, and this relates to the point Mr. Bowman just 
made. As you said, 54 out of the 69 banks that have failed this 
year were State chartered banks. This one thing, I mean, I 
guess it is a historical anomaly, but why the Fed supervises 
State chartered banks and Mr. Dugan supervises federally 
chartered banks. I mean, when I first got to the Banking 
Committee in 1981, I didn't understand that. It just sort of 
happened, I guess.
    And so let me ask both, first Mr. Tarullo, it is true that 
most of this year's failed banks were not regulated by the 
national supervisor, the OCC, or the national thrift 
supervisor, OTS. Explain to me--and then Ms. Bair could answer, 
as well--could you explain to me why the FDIC and the Fed 
should keep State chartered banking supervision, particularly 
if we are giving the Fed more responsibilities in other areas? 
If you think those functions should be kept apart from the 
proposed National Bank Supervisor, why shouldn't we at the very 
least merge FDIC and Fed supervision of the State chartered 
banks, if you are not going to have the same supervisor? Mr. 
Tarullo.
    Senator Warner. Excuse me. Could I just, Senator Schumer, 
just ask the panel all to try to answer quickly because we do 
want to try to get the second panel, at least get their 
statements in.
    Senator Schumer. You know what, I will ask unanimous 
consent that each panelist be asked to answer that question in 
writing, because I didn't realize we had a second panel and I 
was the last one here. Thanks.
    [Pause.]
    Senator Warner. It looks like we are going to have to 
reschedule the second panel, so I am anxious for you all to 
respond to Senator Schumer's question.
    Senator Schumer. Mr. Chairman, I am deeply grateful.
    [Laughter.]
    Mr. Tarullo. Senator, I would start by saying, as you 
noted, the national banks would be supervised by the OCC as 
well as chartered. State banks that are members of the Federal 
Reserve System are supervised by the Fed as their Federal 
supervisors, and if they are nonmember banks, then their 
primary Federal regulator is the FDIC.
    I think that there are two answers to the question. One is, 
as you suggest, history. The Comptroller was started in 1863 to 
create a new national charter and we have had a dual banking 
system ever since. I think there is probably some concern on 
the part of State Banking Commissioners that they not have as 
their overseer at the Federal level the same entity that 
charters national banks----
    Senator Schumer. That is a little bit of what we would say 
in Brooklyn is turf.
    [Laughter.]
    Mr. Tarullo. It is, there is no question. But I think their 
concern is, Senator, whether or not there would be the same 
kind of treatment of national and State chartered institutions.
    Second, the question is, are there gains from having the 
FDIC and the Fed supervising banks as well as performing their 
other functions, and I would suggest that there are.
    Ms. Bair. I would want to comment on the previous statement 
that 54 of the 69 banks were State-chartered. There are a lot 
more State-chartered banks, and a lot of these are very, very 
small institutions.
    Senator Schumer. A lot of the biggest failures were under 
not Mr. Bowman, I don't blame him, but his predecessor's watch.
    Ms. Bair. We also have provided a lot of support for the 
larger institutions, as well, on an open bank basis. So I think 
that all needs to be taken into account. I do think--Senator, I 
know it is confusing that we have these multiple regulators and 
it is frustrating because it is hard to explain to the public. 
On the other hand, as a deposit insurer, we find it extremely 
helpful to have people on the ground in banks all the time. It 
helps us a lot. It gives us a window into seeing what is going 
on in banking, what emerging risks there might be.
    You are right, we could perhaps pick some of that up 
through a backup supervisory process, but I think if we were 
going to shift to that model, give up primary regulation of 
State chartered banks and go up just to that, we would have to 
be much more robust and on-site with our backup examination to 
keep those data points continually into our risk assessment of 
what our risks are. So that would, in turn, add to regulatory 
burden.
    So I think that supervisor perspective we get by regulating 
State-chartered banks is very helpful to us in our insurance 
function.
    Mr. Bowman. Senator, if I could just add to the confusion, 
as you know, the OTS is the back-up regulator for State 
chartered savings associations, so you have a Federal regulator 
regulating the same charter at the State level.
    Senator Warner. I would like to thank the panel for a very 
interesting morning and one that has been very helpful, I know, 
to all the Members.
    I want to also apologize to the next panel, Mr. Ludwig, Mr. 
Carnell, and Mr. Baily. I understand staff will be back to you 
about rescheduling. We do want to hear your views. I know some 
of the second panel views perhaps were more sympathetic to the 
single end-to-end depository regulator and we want to make sure 
we get those views on the record and get a chance to press 
questions, as well. But thank you very much of the first panel 
and we will reschedule the second.
    The hearing is adjourned.
    [Whereupon, at 11:11 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
               PREPARED STATEMENT OF SENATOR TIM JOHNSON
    Thank you Chairman Dodd for holding today's hearing. As we all 
know, the regulatory structure overseeing U.S. financial markets has 
proven unable to keep pace with innovative, but risky, financial 
products; this has had disastrous consequences. Congress is now faced 
with the task of looking at the role and effectiveness of the current 
regulators and fashioning a more responsive system.
    To date, it appears one of the Committee's biggest challenges will 
be to create legislation that better protects consumers. I very much 
look forward to hearing from today's panels of current and former 
regulators to see if they believe a new agency is needed to better 
protect consumers, or if consumer protection should remain a function 
of the prudential regulator.
    I am also interested in hearing from the regulators their views on 
ways to make the regulatory system more effective. For example, does it 
make sense to eliminate any of the bank charters to streamline the 
system? Last, I would also like to know from the witnesses if they 
believe the regulatory gaps that caused our current crisis would be 
filled by the Administration's regulatory restructuring proposal. We 
must get this right, and the proposal we craft must target the most 
pressing problems in our financial regulatory system.
    As this Committee works through many issues to fashion what I hope 
will be a bipartisan proposal that creates an updated system of good, 
effective regulations that balance consumer protection and allow for 
sustainable economic growth, I will continue to advocate for increases 
in transparency, accountability, and consumer protection.
                                 ______
                                 
                PREPARED STATEMENT OF SENATOR JACK REED
    Today's hearing addresses a critical part of this Committee's work 
to modernize the financial regulatory system--strengthening regulatory 
oversight of the safety and soundness of banks, thrifts, and holding 
companies. These institutions are the engine of our economy, providing 
loans to small businesses and helping families buy homes and cars, and 
save for retirement. But in recent years, an outdated regulatory 
structure, poor supervision, and misaligned incentives have caused 
great turmoil and uncertainty in our financial markets.
    Bank regulators failed to use the authority they had to mitigate 
the financial crisis. In particular, they failed to appreciate and take 
action to address risks in the subprime mortgage market, and they 
failed to implement robust capital requirements that would have helped 
soften the impact of the recession on millions of Americans. Regulators 
such as the Federal Reserve also failed to use their rulemaking 
authority to ban abusive lending practices until it was much too late. 
I will work with my colleagues to ensure that any changes to the 
financial system are focused on these failings in order to prevent them 
from reoccurring (including by enhancing capital, liquidity, and risk 
management requirements).
    Just as importantly, however, we have to reform a fragmented and 
inefficient regulatory structure for prudential oversight. Today we 
have an inefficient system of five Federal regulators and State 
regulators that share prudential oversight of banks, thrifts, and 
holding companies. This oversight has fallen short in many significant 
ways. We can no longer ignore the overwhelming evidence that our system 
has led to problematic charter shopping among institutions looking to 
find the most lenient regulator, and has allowed critical market 
activities to go virtually unregulated.
    Regulators under the existing system acted too slowly to stem the 
risks in the subprime mortgage market, in large part because of the 
need to coordinate a response among so many supervisors. The Federal 
Reserve itself has acknowledged that the different regulatory and 
supervisory regimes for lending institutions and mortgage brokers made 
monitoring such institutions difficult for both regulators and 
investors.
    It is time to reduce the number of agencies that share 
responsibility for bank oversight. I support the Administration's plan 
to merge the Office of the Comptroller of the Currency and the Office 
of Thrift Supervision, but I think we should also seriously consider 
consolidating all Federal prudential bank and holding company 
oversight. Right now, a typical large holding company is overseen by 
the Federal Reserve or the Office of Thrift Supervision at the holding 
company level, and then the banks and thrifts within the company can be 
overseen by the Office of the Comptroller of the Currency, the Federal 
Deposit Insurance Corporation, and often many others.
    Creating a new consolidated prudential regulator would bring all 
such oversight under one agency, streamlining regulation and reducing 
duplication and gaps between regulators. It would also bring all large 
complex holding companies and other systemically significant firms 
under one regulator, allowing supervisors to finally oversee 
institutions at the same level as the companies do to manage their own 
risks.
    I appreciate the testimony of the witnesses today and I look 
forward to discussing these important issues.
                                 ______
                                 
                  PREPARED STATEMENT OF SHEILA C. BAIR
            Chairman, Federal Deposit Insurance Corporation
                             August 4, 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. Specifically, you have asked us to address 
the regulatory consolidation aspects of the Administration's proposal 
and whether there should be further consolidation.
    The proposals put forth by the Administration regarding the 
structure of the financial system and the supervision of financial 
entities provide a useful framework for discussion of areas in vital 
need of reform. The goal of any reforms should be to address the 
fundamental causes of the current crisis and to put in place a 
regulatory structure that guards against future crises.
    There have been numerous proposals over the years to consolidate 
the Federal banking regulators. This is understandable given the way in 
which the present system developed, responding to new challenges as 
they were encountered. While appealing in theory, these proposals have 
rarely gained traction because prudential supervision of FDIC insured 
banks has held up well in comparison to other financial sectors in the 
United States and against non-U.S. systems of prudential supervision. 
Indeed, this is evidenced by the fact that large swaths of the so-
called ``shadow banking sector'' have collapsed back into the healthier 
insured sector, and U.S. banks--notwithstanding their current 
problems--entered this crisis with less leverage and stronger capital 
positions than their international competitors.
    Today, we are again faced with proposals to restructure the bank 
regulatory system, including the suggestion of some to eliminate 
separate Federal regulators for national- and State-chartered 
institutions. We have previously testified in support of a systemic 
risk council which would help assure coordination and harmonization in 
prudential standards among all types of financial institutions, 
including commercial banks, investment banks, hedge funds, finance 
companies, and other potentially systemic financial entities to address 
arbitrage among these various sectors. We also have expressed support 
for a new consumer agency to assure strong rules and enforcement of 
consumer protection across the board. However, we do not see merit or 
wisdom in consolidating Federal supervision of national and State 
banking charters into a single regulator for the simple reason that the 
ability to choose between Federal and State regulatory regimes played 
no significant role in the current crisis.
    One of the important causes of the current financial difficulties 
was the exploitation of the regulatory gaps that existed between banks 
and the nonbank shadow financial system, and the virtual nonexistence 
of regulation of over-the-counter (OTC) derivative contracts. These 
gaps permitted lightly regulated or, in some cases, unregulated 
financial firms to engage in highly risky practices and offer toxic 
derivatives and other products that eventually infected the financial 
system. In the absence of regulation, such firms were able to take on 
risks and become so highly levered that the slightest change in the 
economy's health had deleterious effects on them, the broader financial 
system, and the economy.
    Gaps existed in the regulation and supervision of commercial 
banks--especially in the area of consumer protection--and regulatory 
arbitrage occurred there as well. Despite the gaps, bank regulators 
maintained minimum standards for the regulation of capital and leverage 
that prevented many of the excesses that built-up in the shadow 
financial sector.
    Even where clear regulatory and supervisory authority to address 
risks in the system existed, it was not exercised in a way that led to 
the proper management of those risks or to provide stability for the 
system, a problem that would potentially be greatly enhanced by a 
single Federal regulator that embarked on the wrong policy course. 
Prudent risk management argues strongly against putting all your 
regulatory and supervisory eggs in one basket. Moreover, a unified 
supervisor would unnecessarily harm the dual banking system that has 
long served the financial needs of communities across the country and 
undercut the effectiveness of the deposit insurance system.
    In light of these significant failings, it is difficult to see why 
so much effort should be expended to create a single regulator when 
political capital could be better spent on more important and 
fundamental issues which brought about the current crisis and the 
economic harm it has done. In addition, a wholesale reorganization of 
the bank regulatory and supervisory structure would inevitably result 
in a serious disruption to bank supervision at a time when the industry 
still faces major challenges. Based on recent experience in the Federal 
Government with such large scale agency reorganizations, the proposed 
regulatory and supervisory consolidation, directly impacting the 
thousands of line examiners and their leadership, would involve years 
of career uncertainty and depressed staff morale. At a time when the 
supervisory staffs of all the agencies are working intensively to 
address challenges in the banking sector, the resulting distractions 
and organizational confusion that would follow from consolidating the 
banking agency supervision staffs would not result in long term 
benefits. Any benefits would likely be offset by short term risks and 
the serious disadvantages that a wholesale reorganization poses for the 
dual banking system and the deposit insurance system.
    My testimony will discuss the issues raised by the creation of a 
single regulator and supervisor and the impact on important elements of 
the financial system. I also will discuss the very important roles that 
the Financial Services Oversight Council and the Consumer Financial 
Protection Agency (CFPA) can play in addressing the issues that the 
single Federal regulator and supervisor apparently seeks to resolve, 
including the dangers posed by regulatory arbitrage through the closing 
of regulatory gaps and the application of appropriate supervisory 
standards to currently unregulated nonbank financial companies.
Effects of the Single Regulator Model
    The current financial supervisory system was created in a series of 
ad hoc legislative responses to economic conditions over many years. It 
reflects traditional themes in U.S. history, including the observation 
in the American experience that consolidated power, financial or 
regulatory, has rarely resulted in greater accountability or 
efficiency.
    The prospect of a unified supervisory authority is alluring in its 
simplicity. However, there is no evidence that shows that this 
regulatory structure was better at avoiding the widespread economic 
damage that has occurred over the past 2 years. The financial systems 
of Austria, Belgium, Hungary, Iceland and the United Kingdom have all 
suffered in the crisis despite their single regulator approach. 
Moreover, it is important to point out that the single regulator system 
has been adopted in countries that have highly concentrated banking 
systems with only a handful of very large banks. In contrast, our 
system, with over 8,000 banks, needs a regulatory and supervisory 
system adapted to a country of continental dimensions with 50 separate 
States, with significantly different economies, and with a multiplicity 
of large and small banks.
    Foreign experience suggests that, if anything, the unified 
supervisory model performed worse, not better than a system of multiple 
regulators. It should be noted that immediately prior to this crisis, 
organizations representing large financial institutions were calling 
aggressively for a move toward the consolidated model used in the U.K. 
and elsewhere. \1\ Such proposals were viewed by many at the time as 
representing an industry effort to replicate in this country single 
regulator systems viewed as more accommodative to large, complex 
financial organizations. It would indeed be ironic if Congress now 
succumbed to those calls. A regulatory structure based on this approach 
would create serious issues for the dual banking system, the survival 
of community banks as a competitive force, and the strength of the 
deposit insurance system that has served us so well during this crisis.
---------------------------------------------------------------------------
     \1\ See, New York City Economic Development Corporation and 
McKinsey & Co., Sustaining New York's and the U.S.'s Global Financial 
Services Leadership, January 2007. See, also Financial Services 
Roundtable, Effective Regulatory Reform, Policy Statement, May 2008.
---------------------------------------------------------------------------
The Dual Banking System
    Historically, the dual banking system and the regulatory 
competition and diversity that it generates has been credited with 
spurring creativity and innovation in financial products and the 
organization of financial activities. State-chartered institutions tend 
to be community-oriented banks that are close to their communities' 
small businesses and customers. They provide the funding that supports 
economic growth and job creation, especially in rural areas. They stay 
close to their customers, they pay special personal attention to their 
needs, and they are prepared to work with them to solve unanticipated 
problems. These community banks also are more accountable to market 
discipline in that they know their institution will be closed if they 
become insolvent rather than being considered ``too big to fail.''
    A unified supervisory approach would inevitably focus on the 
largest banks to the detriment of the community banking system. This 
could, in turn, feed further consolidation in the banking industry--a 
trend counter to current efforts to reduce systemic exposure to very 
large financial institutions and end too big too fail.
    Further, if the single regulator and supervisor is funded, as the 
national bank regulator and supervisor is now funded, through fees on 
the State-chartered banks it would examine, this would almost certainly 
result in the demise of the dual banking system. State-chartered 
institutions would quickly switch to national charters to escape paying 
examination fees at both the State and Federal levels.
    The undermining of the dual banking system through the creation of 
a single Federal regulator would mean that the concerns and challenges 
of community banks would inevitably be given much less attention or 
even ignored. Even the smallest banks would need to come to Washington 
to try to be heard. In sum, a unified regulatory and supervisory 
approach could result in the loss of many benefits of the community 
banking system.
The Deposit Insurance System
    The concentration of examination authority in a single regulator 
would also have an adverse impact on the deposit insurance system. The 
FDIC's ability to directly examine the vast majority of financial 
institutions enables it to identify and evaluate risks that should be 
reflected in the deposit insurance premiums assessed on individual 
institutions. The loss of an ongoing significant supervisory role and 
the associated staff would greatly diminish the effectiveness of the 
FDIC's ability to perform its congressionally mandated role--reducing 
systemic risk through risk based deposit insurance assessments and 
containing the potential costs of deposit insurance by identifying, 
assessing and taking actions to mitigate risks to the Deposit Insurance 
Fund.
    If the FDIC were to lose its supervisory role to a unified 
supervisor, it would need to rely heavily on the examinations of that 
supervisor. In this context, the FDIC would need to expand the use of 
its backup authority to ensure that it is receiving information 
necessary to properly price deposit insurance assessments for risk. 
This would result in duplicate exams and increased regulatory burden 
for many financial institutions.
    The FDIC as a bank supervisor also brings the perspective of the 
deposit insurer to interagency discussions regarding important issues 
of safety and soundness. During the discussions of the Basel II 
Advanced Approaches, the FDIC voiced deep concern about the reductions 
in capital that would have resulted from its implementation. Under a 
system with a unified supervisor, the perspective of the deposit 
insurer might not have been heard. It is highly likely that the 
advanced approaches of Basel II would have been implemented much more 
quickly and with fewer safeguards, and banks would have entered the 
crisis with much lower levels of capital. In particular, the 
longstanding desire of many large institutions for the elimination of 
the leverage ratio would have been much more likely to have been 
realized in a regulatory structure in which a single regulator plays 
the predominant role. This is a prime example of how multiple 
regulators' different perspectives can result in a better outcome.
Regulatory Capture
    The single regulator approach greatly enhances the risk of 
regulatory capture should this regulator become too closely tied to the 
goals and operations of the regulated banks. This danger becomes much 
more pronounced if the regulator is focused on the needs and problems 
of large banks--as would be highly likely if the single regulator is 
reliant on size-based fees for its funding. The absence of the 
existence of other regulators would make it much more likely that such 
a development would go undetected and uncorrected since there would be 
no standard against which the actions of the single regulator could be 
compared. The end result would be that the damage to the system would 
be all the more severe when the problems produced by regulatory capture 
became manifest.
    One of the advantages of multiple regulators is that they provide 
standards of performance against which the conduct of their peers can 
be assessed, thus preventing any single regulator from undermining 
supervisory standards for the entire industry.
Closing the Supervisory Gaps
    As discussed above, the unified supervisor model does not provide a 
solution to the fundamental causes of the economic crisis, which 
included regulatory gaps between banks and nonbanks and insufficiently 
proactive supervision. As a result of these deficiencies, 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.
    To prevent further arbitrage between the bank and nonbank financial 
systems, the FDIC supports the creation of a Financial Services 
Oversight Council and the CFPA. Respectively, these agencies will 
address regulatory gaps in prudential supervision and consumer 
protection, thereby eliminating the possibility of financial service 
providers exploiting lax regulatory environments for their activities.
    The Council would oversee systemic risk issues, develop needed 
prudential policies and mitigate developing systemic risks. 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, investment funds, and others to determine the extent to which 
differing standards circumvent regulatory efforts to contain excess 
leverage in the system. The Council also should 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 CFPA would eliminate regulatory gaps between insured depository 
institutions and nonbank providers of financial products and services 
by establishing strong, consistent consumer protection standards across 
the board. It also would address another gap by giving the CFPA 
authority to examine nonbank financial service providers that are not 
currently examined by the Federal banking agencies. In addition, the 
Administration's proposal would eliminate the potential for regulatory 
arbitrage that exists because of Federal preemption of certain State 
laws. By creating a floor for consumer protection and allowing more 
protective State consumer laws to apply to all providers of financial 
products and services operating within a State, the CFPA should 
significantly improve consumer protection.
    A distinction should be drawn between the macroprudential oversight 
and regulation of developing risks that may pose systemic risks to the 
U.S. financial system and the direct supervision of financial firms. 
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.
    Prudential supervisors would regulate and supervise the 
institutions under their jurisdiction, and enforce consumer standards 
set by the CFPA and any additional systemic standards established by 
the Council. 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, and to avoid the regulatory arbitrage that is a 
source of the current problem, the Council should be empowered to 
require that they submit to such oversight. Presumably this could take 
the form of a financial holding company under the Federal Reserve--
without subjecting them to the activities restrictions applicable to 
these companies.
    There is not always a clear demarcation of these roles and they 
will need to coordinate to be effective. Industry-wide standards for 
safety and soundness are based on the premise that if most or all 
banking organizations are safe, the system is safe. However, practices 
that may be profitable for a few institutions may not be prudent if 
that same business model is adopted by a large number of institutions. 
From our recent experience we know that there is a big difference 
between one regulated bank having a high concentration of subprime 
loans and concentrations of subprime lending across large sections of 
the regulated and nonregulated financial system. Coordination of the 
prudential and systemic approaches will be vital to improving 
supervision at both the bank and systemic level.
    Risk management is another area where there should be two different 
points of view. Bank supervisors focus on whether a banking 
organization has a reasonable risk management plan for its 
organization. The systemic risk regulator would look at how risk 
management plans are developed across the industry. If everyone relies 
on similar risk mitigation strategies, then no one will be protected 
from the risk. In other words, if everyone rushes to the same exit at 
the same time, no one will get out safely.
    Some may believe that financial institutions are able to arbitrage 
between regulators by switching charters. This issue has been addressed 
directly by recent action by the Federal banking regulators to 
coordinate prudential supervision so institutions cannot evade uniform 
enforcement of regulatory standards. The agencies all but eliminated 
any possibility of this in the recent issuance of a Statement on 
Regulatory Conversions that will not permit charter conversions that 
undermine the supervisory process. The FDIC would support legislation 
making the terms of this agreement binding by statute. We also would 
support time limits on the ability to convert. The FDIC has no 
statutory role in the charter conversion process. However, as insurer 
of all depository institutions, we have a vital interest in protecting 
the integrity of the supervisory process and guarding against any 
possibility that the choice of a Federal or State charter could 
undermine that process.
Conclusion
    The focus of efforts to reform the financial system should be the 
elimination of the regulatory gaps between banks and nonbank financial 
providers outside the traditional banking system, as well as between 
commercial banks and investment banks. Proposals to create a unified 
supervisor would undercut the benefits of diversity that are derived 
from the dual banking system and that are so important to a very large 
country with a very large number of banks chartered in multiple 
jurisdictions with varied local needs. As evidenced by the experience 
of other much smaller countries with much more concentrated banking 
systems, such a centralized, monolithic regulation and supervision 
system has significant disadvantages and has resulted in greater 
systemic risk. A single regulator is no panacea for effective 
supervision.
    Congress should create a Financial Services Oversight Council and 
Consumer Financial Protection Agency with authority to look broadly at 
our financial system and to set minimum uniform rules for the financial 
sector. In addition, the Administration's proposal to create a new 
agency to supervise federally chartered institutions will better 
reflect the current composition of the banking industry. Finally, but 
no less important, there needs to be a resolution mechanism that 
encourages market discipline for financial firms by imposing losses on 
shareholders and creditors and replacing senior management in the event 
of failure.
    I would be pleased respond to your questions.
                                 ______
                                 
                  PREPARED STATEMENT OF JOHN C. DUGAN
 Comptroller of the Currency, Office of the Comptroller of the Currency
                             August 4, 2009
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
I appreciate this opportunity to discuss the modernization of financial 
services regulation in the context of the Administration's Proposal for 
regulatory reform. \1\ The events of the last 2 years--including the 
unprecedented distress and failure of financial firms, the accumulation 
of toxic subprime mortgage assets in our financial system, and the 
steep rise in foreclosures--have exposed gaps and weaknesses in our 
regulatory framework. The Proposal put forward by the Treasury 
Department for strengthening that framework is thoughtful and 
comprehensive, and I support many of its proposed reforms. But I also 
have significant concerns with two parts of it, i.e., (1) the proposed 
broad authority of the Federal Reserve, as systemic risk regulator, to 
override authority of the primary prudential banking supervisor; and 
(2) the elimination of uniform national consumer protection standards 
for national banks in connection with establishing the newly proposed 
Consumer Financial Protection Agency (CFPA), and the transfer of all 
existing consumer protection examination and enforcement from the 
Federal banking agencies to the new CFPA. Both concerns relate to the 
way in which important new authorities would interact with the 
essential functions of the dedicated prudential banking supervisor.
---------------------------------------------------------------------------
     \1\ See, U.S. Department of the Treasury, ``Financial Regulatory 
Reform--A New Foundation: Rebuilding Financial Supervision and 
Regulation'' (June 2009) (the ``Proposal''), available at 
www.financialstability.gov/docs/regs/FinalReport.web.pdf. Treasury also 
has released legislative language to implement most components of the 
Proposal. That proposed legislation is available at www.treas.gov/
initiatives/regulatoryreform.
---------------------------------------------------------------------------
    My testimony begins with a brief summary of the key parts of the 
Proposal we generally support. The second section focuses on the topics 
pertaining to regulatory structure on which the Committee has 
specifically invited our views; this portion includes a discussion of 
the Federal Reserve's role and authority. The last section addresses 
our second area of major concern--uniform national standards and the 
CFPA.
I. Key Provisions Supported by the OCC
    We believe many of the Administration's proposed reforms will 
strengthen the financial system and help prevent future market 
disruptions of the type we witnessed last year, including the 
following:

    Establishment of a Financial Stability Oversight Council. 
        This council would consist of the Secretary of the Treasury and 
        all of the Federal financial regulators, and would be supported 
        by a permanent staff. Its general role would be to identify and 
        monitor systemic risk, and it would have strong authority to 
        gather the information necessary for that mission, including 
        from any entity that might pose systemic risk. We believe that 
        having a centralized and formalized mechanism for gathering and 
        sharing systemically significant information, and making 
        recommendations to individual regulators, makes good sense. It 
        also could provide a venue or mechanism for resolving 
        differences of opinions among regulators.

    Enhanced authority to resolve systemically significant 
        financial firms. The Federal Deposit Insurance Corporation 
        (FDIC) currently has broad authority to resolve a distressed 
        systemically significant depository institution in an orderly 
        manner. No comparable resolution authority exists for large 
        bank holding companies, or for systemically significant 
        financial companies that are not banks, as we learned painfully 
        with the problems of such large financial companies as Bear 
        Stearns, Lehman Brothers, and AIG. The Proposal would extend 
        resolution authority like the FDIC's to such nonbanking 
        companies, while preserving the flexibility to use the FDIC or 
        another regulator as the receiver or conservator, depending on 
        the circumstances. This is a sound approach that would help 
        maximize orderly resolutions of systemically significant firms.

    Strengthened regulation of systemically significant firms, 
        including requirements for higher capital and stronger 
        liquidity. We support the concept of imposing more stringent 
        prudential standards on systemically significant financial 
        firms to address their heightened risk to the system and to 
        mitigate the competitive advantage they could realize from 
        being designated as systemically significant. But these 
        standards should not displace the standard-setting and 
        supervisory responsibilities of the primary banking supervisor 
        with respect to bank subsidiaries of these companies. And in 
        those instances where the largest asset of the systemically 
        significant firm is a bank--as may often be the case--the 
        primary banking supervisor should have a strong role in helping 
        to craft the new standards for the holding company.

    Changes in accounting standards that would allow banks to 
        build larger loan loss reserves in good times to absorb more 
        losses in bad times.  One of the problems that has impaired 
        banks' ability to absorb increased credit losses while 
        continuing to provide appropriate levels of credit is that 
        their levels of loan loss reserves available to absorb such 
        losses were not as high as they should have been entering the 
        crisis. One reason for this is the currently cramped accounting 
        regime for building loan loss reserves, which is based on the 
        concept that loan loss provisions are permissible only when 
        losses are ``incurred.'' The Proposal calls for accounting 
        standard setters to improve this standard to make it more 
        forward looking so that banks could build bigger loan loss 
        reserves when times are good and losses are low, in recognition 
        of the fact that good times inevitably end, and large loan loss 
        reserves will be needed to absorb increased losses when times 
        turn bad. The OCC strongly supports this part of the Proposal. 
        In fact, I cochaired an international task force under the 
        auspices of the Financial Stability Board to achieve this very 
        objective on a global basis, which we hope will contribute to 
        stronger reserving policy both here and abroad.

    Enhanced consumer protection.  The Proposal calls for 
        enhanced consumer protection standards for consumer financial 
        products through new rules that would be written and 
        implemented by the new Consumer Financial Protection Agency. 
        The OCC supports strong, uniform Federal consumer protection 
        standards. While we generally do not have rulewriting authority 
        in this area, we have consistently applied and enforced the 
        rules written by the Federal Reserve (and others), and, in the 
        absence of our own rulewriting authority, have taken strong 
        enforcement actions to address unfair and deceptive practices 
        by national banks. We believe that an independent agency like 
        the CFPA could appropriately strengthen consumer protections, 
        but we have serious concerns with the CFPA as proposed. We 
        believe the goal of strong consumer protection can be 
        accomplished better through CFPA rules that reflect meaningful 
        input from the Federal banking agencies and are truly uniform, 
        rather than resulting in a patchwork of different rules amended 
        and enforced differently by individual States. We also believe 
        that these rules should continue to be implemented by the 
        Federal banking agencies for banks, under the existing, well-
        established regulatory and enforcement regime, and by the CFPA 
        and the States for nonbank financial providers, which today are 
        subject to different standards and far less actual oversight 
        than federally regulated depository institutions. This is 
        discussed in greater detail below.

    Stronger regulation of payments systems, hedge funds, and 
        over-the-counter derivatives, such as credit default swaps. The 
        Proposal calls for significant enhancements in regulation in 
        each of these areas, which we generally support in concept. We 
        will provide more detailed comments about each, as appropriate, 
        once we have had more time to review the implementing 
        legislative language.
II. Regulatory Structure Issues
1. Proposed Establishment of the National Bank Supervisor and 
        Elimination of the Federal Thrift Charter
    In proposing to restructure the banking agencies, the Proposal 
appropriately preserves an agency whose only mission is banking 
supervision. This new agency, the National Bank Supervisor (NBS), would 
serve as the primary regulator of federally chartered depository 
institutions, including the national banks that comprise the dominant 
businesses of many of the largest financial holding companies. To 
achieve this goal, the Proposal would effectively merge the Office of 
Thrift Supervision (OTS) into the OCC.
    It would eliminate the Federal thrift charter--and also, as I will 
shortly discuss, the separate treatment of savings and loan holding 
companies--with all Federal thrifts required to convert to a national 
bank, a State bank, or a State thrift, over the course of a reasonable 
transition period. (State thrifts would then be treated as State 
``banks'' under Federal law.) We believe this approach to the agency 
merger is preferable to one that would preserve the Federal thrift 
charter, with Federal thrift regulation being conducted by a division 
of the merged agency. With the same deposit insurance fund, same 
prudential regulator, same holding company regulator, same branching 
powers, and a narrower charter (a national bank has all the powers of a 
Federal thrift plus many others), there would no longer be a need for a 
separate Federal thrift charter. In addition, the approach in the 
Proposal avoids the considerable practical complexities and costs of 
administering two separate statutory and regulatory regimes that are 
largely redundant in many areas, and needlessly different in others. 
Finally, the legislation implementing this aspect of the Proposal 
should be unambiguously clear--as we believe is intended--that the new 
agency is independent from the Treasury Department and the 
Administration to the same extent that the OCC and OTS are currently 
independent. \2\
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     \2\ For example, current law provides the OCC with important 
independence from political interference in decision making in matters 
before the Comptroller, including enforcement proceedings; provides for 
funding independent of political control; enables the OCC to propose 
and promulgate regulations without approval by the Treasury; and 
permits the agency to testify before Congress without the need for the 
Administration's clearance of the agency's statements.
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2. Enhancement of the Federal Reserve's Supervision of Systemically 
        Significant Financial Holding Companies
    The Federal Reserve Board already has strong authority as 
consolidated supervisor to identify and address problems at large, 
systemically significant bank holding companies. In the financial 
crisis of the last 2 years, the absence of a comparable authority with 
respect to large securities firms, insurance companies, and Government-
sponsored enterprises that were not affiliated with banks proved to be 
an enormous problem, as a disproportionate share of the financial 
stress in the markets was created by these institutions. The lack of a 
consistent and coherent regulatory regime applicable to them by a 
single regulator helped mask problems in these nonbanking companies 
until they were massive. And gaps in the regulatory regime constrained 
the Government's ability to deal with them once they emerged. The 
Proposal would extend the Federal Reserve's consolidated bank holding 
company regulation to systemically significant nonbanking companies in 
the future, which would appropriately address the regulatory gap. 
However, as discussed below, one aspect of this part of the proposal 
goes too far, i.e., the new Federal Reserve authority to ``override'' 
key functions of the primary banking supervisor, which would undermine 
the authority--and the accountability--of the banking supervisor for 
the soundness of the banks that anchor systemically significant holding 
companies.
3. Elimination of the Thrift Holding Company and Industrial Loan 
        Company Exceptions to Bank Holding Company Act Regulation
    Under the law today, companies that own thrifts or industrial loan 
companies (ILCs) are exempt from regulation under the Bank Holding 
Company Act. The Proposal would eliminate these exemptions, making 
these types of firms subject to supervision by the Federal Reserve 
Board.
    Thrift holding companies, unlike bank holding companies, are not 
subject to consolidated regulation; for example, no consolidated 
capital requirements apply at the holding company level. This 
difference between bank and thrift holding company regulation created 
arbitrage opportunities for companies that were able to take on greater 
risk under a less rigorous regulatory regime. Yet, as we have seen - 
AIG is the obvious example--large nonbank firms can present similar 
risks to the system as large banks. This regulatory gap should be 
closed, and these firms should be subject to the same type of oversight 
as bank holding companies.
    Companies controlling ILCs also are not subject to bank holding 
company regulation, but admittedly, ILCs have not been the source of 
the same kinds of problems as thrift holding companies. For that 
reason, it may be appropriate to continue to exempt small ILCs from 
bank holding company regulation. If this approach were pursued, the 
exemption should terminate once the ILC exceeds a certain size 
threshold, however, because the same potential risks can arise as with 
banks. Alternatively, if the ILC exemption were repealed altogether, 
appropriate grandfathering of existing ILCs and their parent companies 
should be considered.
4. The Merits of Further Regulatory Consolidation
    It is clear that the United States has too many bank regulators. We 
have four Federal bank regulators, 12 Federal Reserve Banks, and 50 
State regulators, nearly all of which have some type of overlapping 
supervisory responsibilities. This system is largely the product of 
historical evolution, with different agencies created for different 
legitimate purposes reflecting a much more segmented financial system 
from the past. No one would design such a system from scratch, and it 
is fair to say that, at times, it has not been the most efficient way 
to establish banking policy or supervise banks.
    Nevertheless, the banking agencies have worked hard over the years 
to make the system function appropriately despite its complexities. On 
many occasions, the diversity in perspectives and specialization of 
roles has provided real value. And from the agencies has been a primary 
driver of recent problems in the banking system.
    That said, I recognize the considerable interest in reducing the 
number of bank regulators. The impulse to simplify is understandable, 
and it may well be appropriate to streamline our current system. But we 
ought not approach the task by prejudging the appropriate number of 
boxes on the organization chart. The better approach is to determine 
what would be achieved if the number of regulators were reduced. What 
went wrong in the current crisis that changes in regulatory structure 
(rather than regulatory standards) will fix? Will accountability be 
enhanced? Will the change result in greater efficiency and consistency 
of regulation? Will gaps be closed so that opportunities for regulatory 
arbitrage in the current system are eliminated? Will overall market 
regulation be improved?
    In testimony provided earlier this year, I strongly urged that 
Congress, in reforming financial services regulation, preserve a 
robust, independent bank supervisor that is solely dedicated to the 
prudential oversight of depository institutions. Banks are the anchor 
of most financial holding companies, including the very largest, and I 
continue to believe that the benefits of dedicated, strong prudential 
supervision are significant--indeed, necessary. Dedicated supervision 
assures there is no confusion about the supervisor's goals and 
objectives, and no potential conflict with competing objectives. 
Responsibility is well defined, and so is accountability. Supervision 
takes a back seat to no other part of the organization, and the result 
is a strong culture that fosters the development of the type of 
seasoned supervisors that are needed to confront the many challenges 
arising from today's banking business. The strength of national banks 
at the core of many of the largest financial holding companies has been 
an essential anchor to the ability of those companies to weather recent 
financial crises--and to absorb distressed securities and thrift 
companies.
    While there is arguably an agreement on the need to reduce the 
number of bank regulators, there is no such consensus on what the right 
number is or what their roles should be. As I have mentioned, we 
support reducing the number of Federal banking regulators from four to 
three by effectively merging the OTS into the OCC, leaving just one 
Federal regulator for federally chartered banks. There are reasonable 
arguments for streamlining the regulatory structure even further, but 
there would be advantages and disadvantages at each step.
    For example, the number of banking regulators could be further 
reduced from three to two by creating a single Federal regulator for 
State-chartered banks, whose Federal supervision is now divided between 
the Federal Reserve Board and the FDIC, depending on whether the State 
bank is a member of the Federal Reserve System. Today there is 
virtually no difference in the regulation applicable to State banks at 
the Federal level based on membership in the System and thus no real 
reason to have two different Federal regulators. It would be simpler to 
have one. Opportunities for regulatory arbitrage--resulting, for 
example, from differences in the way Federal activities restrictions 
are administered by one or the other regulator--would be reduced. 
Policymaking would be streamlined. Fewer decision-makers would have to 
agree on the implementation of banking policies and restrictions that 
Congress has required to be carried out on a joint basis.
    On the other hand, whichever agency loses supervisory authority 
over State banks also would lose the day-to-day ``window'' into the 
condition of the banking industry that today informs the conduct of 
other aspects of its mission. This may present a greater problem for 
the FDIC, which would have much less engagement with the banking sector 
during periods with few bank failures, especially if the Federal 
Reserve retained holding company jurisdiction, an issue I discuss 
below.
    Still further consolidation could be achieved by reducing the 
number of bank regulators to one dedicated prudential supervisor. If 
this were done, the single Federal supervisor should be structured to 
be independent from the Treasury Department and headed by a board of 
directors, with the Chairmen of the FDIC and the Federal Reserve Board 
serving as board members. This is the simplest, and arguably the most 
logical, approach. It would afford the most direct accountability--
there would be no confusion about which regulator was responsible for 
the Federal supervision of a bank--and it would end opportunities for 
regulatory arbitrage. Moreover, it could be done within the framework 
of the dual banking system by preserving both State and national 
charters. It would be desirable, however, for the single regulator to 
maintain separate divisions for the supervision of large and small 
institutions, given the differences in complexity and types of risk 
that banks of different sizes present.
    The disadvantages of such an approach include removing both the 
Federal Reserve and the FDIC from day-to-day bank supervision (although 
that concern would be mitigated for the Federal Reserve to the extent 
it retained holding company regulation). In addition, States may be 
concerned that the State charter would be significantly less attractive 
if the same Federal regulator supervised both State and Federal 
institutions, especially if State-chartered institutions were required 
to pay for Federal supervision in addition to the assessments charged 
by the State (although that issue could be addressed separately).
    Finally, the Committee has asked whether a consolidated prudential 
bank supervisor also could regulate the holding company. While this 
could be done, and has significant appeal with respect to small and 
``bank-only'' holding companies, there would be significant issues 
involved with such an approach in the case of the largest companies 
where the challenges would be the greatest.
    Little need remains for separate holding company regulation where 
the bank is small or where it is the holding company's only, or 
dominant, asset. (The previously significant role of the Federal 
Reserve, as holding company supervisor, in approving new activities was 
dramatically reduced by the provisions in the Gramm-Leach-Bliley Act 
that authorized financial holding companies and specifically identified 
and approved in advance the types of activities in which they could 
engage.) For these firms, the holding company regulator's other 
authorities are not necessary to ensure effective prudential 
supervision to the extent that they duplicate the Federal prudential 
supervisor's authority to set standards, examine, and take appropriate 
enforcement action with respect to the bank. Elimination of a separate 
holding company regulator thus would eliminate duplication, promote 
simplicity and accountability, and reduce unnecessary compliance burden 
for institutions as well.
    The case is harder and more challenging for the very largest bank 
holding companies engaged in complex capital markets activities, 
especially where the company is engaged in many, or predominantly, 
nonbanking activities, such as securities and insurance. Given its 
substantial role and direct experience with respect to capital markets, 
payments systems, the discount window, and international central 
banking, the Federal Reserve Board provides unique resources and 
perspective to supervision. Eliminating the Board as holding company 
regulator would mean losing the direct effect of that expertise. The 
benefits of the different perspectives of holding company regulator and 
prudential regulator would be lost. The focus of a dedicated, strong 
prudential banking supervisor could be significantly diluted by 
extending its focus to nonbanking activities. It also would take time 
for the consolidated banking supervisor to acquire and maintain a 
comparable level of expertise, especially in nonbanking activities.
5. Delineation of Responsibilities Between the Systemic Supervisor and 
        Prudential Supervisor
    If, as under the Administration's Proposal, the Board is the 
systemic holding company supervisor, then it is essential that clear 
lines be drawn between the Board's authority and the authority of the 
prudential banking supervisor. As I will explain, the Proposal goes too 
far in authorizing the systemic supervisor to override the prudential 
supervisor's role and authorities.
    The Proposal would establish the Federal Reserve Board as the 
systemic supervisor by providing it with enhanced, consolidated 
authority over a ``Tier 1'' financial holding company--that is, a 
company that poses significant systemic risk--and all of its 
subsidiaries. In essence, this structure builds on and expands the 
current system for supervising bank holding companies, where the Board 
already has consolidated authority over the company, and the prudential 
bank supervisor is responsible for direct bank supervision.
    In practice, many of the companies likely to be designated as Tier 
1 financial holding companies will have at their heart very large 
banks, many of which are national banks. Because of their core role as 
financial intermediaries, large banks have extensive ties to the 
``Federal safety net'' of deposit insurance, the discount window, and 
the payments system. Accordingly, the responsibility of the prudential 
bank supervisor must be to ensure that the bank remains a strong anchor 
within the company as a whole. Indeed, this is our existing 
responsibility at the OCC, which we take very seriously through our 
continuous on-site supervision by large teams of resident examiners in 
all of our largest national banks. As a result, the bank is by far the 
most intensively regulated part of the largest bank holding companies, 
which has translated into generally lower levels of losses of banks 
within the holding company versus other companies owned by that holding 
company--including those large bank holding companies that have 
sustained the greatest losses.
    In the context of regulatory restructuring for systemically 
significant bank holding companies, preserving the essential role of 
the prudential supervisor of the bank means that its relationship with 
the systemic supervisor should be complementary; it should not be 
subsumed or overtaken by the systemic supervisor. Conflating the two 
roles undermines the bank supervisor's authority, responsibility, and 
accountability. Moreover, it would impose major new responsibilities on 
and further stretch the role of the Board.
    Parts of the Proposal are consistent with this type of 
complementary relationship between the Board and the prudential bank 
supervisor. For example, the Board would be required to rely, as far as 
possible, on the reports of examination prepared by the prudential bank 
supervisors. This approach reflects the practical relationship that the 
OCC has with the Board today, a relationship that works, in part 
because the lines of authority between the two regulators are 
appropriately defined. And it has allowed the Board to use and rely on 
our work to perform its role as supervisor for complex banking 
organizations that are often involved in many businesses other than 
banking. It is a model well suited for use in a new regulatory 
framework where the Board assumes substantial new responsibilities, 
including potential authority over some Tier 1 companies that do not 
have bank subsidiaries at all.
    In one crucial respect, however, the Proposal departs dramatically 
from that model and is not consistent with its own stated objective of 
maintaining a robust, responsible, and independent prudential 
supervisor that will be accountable for its safety and soundness 
supervision. That is, the Proposal provides the Board with authority to 
establish, examine, and enforce more stringent standards with respect 
to the ``functionally regulated'' subsidiaries of Tier 1 financial 
holding companies--which under the proposal would include bank 
subsidiaries--in order to mitigate systemic risk posed by those 
subsidiaries. This open-ended authorization would allow the Board to 
impose customized requirements on virtually any aspect of the bank's 
operations at any time, subject only to a requirement for 
``consultation'' with the Secretary of the Treasury and the bank's 
primary Federal or State supervisor. This approach is entirely 
unnecessary and unwarranted in the case of banks already subject to 
extensive regulation. It would fundamentally alter the relationship 
between the Board and the bank supervisor by superseding the bank 
supervisor's authority over bank subsidiaries of systemically 
significant companies, and would be yet another measure that 
concentrates more authority in, and stretches the role of, the Board.
    In addition, while the Proposal centralizes in the Board more 
authority over Tier 1 financial holding companies, it does not address 
the current, significant gap in supervision that exists within bank 
holding companies. In today's regulatory regime, a bank holding company 
may engage in a particular banking activity, such as mortgage lending, 
either through a subsidiary that is a bank or through a subsidiary that 
is not a bank. If engaged in by the banking subsidiary, the activity is 
subject to required examination and supervision on a periodic basis by 
the primary banking supervisor. However, if it is engaged in by a 
nonbanking subsidiary, it is potentially subject to examination by the 
Federal Reserve, but regular supervision and examination is not 
required. As a policy matter, the Federal Reserve had previously 
elected not to subject such nonbanking subsidiaries to full bank-like 
examination and supervision on the theory that such activities would 
inappropriately extend ``the safety net'' of Federal protections from 
banks to nonbanks. \3\ The result has been the application of uneven 
standards to bank and nonbank subsidiaries of bank holding companies. 
For example, in the area of mortgage lending, banks were held to more 
rigorous underwriting and consumer compliance standards than nonbank 
affiliates in the same holding company. While the Board has recently 
indicated its intent to increase examination of nonbank affiliates, it 
is not clear that such examinations will be required to be as regular 
or extensive as the examination of the same activities conducted in 
banks.
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     \3\ See, e.g., Chairman Alan Greenspan, ``Insurance Companies and 
Banks Under the New Regulatory Law'', Remarks Before the Annual Meeting 
of the American Council of Life Insurance (November 14, 1999) (``The 
Gramm-Leach-Bliley Act is designed to limit extensions of the safety 
net, and thus to eliminate the need to impose banklike regulation on 
nonbank subsidiaries and affiliates of organizations that contain a 
bank.''), available at www.federalreserve.gov/boarddocs/speeches/1999/
19991115.htm.
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    I believe that such differential regulation and supervision of the 
same activity conducted in different subsidiaries of a single bank 
holding company--whether in terms of safety and soundness or consumer 
protection--doesn't make sense and is an invitation to regulatory 
arbitrage. Indeed, leveling the supervision of all subsidiaries of a 
bank holding company takes on added importance for a ``Tier 1'' 
financial holding company because, by definition, the firm as a whole 
presents systemically significant risk.
    One way to address this problem would be to include in legislative 
language an explicit direction to the Board to actively supervise 
nonbanking subsidiaries engaged in banking activities in the same way 
that a banking subsidiary is supervised by the prudential supervisor, 
with required regular exams. Of course, adding new required 
responsibilities for the direct supervision of more companies may serve 
as a distraction both from the Board's other new assignments under the 
Proposal as well as the continuation of its existing responsibilities.
    An alternative approach that may be preferable would be to assign 
responsibility to the prudential banking supervisor for supervising 
certain nonbank holding company subsidiaries. In particular, where 
those subsidiaries are engaged in the same business as is conducted, or 
could be conducted, by an affiliated bank--mortgage or other consumer 
lending, for example--the prudential supervisor already has the 
resources and expertise needed to examine the activity. Affiliated 
companies would then be made subject to the same standards and examined 
with the same frequency as the affiliated bank. This approach also 
would ensure that the placement of an activity in a holding company 
structure could not be used to arbitrage between different supervisory 
regimes or approaches.
III. The Proposed Consumer Financial Protection Agency and the 
        Elimination of Uniform National Standards for National Banks
    Today's severe consumer credit problems can be traced to the 
multiyear policy of easy money and easy credit that led to an asset 
bubble, with too many people getting loans that could not be repaid 
when the bubble burst. With respect to these loans--especially 
mortgages--the core problem was lax underwriting that relied too 
heavily on rising house prices. Inadequate consumer protections--such 
as inadequate and ineffective disclosures--contributed to this problem, 
because in many cases consumers did not understand the significant 
risks of complex loans that had seductively low initial monthly 
payments. Both aspects of the problem--lax underwriting and inadequate 
consumer protections--were especially acute in loans made by nonbank 
lenders that were not subject to Federal regulation. \4\
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     \4\ Some have suggested that the Community Reinvestment Act (CRA) 
caused the subprime lending crisis. That is simply not true. As the 
Administration's Proposal expressly recognizes, and as I have testified 
before, far fewer problem mortgages were made by institutions subject 
to CRA--that is, federally regulated depository institutions--than were 
made by mortgage brokers and originators that were not depository 
institutions. The Treasury Proposal specifically notes that CRA-covered 
depository institutions made only 6 percent of recent higher-priced 
mortgages provided to lower-income borrowers or in areas that are the 
focus of CRA evaluations. Proposal, supra, note 1, at 69-70. Moreover, 
our experience with the limited portion of subprime loans made by 
national banks is that they are performing better than nonbank subprime 
loans. This belies any suggestion that the banking system, and national 
banks in particular, were any sort of haven for abusive lending 
practices.
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    In terms of changes to financial consumer protection regulation, 
legislation should be targeted to the two types of fundamental gaps 
that fueled the current mortgage crisis. The first gap relates to 
consumer protection rules themselves, which were written under a 
patchwork of authorities scattered among different agencies; were in 
some cases not sufficiently robust or timely; and importantly, were not 
applied to all financial services providers, bank or nonbank, 
uniformly. The second gap relates to implementation of consumer 
protection rules, where there was no effective mechanism or framework 
to ensure that nonbank financial institutions complied with rules to 
the same extent as regulated banks. That is, the so-called ``shadow 
banking system'' of nonbank firms, such as finance companies and 
mortgage brokers, provides products comparable to those provided by 
banks, but is not subject to comparable oversight. This shadow banking 
system has been widely recognized as central to the most abusive 
subprime lending that fueled the mortgage crisis.
    A new Consumer Financial Protection Agency could be one mechanism 
to target both the rulewriting gap and the implementation gap. In terms 
of the rulewriting gap, all existing consumer financial protection 
authority could be centralized in the CFPA and strengthened as Congress 
sees fit, and that authority could be applied to all providers of a 
particular type of financial product with rules that are uniform. In 
terms of the implementation gap, the CFPA could be focused on 
supervision and/or enforcement mechanisms that raise consumer 
protection compliance for nonbank financial providers to a similar 
level as exists for banks--but without diminishing the existing regime 
for bank compliance. And in both cases, the CFPA could be structured to 
recognize legitimate bank safety and soundness concerns that in some 
cases are inextricably intertwined with consumer protection--as is the 
case with underwriting standards.
    Unfortunately, the Proposal's CFPA falls short in addressing these 
two fundamental consumer protection regulatory gaps. Let me address 
each in turn.
1. Rulewriting
a. Lack of Uniform Rules and National Bank Preemption--To address the 
        rulewriting gap, the Proposal's CFPA provides a mechanism for 
        centralized authority and stronger rules that could be applied 
        to all providers of financial products. But the rules would not 
        be uniform; that is, because the Proposal authorizes States to 
        adopt different rules, there could be 50 different standards 
        that apply to providers of a particular product or service, 
        including national banks.
    A core principle of the Proposal is its recognition that consumers 
benefit from uniform rules. \5\ Yet this very principle is expressly 
undermined by the specific grant of authority to States to adopt 
different rules; by the repeal of uniform standards for national banks; 
and by the empowerment of individual States, with their very differing 
points of view, to enforce Federal consumer protection rules--under all 
Federal statutes--in ways that might vary from State to State. In 
effect, the resulting patchwork of Federal-plus-differing-State 
standards would effectively distort and displace the Federal agency's 
rulemaking, even though the CFPA's rule would be the product of an open 
public comment process and the behavioral research and evaluative 
functions that the Proposal highlights.
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     \5\ See, e.g., Proposal, supra note 1, at 69 (discussing the 
proposed CFPA, observing that ``[f]airness, effective competition, and 
efficient markets require consistent regulatory treatment for similar 
products,'' and noting that consistent regulation facilitates 
consumers' comparison shopping); and at 39 (discussing the history of 
insurance regulation by the States, which ``has led to a lack of 
uniformity and reduced competition across State and international 
boundaries, resulting in inefficiency, reduced product innovation, and 
higher costs to consumers.'').
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    In particular, for the first time in the nearly 150-year history of 
the national banking system, federally chartered banks would be subject 
to this multiplicity of State operating standards, because the Proposal 
sweepingly repeals the ability of national banks to conduct any retail 
banking business under uniform national standards.
    This is a profound change and, in my view, the rejection of a 
national standards option is unwise and unjustified, especially as it 
relates to national banks. Given the CFPA's enhanced authority and 
mandate to write stronger consumer protection rules, and the thorough 
and expert processes described as integral to its rulemaking, there 
should no longer be any issue as to whether sufficiently strong Federal 
consumer protection standards would be in place and applicable to 
national banks. In this context there is no need to authorize States to 
adopt different standards for such banks. Likewise, there is no need to 
authorize States to enforce Federal rules against national banks--which 
would inevitably result in differing State interpretations of Federal 
rules--because Federal regulators already have broad enforcement 
authority over such institutions and the resources to exercise that 
authority fully.
    More fundamentally, we live in an era where the market for 
financial products and services is often national in scope. Advances in 
technology, including the Internet and the increased functionality of 
mobile phones, enable banks to do business with customers in many 
States. Our population is increasingly mobile, and many people live in 
one State and work in another--the case for many of us in the 
Washington, DC, metropolitan area.
    In this context, regressing to a regulatory regime that fails to 
recognize the way retail financial services are now provided, and the 
need for an option for a single set of rules for banks with multistate 
operations and multistate customers, would discard many of the benefits 
consumers reap from our modern financial product delivery system. The 
Proposal's balkanized approach could give rise to significant 
uncertainty about which sets of standards apply to institutions 
conducting a multistate business, generating major legal and compliance 
costs, and major impediments to interstate product delivery.
    This issue is very real for all banks operating across State 
lines--not just national banks. Recognizing the importance of 
preserving uniform interstate standards for all banks operating in 
multiple States, Congress expressly provided in the ``Riegle-Neal II'' 
Act enacted in 1997 that State banks operating through interstate 
branches in multiple States should enjoy the same Federal preemption 
and ability to operate with uniform standards as national banks. \6\
---------------------------------------------------------------------------
     \6\ 12 U.S.C. 1831a(j); See, also id. at 1831d (interest rates; 
parity for State banks).
---------------------------------------------------------------------------
    Accordingly, repealing the uniform standards option would create 
fundamental, practical problems for all banks operating across State 
lines, large or small. For example, there are a number of areas in 
which complying with different standards set by individual States would 
require a bank to determine which State's law governs--the law of the 
State where a person providing a product or service is located, the law 
of the home State of the bank employing that person, or the law of the 
State where the customer is located. It is far from clear how a bank 
could do this based on objective analysis, and any conflicts could 
result in penalties and litigation in multiple jurisdictions.
    Consider the following practical examples of the potential for 
multiple State standards:

    Different rules regarding allowable terms and conditions of 
        particular products;

    Different standards for how products may be solicited and 
        sold (including the internal organizational structure of the 
        provider selling the product);

    Different duties and responsibilities for individuals 
        providing a particular financial product;

    Different limitations on how individuals offering 
        particular products and services may be compensated;

    Different standards for counterparty and assignee liability 
        in connection with specified products;

    Different standards for risk retention (``skin in the 
        game'') by parties in a chain of origination and sale;

    Different disclosure standards;

    Different requirements, or permissible rates of interest, 
        for bank products; and

    Different licensing and product clearance requirements.

    Taking permissible interest rates as an example, today the maximum 
permissible interest rate is derived from the bank's home State. Under 
the proposal, States could claim that the permissible rate should be 
the rate of the State in which the customer resides, or the rate of the 
location where the loan is made, or someplace else. States could also 
have different rules about the types of charges that constitute 
``interest'' subject to State limits. And States could have different 
standards for exerting jurisdiction over interest rates, creating the 
potential for the laws of two or more States to apply to the same 
transaction. And even if the bank figures all this out for a particular 
customer, and for all the product relationships it has with the 
customer, that could all change if the customer moved. Does that mean 
the customer would have to open a new account to incorporate the new 
required terms?
    Such uncertainties have the real potential to confuse consumers, 
subject providers to major new potential liabilities, and significantly 
increase the costs of doing business in ways that will be passed on to 
consumers. It could also cause product providers to pull back where 
increased costs erase an already thin profit margin--for example, with 
``indirect'' auto lending across State lines--or where they see 
unacceptable levels of uncertainty and potential risk.
    Moreover, a bank with multistate operations might well decide that 
the only sensible way to conduct a national business is to operate to 
the most stringent standard prevailing in its most significant State 
market. It should not be the case that a decision by one State 
legislature about how products should be designed, marketed, or sold 
should effectively replace a national regulatory standard established 
by the Federal Government based on thorough research and an open and 
nationwide public comment process.
    Finally, subjecting national banks to state laws and state 
enforcement of Federal laws is a potentially crippling change to the 
national bank charter and a rejection of core principles that form the 
bedrock of the dual banking system. For nearly 150 years, national 
banks have been subject to a uniform set of Federal rules enforced by 
the OCC, and State banks have been subject to their own States' rules. 
This dual banking system has worked, as it has allowed an individual 
State to serve as a ``laboratory'' for new approaches to an issue--
without compelling adoption of a particular approach by all States or 
as a national standard. That is, the dual banking system is built on 
individual States experimenting with different kinds of laws, including 
new consumer protection laws, that apply to State banks in a given 
State, but not to State banks in all States and not to national banks. 
Some of these individual State laws have proven to be good ideas, while 
others have not. When Congress has believed that a particular State's 
experiment is worthwhile, it has enacted that approach to apply 
throughout the country, not only to all national banks, but to State 
banks operating in other States that have not yet adopted such laws. As 
a result of this system, national banks have always operated under an 
evolving set of Federal rules that are at any one time the same, 
regardless of the State in which the banks are headquartered, or the 
number of different States in which they operate. This reliable set of 
uniform Federal rules is a defining characteristic of the national bank 
charter, helping banks to provide a broader range of financial products 
and services at lower cost, which in turn can be passed along to the 
consumer.
    The Proposal's CFPA, by needlessly eliminating this defining 
characteristic, will effectively ``de-nationalize'' the national 
charter and undermine the dual banking system. What will be the point 
of a national charter if all banks must operate in every State as if 
they were chartered in that State? In such circumstances there would be 
a strong impetus to convert to a State bank regulated by the Federal 
Reserve in order to obtain the same regulator for the bank and the 
holding company, while avoiding any additional cost associated with 
national bank supervision--and that would further concentrate 
responsibilities in, and stretch the mission of, the Federal Reserve.
    In short, with many consumer financial products now commoditized 
and marketed nationally, it is difficult to understand the sense of 
replacing the existing, long-standing option of enhanced and reliable 
Federal standards that are uniform, with a balkanized ``system'' of 
differing State standards that may be adopted under processes very 
different from the public-comment and research-based rulemaking process 
that the CFPA would employ as a Federal agency.
b. Safety and Soundness Implications of CFPA Rulemaking--The Proposal 
        would vest all consumer protection rulewriting authority in the 
        CFPA, which in turn would not be constrained in any meaningful 
        way by safety and soundness concerns. That presents serious 
        issues because, in critical aspects of bank supervision, such 
        as underwriting standards, consumer protection cannot be 
        separated from safety and soundness. They are both part of 
        comprehensive and effective banking supervision. Despite this 
        integral relationship, the Proposal as drafted would allow the 
        CFPA, in writing rules, to dismiss legitimate safety and 
        soundness concerns raised by a banking supervisor. That is, if 
        a particular CFPA rule conflicts with a safety and soundness 
        standard, the CFPA's views would always prevail, because the 
        legislation provides no mechanism for striking an appropriate 
        balance between consumer protection and safety and soundness 
        objectives.
    For example, the CFPA could require a lender to offer a 
standardized mortgage that has simple terms, but also has a low down 
payment to make it more beneficial to consumers. That type of rule 
could clearly raise safety and soundness concerns, because lower down 
payments are correlated with increased defaults on loans--yet a safety 
and soundness supervisor would have no ability to stop such a rule from 
being issued.
    In short, as applied to depository institutions, the CFPA rules 
need to have meaningful input from banking supervisors--both for safety 
and soundness purposes and because bank supervisors are intimately 
familiar with bank operations and can help ensure that rules are 
crafted to be practical and workable. A workable mechanism needs to be 
specifically provided to incorporate legitimate operational and safety 
and soundness concerns of the banking agencies into any final rule that 
would be applicable to insured depository institutions. Moreover, I do 
not believe it is sufficient to have only one banking supervisor on the 
agency's board, as provided under the Proposal; instead, all the 
banking agencies should be represented, even if that requires expanding 
the size of the board.
2. Implementation: Supervision, Examination, and Enforcement
    Consumer protection rules are implemented through examination, 
supervision, and/or enforcement. In this context, the Proposal fails to 
adequately address the implementation gap I have previously described 
because it fails to carefully and appropriately target the CFPA's 
examination, supervision, and enforcement jurisdiction to the literally 
tens of thousands of nondepository institution financial providers that 
are either unregulated or very lightly regulated. These are the firms 
most in need of enhanced consumer protection regulation, and these are 
the ones that will present the greatest implementation challenges to 
the CFPA. Yet rather than focus the CFPA's implementation 
responsibilities on these firms, the Proposal would effectively dilute 
both the CFPA's and the States' supervisory and enforcement authorities 
by extending them to already regulated banks. To do this, the Proposal 
would strip away all consumer compliance examination and supervisory 
responsibilities--and for all practical purposes enforcement powers as 
well--from the Federal banking agencies and transfer them to the CFPA. 
And, although the legislation is unclear about the new agency's 
responsibilities for receiving and responding to consumer complaints, 
it would either remove or duplicate the process for receiving and 
responding to complaints by consumers about their banks.
    The likely results will be that: (1) nonbank financial providers 
will not receive the degree of examination, supervision, and 
enforcement attention required to achieve effective compliance with 
consumer protection rules; and (2) consumer protection supervision of 
banks will become less rigorous and less effective.
    In relative terms, it will be easy for the CFPA to adopt consumer 
protection rules that apply to all providers of financial products and 
services. But it will be far harder to craft a workable supervisory and 
enforcement regime to achieve effective implementation of those rules. 
In particular, it will be a daunting challenge to implement rules with 
respect to the wide variety and huge number of unregulated or lightly 
regulated providers of financial services over which the new CFPA would 
have jurisdiction, i.e., mortgage brokers; mortgage originators; payday 
lenders; money service transmitters; check cashers; real estate 
appraisers; title, credit, and mortgage insurance companies; credit 
reporting agencies; stored value providers; financial data processing, 
transmission, and storage firms; debt collection firms; investment 
advisers not subject to SEC regulation; financial advisors; and credit 
counseling and tax preparation services, among other types of firms. 
Likewise, it will be daunting to respond to complaints from consumers 
about these types of firms.
    Yet, although the Proposal would give the CFPA broad consumer 
protection authority over these types of financial product and service 
providers, it contains no framework or detail for examining them or 
requiring reports from them--or even knowing who they are. No functions 
are specified for the CFPA to monitor or examine even the largest of 
these nonbank firms, much less to supervise and examine them as 
depository institutions would be when they engaged in the same 
activities. No provision is even made for registration with the CFPA so 
that the CFPA could at least know the number and size of firms for 
which it has supervisory, examination, and enforcement 
responsibilities. Nor is any means specified for the CFPA to learn this 
information so that it may equitably assess the costs of its 
operations--and lacking that, there is a very real concern that 
assessments will be concentrated on already regulated banks, for which 
size and operational information is already available.
    In short, the CFPA has a full-time job ahead to supervise, examine, 
and take enforcement actions against nonbank firms in order to effect 
their compliance with CFPA rules. In contrast, achieving effective 
compliance with such rules by banks is far more straightforward, since 
an extensive and effective supervisory and enforcement regime is 
already in place at the Federal banking agencies. It therefore makes 
compelling sense for the new CFPA to target its scarce implementation 
resources on the part of the industry that requires the most attention 
to raise its level of compliance--the shadow banking system--rather 
than also try to assume supervisory, examination, and enforcement 
functions with respect to depository institutions.
    Similarly, State consumer protection resources would be best 
focused on examining and enforcing consumer protection laws with 
respect to the nonbank financial firms that are unregulated or lightly 
regulated--and have been the disproportionate source of financial 
consumer protection problems. If States targeted their scarce resources 
in this way, and drew on new examination and enforcement resources of 
the CFPA that were also targeted in this way, the States could help 
achieve significantly increased compliance with consumer protection 
laws by nonbank financial firms. Unfortunately, rather than have this 
focus, the Proposal's CFPA would stretch the States' enforcement 
jurisdiction to federally chartered banks, which are already subject to 
an extensive examination and enforcement regime at the Federal level. 
We believe this dilution of their resources is unnecessary, and it will 
only make it more difficult to fill the implementation gap that 
currently exists in achieving effective compliance of nonbank firms 
with consumer protection rules.
    Finally, I firmly believe that, by transferring all consumer 
protection examination, supervision, and enforcement functions from the 
Federal banking agencies to the CFPA, the Proposal would create a 
supervisory system for banks that would be a less effective approach to 
consumer protection than the integrated approach to banking supervision 
that exists today. Safety and soundness is not divorced from consumer 
protection--they are two aspects of comprehensive bank supervision that 
are complementary. As evidence of this, attached to my testimony are 
summaries of our actual supervisory experience, drawn from supervisory 
letters and examination conclusion memoranda, which show the real life 
linkage between safety and soundness and consumer protection 
supervision. These summaries demonstrate that the results would be 
worse for consumers and the prudential supervision of these banks if 
bank examiners were not allowed to address both safety and soundness 
and consumer protection issues as part of their integrated supervision.
    Indeed, we believe that transferring bank examination and 
supervision authority to the CFPA will not result in more effective 
supervision of banks--or consumer protection--because the new agency 
will never have the same presence or knowledge about the institution. 
Our experience at the OCC has been that effective, integrated safety 
and soundness and compliance supervision grows from the detailed, core 
knowledge that our examiners develop and maintain about each bank's 
organizational structure, culture, business lines, products, services, 
customer base, and level of risk; this knowledge and expertise is 
cultivated through regular on-site examinations and contact with our 
community banks, and close, day-to-day focus on the activities of 
larger banks. An agency with a narrower focus, like that envisioned for 
the CFPA, would be less effective than a supervisor with a 
comprehensive grasp of the broader banking business.
Conclusion
    The OCC appreciates the opportunity to testify on proposed 
regulatory reform, and we would be pleased to provide additional 
information as the Committee continues its consideration of this 
important Proposal.




                PREPARED STATEMENT OF DANIEL K. TARULLO
        Member, Board of Governors of the Federal Reserve System
                             August 4, 2009
    Chairman Dodd, Ranking Member Shelby, and other Members of the 
Committee, thank you for your invitation to testify this morning. The 
financial crisis had many causes, including global imbalances in 
savings and capital flows, the rapid integration of lending activities 
with the issuance, trading, and financing of securities, the existence 
of gaps in the regulatory structure for the financial system, and 
widespread failures of risk management across a range of financial 
institutions. Just as the crisis had many causes, the response of 
policymakers must be broad in scope and multifaceted.
    Improved prudential supervision--the topic of today's hearing--is a 
necessary component of the policy response. The crisis revealed 
supervisory shortcomings among all financial regulators, to be sure. 
But it also demonstrated that the framework for prudential supervision 
and regulation had not kept pace with changes in the structure, 
activities, and growing interrelationships of the financial sector. 
Accordingly, it is essential both to refocus the regulation and 
supervision of banking institutions under existing authorities and to 
augment those authorities in certain respects.
    In my testimony today, I will begin by suggesting the elements of 
an effective framework for prudential supervision. Then I will review 
actions taken by the Federal Reserve within its existing statutory 
authorities to strengthen supervision of banks and bank holding 
companies in light of developments in the banking system and the 
lessons of the financial crisis. Finally, I will identify some gaps and 
weaknesses in the system of prudential supervision. One potential gap 
has already been addressed through the cooperative effort of Federal 
and State banking agencies to prevent insured depository institutions 
from engaging in ``regulatory arbitrage'' through charter conversions. 
Others, however, will require congressional action.
Elements of an Effective Framework for Prudential Supervision
    An effective framework for the prudential regulation and 
supervision of banking institutions includes four basic elements.
    First, of course, there must be sound regulation and supervision of 
each insured depository institution. Applicable regulations must be 
well-designed to promote the safety and soundness of the institution. 
Less obvious, perhaps, but of considerable importance, is the 
usefulness of establishing regulatory requirements that make use of 
market discipline to help confine undue risk taking in banking 
institutions. Supervisory policies and techniques also must be up to 
the task of enforcing and supplementing regulatory requirements.
    Second, there must be effective supervision of the companies that 
own insured depository institutions. The scope and intensity of this 
supervision should vary with the extent and complexity of activities 
conducted by the parent company or its nonbank subsidiaries. When a 
bank holding company is essentially a shell, with negligible activities 
or ownership stakes outside the bank itself, holding company regulation 
can be less intensive and more modest in scope. But when material 
activities or funding are conducted at the holding company level, or 
when the parent owns nonbank entities, the intensity of scrutiny must 
increase in order to protect the bank from both the direct and indirect 
risks of such activities or affiliations and to ensure that the holding 
company is able to serve as a source of strength to the bank on a 
continuing basis. The task of holding company supervision thus involves 
an examination of the relationships between the bank and its affiliates 
as well as an evaluation of risks associated with those nonbank 
affiliates. Consolidated capital requirements also play a key role, by 
helping ensure that a holding company maintains adequate capital to 
support its groupwide activities and does not become excessively 
leveraged.
    Third, there cannot be significant gaps or exceptions in the 
supervisory and regulatory coverage of insured depository institutions 
and the firms that own them. Obviously, the goals of prudential 
supervision will be defeated if some institutions are able to escape 
the rules and requirements designed to achieve those goals. There is a 
less obvious kind of gap, however, where supervisors are restricted 
from obtaining relevant information or reaching activities that could 
pose risks to banking organizations.
    Fourth, prudential supervision--especially of larger institutions--
must complement and support regulatory measures designed to contain 
systemic risk and the too-big-to-fail problem, topics that I have 
discussed in previous appearances before this Committee. \1\ One clear 
lesson of the financial crisis is that important financial risks may 
not be readily apparent if supervision focuses only on the exposures 
and activities of individual institutions. For example, the liquidity 
strategy of a banking organization may appear sound when viewed in 
isolation but, when examined alongside parallel strategies of other 
institutions, may be found to be inadequate to withstand periods of 
financial stress.
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     \1\ See, Daniel K. Tarullo (2009), ``Regulatory Restructuring'', 
statement before the Committee on Banking, Housing, and Urban Affairs, 
U.S. Senate, July 23, www.federalreserve.gov/newsevents/testimony/
tarullo20090723a.htm; and Daniel K. Tarullo (2009), ``Modernizing Bank 
Supervision and Regulation'', statement before the Committee on 
Banking, Housing, and Urban Affairs, U.S. Senate, March 19, 
www.federalreserve.gov/newsevents/testimony/tarullo20090319a.htm.
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Strengthening Prudential Supervision and Regulation
    The crisis has revealed significant risk-management deficiencies at 
a wide range of financial institutions, including banking 
organizations. It also has challenged some of the assumptions and 
analysis on which conventional supervisory wisdom has been based. For 
example, the collapse of Bear Stearns, which at the end was unable to 
borrow privately even with U.S. Government securities as collateral, 
has undermined the widely held belief that a company can readily borrow 
against high-quality collateral, even in stressed environments. 
Moreover, the growing codependency between financial institutions and 
markets--evidenced by the significant role that investor and 
counterparty runs played in the crisis--implies that supervisors must 
pay closer attention to the potential for financial markets to 
influence the safety and soundness of banking organizations. These and 
other lessons of the financial crisis have led to changes in regulatory 
and supervisory practices in order to improve prudential oversight of 
banks and bank holding companies, as well as to advance a 
macroprudential, or systemic, regulatory agenda.
    Working with other domestic and foreign supervisors, the Federal 
Reserve has taken steps to require the strengthening of capital, 
liquidity, and risk management at banking organizations. There is 
little doubt that, in the period before the crisis, capital levels were 
insufficient to serve as a needed buffer against loss, particularly at 
some of the largest financial institutions, both in the United States 
and elsewhere. Measures to strengthen the capital requirements for 
trading activities and securitization exposures--two areas where 
banking organizations have experienced greater losses than 
anticipated--were recently announced by the Basel Committee on Banking 
Supervision. Additional efforts are under way to improve the quality of 
the capital used to satisfy minimum capital ratios, to strengthen the 
capital requirements for other types of on- and off-balance-sheet 
exposures, and to establish capital buffers in good times that can be 
drawn down as economic and financial conditions deteriorate. Capital 
buffers, though not easy to design or implement in an efficacious 
fashion, could be an especially important step in reducing the 
procyclical effects of the current capital rules. Further review of 
accounting standards governing valuation and loss provisioning also 
would be useful, and might result in modifications to the accounting 
rules that reduce their procyclical effects without compromising the 
goals of disclosure and transparency.
    The Federal Reserve also helped lead the Basel Committee's 
development of enhanced principles of liquidity risk management, which 
were issued last year. \2\ Following up on that initiative, on June 30, 
2009, the Federal banking agencies requested public comment on new 
Interagency Guidance on Funding and Liquidity Risk Management, which is 
designed to incorporate the Basel Committee's principles and clearly 
articulate consistent supervisory expectations on liquidity risk 
management. \3\ The guidance reemphasizes the importance of cash flow 
forecasting, adequate buffers of contingent liquidity, rigorous stress 
testing, and robust contingent funding planning processes. It also 
highlights the need for institutions to better incorporate liquidity 
costs, benefits, and risks in their internal product pricing, 
performance measurement, and new product approval process for all 
material business lines, products, and activities.
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     \2\ See, Basel Committee on Banking Supervision (2008), 
``Principles for Sound Liquidity Risk Management and Supervision'' 
(Basel, Switzerland: Bank for International Settlements, September), 
www.bis.org/publ/bcbs144.htm.
     \3\ See, Office of the Comptroller of the Currency, Board of 
Governors of the Federal Reserve System, Federal Deposit Insurance 
Corporation, Office of Thrift Supervision, and National Credit Union 
Administration (2009), ``Agencies Seek Comment on Proposed Interagency 
Guidance on Funding and Liquidity Risk Management'', joint press 
release, June 30, www.federalreserve.gov/newsevents/press/bcreg/
20090630a.htm.
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    With respect to bank holding companies specifically, the 
supervisory program of the Federal Reserve has undergone some basic 
changes. As everyone is aware, many of the financial firms that lay at 
the center of the crisis were not bank holding companies; some were not 
subject to mandatory prudential supervision of any sort. During the 
crisis a number of very large firms became bank holding companies--in 
part to reassure markets that they were subject to prudential oversight 
and, in some cases, to qualify for participation in various Government 
liquidity support programs. The extension of holding company status to 
these firms, many of which are not primarily composed of a commercial 
bank, highlights the degree to which the traditional approach to 
holding company supervision must evolve.
    Recent experience also reinforces the value of holding company 
supervision in addition to, and distinct from, bank supervision. Large 
organizations increasingly operate and manage their businesses on an 
integrated basis with little regard for the corporate boundaries that 
typically define the jurisdictions of individual functional 
supervisors. Indeed, the crisis has highlighted the financial, 
managerial, operational, and reputational linkages among the bank, 
securities, commodity, and other units of financial firms.
    The customary focus on protecting the bank within a holding 
company, while necessary, is clearly not sufficient in an era in which 
systemic risk can arise wholly outside of insured depository 
institutions. Similarly, the premise of functional regulation that 
risks within a diversified organization can be evaluated and managed 
properly through supervision focused on individual subsidiaries within 
the firm has been undermined further; the need for greater attention to 
the potential for damage to the bank, the organization within which it 
operates, and, in some cases, the financial system generally, requires 
a more comprehensive and integrated assessment of activities throughout 
the holding company.
    Appropriate enhancements of both prudential and consolidated 
supervision will only increase the need for supervisors to be able to 
draw on a broad foundation of economic and financial knowledge and 
experience. That is why we are incorporating economists and other 
experts from nonsupervisory divisions of the Federal Reserve more 
completely into the process of supervisory oversight. The insights 
gained from the macroeconomic analyses associated with the formulation 
of monetary policy and from the familiarity with financial markets 
derived from our open market operations and payments systems 
responsibilities can add enormous value to holding company supervision.
    The recently completed Supervisory Capital Assessment Program 
(SCAP) heralds some of the changes in the Federal Reserve's approach to 
prudential supervision of the largest banking organizations. This 
unprecedented process involved, at its core, 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. Bank 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 
under both a baseline and more-adverse-than-expected scenario, drawing 
on individual firm information and independently estimated outcomes 
using supervisory models.
    Drawing on this experience, we are prioritizing and expanding our 
program of horizontal examinations to assess key operations, risks, and 
risk-management activities of large institutions. For the largest and 
most complex firms, we are creating an enhanced quantitative 
surveillance program 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.
    Capital serves as an important bulwark against potential unexpected 
losses for banking organizations of all sizes, not just the largest 
ones. Accordingly, internal capital analyses of banking organizations 
must reflect a wide range of scenarios and capture stress environments 
that could impair solvency. Earlier this year, we issued supervisory 
guidance for all bank holding companies regarding dividends, capital 
repurchases, and capital redemptions. \4\ That guidance also 
reemphasized the Federal Reserve's long-standing position that bank 
holding companies must serve as a source of strength for their 
subsidiary banks.
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     \4\ See, Board of Governors of the Federal Reserve System (2009), 
Supervision and Regulation Letter SR 09-4, ``Applying Supervisory 
Guidance and Regulations on the Payment of Dividends, Stock 
Redemptions, and Stock Repurchases at Bank Holding Companies'', 
February 24 (as revised on March 27, 2009), www.federalreserve.gov/
boarddocs/srletters/2009/SR0904.htm.
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    Commercial real estate (CRE) is one area of risk exposure that has 
gained much attention recently. We began to observe rising CRE 
concentrations earlier this decade and, in light of the central role 
that CRE lending played in the banking problems of the late 1980s and 
early 1990s, led an interagency effort to issue supervisory guidance 
directed at the risks posed by CRE concentrations. This guidance, which 
generated significant controversy at the time it was proposed, was 
finalized in 2006 and emphasized the need for banking organizations to 
incorporate realistic risk estimates for CRE exposures into their 
strategic- and capital-planning processes, and encouraged institutions 
to conduct stress tests or similar exercises to identify the impact of 
potential CRE shocks on earnings and capital. Now that weaker housing 
markets and deteriorating economic conditions have, in fact, impaired 
the quality of CRE loans at many banking organizations, we are 
monitoring carefully the effect that declining collateral values may 
have on CRE exposures and assessing the extent to which banking 
organizations have been complying with the CRE guidance. At the same 
time, we have taken actions to ensure that supervisory and regulatory 
policies and practices do not inadvertently curtail the availability of 
credit to sound borrowers.
    While CRE exposures represent perhaps an ``old'' problem, the 
crisis has newly highlighted the potential for compensation practices 
at financial institutions to encourage excessive risk taking and unsafe 
and unsound behavior--not just by senior executives, but also by other 
managers or employees who have the ability, individually or 
collectively, to materially alter the risk profile of the institution. 
Bonuses and other compensation arrangements should not provide 
incentives for employees at any level to behave in ways that 
imprudently increase risks to the institution, and potentially to the 
financial system as a whole. The Federal Reserve worked closely with 
other supervisors represented on the Financial Stability Board to 
develop principles for sound compensation practices, which were 
released earlier this year. \5\ The Federal Reserve expects to issue 
soon our own guidance on this important subject to promote compensation 
practices that are consistent with sound risk-management principles and 
safe and sound banking.
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     \5\ See, Financial Stability Forum (2009), FSF Principles for 
Sound Compensation Practices, April 2, www.financialstabilityboard.org/
publications/r_0904b.pdf. The Financial Stability Forum has 
subsequently been renamed the Financial Stability Board.
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    Finally, I would note the importance of continuing to analyze the 
practices of financial firms and supervisors that preceded the crisis, 
with the aim of fashioning additional regulatory tools that will make 
prudential supervision more effective and efficient. One area that 
warrants particular attention is the potential for supervisory agencies 
to enlist market discipline in pursuit of regulatory ends. For example, 
supervisors might require that large financial 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 because of extraordinary losses. While the costs, benefits, 
and feasibility of this type of capital requires further study, 
policymakers should actively seek ways of motivating the private owners 
of banking organizations to monitor the financial positions of the 
issuing firms more effectively.
Addressing Gaps and Weaknesses in the Regulatory Framework
    While the actions that I have just discussed should help make 
banking organizations and the financial system stronger and more 
resilient, the crisis also has highlighted gaps and weaknesses in the 
underlying framework for prudential supervision of financial 
institutions that no regulatory agency can rectify on its own. One, 
which I will mention in a moment, has been addressed by the banking 
agencies working together. Others require congressional attention.
Charter Conversions and Regulatory Arbitrage
    The dual banking system and the existence of different Federal 
supervisors create the opportunity for insured depository institutions 
to change charters or Federal supervisors. While institutions may 
engage in charter conversions for a variety of sound business reasons, 
conversions that are motivated by a hope of escaping current or 
prospective supervisory actions by the institution's existing 
supervisor undermine the efficacy of the prudential supervisory 
framework.
    Accordingly, the Federal Reserve welcomed and immediately supported 
an initiative led by the Federal Deposit Insurance Corporation (FDIC) 
to address such regulatory arbitrage. This initiative resulted in a 
recent statement of the Federal Financial Institutions Examination 
Council reaffirming that charter conversions or other actions by an 
insured depository institution that would result in a change in its 
primary supervisor should occur only for legitimate business and 
strategic reasons. \6\ Importantly, this statement also provides that 
conversion requests should not be entertained by the proposed new 
chartering authority or supervisor while serious or material 
enforcement actions are pending with the institution's current 
chartering authority or primary Federal supervisor. In addition, it 
provides that the examination rating of an institution and any 
outstanding corrective action programs should remain in place when a 
valid conversion or supervisory change does occur.
---------------------------------------------------------------------------
     \6\ See, Federal Financial Institutions Examination Council 
(2009), ``FFIEC Issues Statement on Regulatory Conversions'', press 
release, July 1, www.ffiec.gov/press/pr070109.htm.
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Systemically Important Financial Institutions
    The Lehman experience clearly demonstrates that the financial 
system and the broader economy can be placed at risk by the failure of 
financial firms that traditionally have not been subject to the type of 
consolidated supervision applied to bank holding companies. As I 
discussed in my most recent testimony before this Committee, the 
Federal Reserve believes that all systemically important financial 
firms--not just those affiliated with a bank--should be subject to, and 
robustly supervised under, a statutory framework for consolidated 
supervision like the one embodied in the Bank Holding Company Act (BHC 
Act).
    Doing so would help promote the safety and soundness of these firms 
individually and the stability of the financial system generally. 
Indeed, given the significant adverse effects that the failure of such 
a firm may have on the financial system and the broader economy, the 
goals and implementation of prudential supervision and systemic risk 
reduction are inextricably intertwined in the case of these 
organizations. For example, while the strict capital, liquidity, and 
risk-management requirements that are needed for these organizations 
are traditional tools of prudential supervision, the supervisor of such 
firms will need to calibrate these standards appropriately to account 
for the firms' systemic importance.
Industrial Loan Companies and Thrifts
    Another gap in existing law involves industrial loan companies 
(ILCs). ILCs are State-chartered banks that have full access to the 
Federal safety net, including FDIC deposit insurance and the Federal 
Reserve's discount window and payments systems; have virtually all of 
the deposit-taking powers of commercial banks; and may engage in the 
full range of other banking services, including commercial, mortgage, 
credit card, and consumer lending activities, as well as cash 
management services, trust services, and payment-related services, such 
as Fedwire, automated clearinghouse, and check-clearing services.
    A loophole in current law, however, permits any type of firm--
including a commercial company or foreign bank--to acquire an FDIC-
insured ILC chartered in a handful of States without becoming subject 
to the prudential framework that the Congress has established for the 
corporate owners of other full-service insured banks. Prior to the 
crisis, several large firms-including Lehman Brothers, Merrill Lynch, 
Goldman Sachs, Morgan Stanley, GMAC, and General Electric--took 
advantage of this opportunity by acquiring ILCs while avoiding 
consolidated supervision under the BHC Act.
    The Federal Reserve has long supported closing this loophole, 
subject to appropriate ``grandfather'' provisions for the existing 
owners of ILCs. Such an approach would prevent additional firms from 
acquiring a full-service bank and escaping the consolidated supervision 
framework and activity restrictions that apply to bank holding 
companies. It also would require that all firms controlling an ILC, 
including a grandfathered firm, be subject to consolidated supervision. 
For reasons of fairness, the Board believes that the limited number of 
firms that currently own an ILC and are not otherwise subject to the 
BHC Act should be permitted to retain their nonbanking or commercial 
affiliations, subject to appropriate restrictions to protect the 
Federal safety net and prevent abuses.
    Corporate owners of savings associations should also be subject to 
the same regulation and examination as corporate owners of insured 
banks. In addition, grandfathered commercial owners of savings 
associations should, like we advocate for corporate owners of ILCs, be 
subject to appropriate restrictions to protect the Federal safety net 
and prevent abuses.
Strengthening the Framework for Consolidated Supervision
    Consolidated supervision is intended to provide a supervisor the 
tools necessary to understand, monitor, and, when appropriate, restrain 
the risks associated with an organization's consolidated or groupwide 
activities. Risks that cross legal entities and that are managed on a 
consolidated basis cannot be monitored properly through supervision 
directed at any one, or even several, of the legal entity subdivisions 
within the overall organization.
    To be fully effective, consolidated supervisors need the 
information and ability to identify and address risks throughout an 
organization. However, the BHC Act, as amended by the so-called ``Fed-
lite'' provisions of the Gramm-Leach-Bliley Act, places material 
limitations on the ability of the Federal Reserve to examine, obtain 
reports from, or take actions to identify or address risks with respect 
to both nonbank and depository institution subsidiaries of a bank 
holding company that are supervised by other agencies. Consistent with 
these provisions, we have worked with other regulators and, wherever 
possible, sought to make good use of the information and analysis they 
provide. In the process, we have built cooperative relationships with 
other regulators--relationships that we expect to continue and 
strengthen further.
    Nevertheless, the restrictions in current law still can present 
challenges to timely and effective consolidated supervision in light 
of, among other things, differences in supervisory models--for example, 
between the safety and soundness approach favored by bank supervisors 
and the approaches used by regulators of insurance and securities 
subsidiaries--and differences in supervisory timetables, resources, and 
priorities. Moreover, the growing linkages among the bank, securities, 
insurance, and other entities within a single organization that I 
mentioned earlier heighten the potential for these restrictions to 
hinder effective groupwide supervision of firms, particularly large and 
complex organizations. To ensure that consolidated supervisors have the 
necessary tools and authorities to monitor and address safety and 
soundness concerns in all parts of an organization on a timely basis, 
we would urge statutory modifications to the Fed-lite provisions of the 
Gramm-Leach-Bliley Act. Such changes, for example, should remove the 
limits first imposed in 1999 on the scope and type of information that 
the Federal Reserve may obtain from subsidiaries of bank holding 
companies in furtherance of its consolidated supervision 
responsibilities, and on the ability of the Federal Reserve to take 
action against subsidiaries to address unsafe and unsound practices and 
enforce compliance with applicable law.
Limiting the Costs of Bank Failures
    The timely closing and resolution of failing insured depository 
institutions is critical to limiting the costs of a failure to the 
deposit insurance fund. \7\ The conditions governing when the Federal 
Reserve may close a failing State member bank, however, are 
significantly more restrictive than those under which the Office of the 
Comptroller of the Currency may close a national bank, and are even 
more restrictive than those governing the FDIC's backup authority to 
close an insured depository institution after consultation with the 
appropriate primary Federal and, if applicable, state banking 
supervisor. The Federal Reserve generally may close a state member bank 
only for capital-related reasons. The grounds for which the OCC or FDIC 
may close a bank include a variety of non-capital-related conditions, 
such as if the institution is facing liquidity pressures that make it 
likely to be unable to pay its obligations in the normal course of 
business or if the institution is otherwise in an unsafe or unsound 
condition to transact business. We hope that the Congress will consider 
providing the Federal Reserve powers to close a state member bank that 
are similar to those possessed by other Federal banking agencies.
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     \7\ Similarly, the creation of a resolution regime that would 
provide the Government the tools it needs to wind down a systemically 
important nonbank financial firm in an orderly way and impose losses on 
shareholders and creditors where possible would help the Government 
protect the financial system and economy while reducing the potential 
cost to taxpayers and mitigating moral hazard.
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    In view of the number of bank failures that have occurred over the 
past 18 months and the resulting costs to the deposit insurance fund, 
policymakers also should explore whether additional triggers--beyond 
the capital ratios in the current Prompt Corrective Action framework--
may be more effective in promoting the timely resolution of troubled 
institutions at lower cost to the insurance fund. Capital is a lagging 
indicator of financial difficulties in most instances, and one or more 
additional measures, perhaps based on asset quality, may be worthy of 
analysis and consideration.
Conclusion
    Thank you for the opportunity to testify on these important 
matters. We look forward to working with the Congress, the 
Administration, and the other banking agencies to ensure that the 
framework for prudential supervision of banking organizations and other 
financial institutions adjusts, as it must, to meet the challenges our 
dynamic and increasingly interconnected financial system.
                                 ______
                                 
                  PREPARED STATEMENT OF JOHN E. BOWMAN
             Acting Director, Office of Thrift Supervision
                             August 4, 2009
I. Introduction
    Good morning, Chairman Dodd, Ranking Member Shelby, and Members of 
the Committee. Thank you for the opportunity to testify today on the 
Administration's Proposal for Financial Regulatory Reform. It is my 
pleasure to address the Committee for the first time in my role as 
Acting Director of the Office of Thrift Supervision (OTS).
    We appreciate this Committee's efforts to improve supervision of 
financial institutions in the United States. We share the Committee's 
commitment to reforms to prevent any recurrence of our Nation's current 
financial problems.
    We have studied the Administration's Proposal for Financial 
Regulatory Reform and are pleased to address the questions you have 
asked us about specific aspects of that Proposal. Specifically, you 
asked for our opinion of the merits of the Administration's Proposal 
for a National Bank Supervisor and the elimination of the Federal 
thrift charter. You also requested our opinion on the elimination of 
the exceptions in the Bank Holding Company Act for thrifts and certain 
special purpose banks and about the Federal Reserve System's prudential 
supervision of holding companies.
II. Goals of Regulatory Restructuring
    The recent turmoil in the financial services industry has exposed 
major regulatory gaps and other significant weaknesses that must be 
addressed. Our evaluation of the specifics of the Administration's 
Proposal is predicated on whether or not those elements address the 
core principles OTS believes arc essential to accomplishing true and 
lasting reform:

  1.  Ensure Changes to Financial Regulatory System Address Real 
        Problems--Proposed changes to financial regulatory agencies 
        should be evaluated based on whether they would address the 
        causes of the economic crisis or other true problems.

  2.  Establish Uniform Regulation--All entities that offer financial 
        products to consumers must be subject to the same consumer 
        protection rules and regulations, so under-regulated entities 
        cannot gain a competitive advantage over their more regulated 
        counterparts. Also, complex derivative products, such as credit 
        default swaps, should be regulated.

  3.  Create Ability To Supervise and Resolve Systemically Important 
        Firms--No provider of financial products should be too big to 
        fail, achieving through size and complexity an implicit Federal 
        Government backing to prevent its collapse--and thereby gaining 
        an unfair advantage over its more vulnerable competitors.

  4.  Protect Consumers--One Federal agency should have as its central 
        mission the regulation of financial products and that agency 
        should establish the rules and standards for all consumer 
        financial products rather than the current, multiple number of 
        agencies with fragmented authority and a lack of singular 
        accountability.

    As a general matter the OTS supports all of the fundamental 
objectives that are at the heart of the Administration's Proposal. By 
performing an analysis based on these principles, we offer OTS' views 
on specific provisions of the Administration's Proposal.
III. Administration Proposal To Establish a National Bank Supervisor
    We do not support the Administration's Proposal to establish a new 
agency, the National Bank Supervisor (NBS), by eliminating the Office 
of the Comptroller of the Currency, which charters and regulates 
national banks, and the OTS, which charters Federal thrifts and 
regulates thrifts and their holding companies.
    There is little dispute that the ad hoc framework of financial 
services regulation cobbled together over the last century-and-a-half 
is not ideal. The financial services landscape has changed and the 
economic crisis has revealed gaps in the system that must be addressed 
to ensure a sustainable recovery and appropriate oversight in the years 
ahead. We believe other provisions within the Administration's proposal 
would assist in accomplishing that goal.
    While different parts of the system were created to respond to the 
needs of the time, the current system has generally served the Nation 
well over time, despite economic downturns such as the current one. We 
must ensure that in the rush to address what went wrong, we do not try 
to ``fix'' nonexistent problems nor attempt to fix real problems with 
flawed solutions.
    I would like to dispel the two rationales that have been alleged to 
support the proposal to eliminate the OTS: (1) The OTS was the 
regulator of the purportedly largest insured depository institutions 
that failed during the current economic turmoil, and, (2) Financial 
institutions ``shopping'' for the most lenient regulator allegedly 
flocked to OTS supervision and the thrift charter. Both of those 
allegations are false.
    There are four reasons why the first allegation is untrue:
    First, failures by insured depository institutions have been no 
more severe among OTS-regulated thrifts than among institutions 
supervised by other Federal banking regulators. OTS-regulated 
Washington Mutual, which failed in September 2008 at no cost to the 
deposit insurance fund, was the largest bank failure in U.S. history 
because anything larger has been deemed ``too big to fail.'' By law, 
the Federal Government can provide ``open-bank assistance'' only to 
prevent a failure. Institutions much larger than Washington Mutual, for 
example, Citigroup and Bank of America, had collapsed, but the Federal 
Government prevented their failure by authorizing open bank assistance. 
The ``too big to fail'' institutions are not regulated by the OTS. The 
OTS did not regulate the largest banks that failed; the OTS regulated 
the largest banks that were allowed to fail.
    Second, in terms of numbers of bank failures during the crisis, 
most banks that have failed have been State-chartered institutions, 
whose primary Federal regulator is not the OTS.
    Third, the OTS regulates financial institutions that historically 
make mortgages for Americans to buy homes, By law, thrift institutions 
must keep most of their assets in home mortgages or other retail 
lending activities, The economic crisis grew out of a sharp downturn in 
the residential real estate market, including significant and sustained 
home price depreciation, a protracted decline in home sales and a 
plunge in rates of real estate investment. To date, this segment of the 
market has been hardest hit by the crisis and OTS-regulated 
institutions were particularly affected because their business models 
focus on this segment.
    Fourth, the largest failures among OTS-regulated institutions 
during this crisis concentrated their mortgage lending in California 
and Florida, two of the States most damaged by the real estate decline, 
These States have had significant retraction in the real estate market, 
including double-digit declines in home prices and record rates of 
foreclosure, \1\ Although today's hindsight is 20/20, no one predicted 
during the peak of the boom in 2006 that nationwide home prices would 
plummet by more than 30 percent.
---------------------------------------------------------------------------
     \1\ See, Office of Thrift Supervision Quarterly Market Monitor, 
May 7, 2009, (http://files.ots.treas.gov/131020.pdf).
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    The argument about regulator shopping, or arbitrage, seems to stem 
from the conversion of Countrywide, which left the supervision of the 
OCC and the Board of Governors of the Federal Reserve System (FRB) in 
March 2007--after the height of the housing and mortgage boom--and came 
under OTS regulation, Countrywide made most of its high-risk loans 
through its holding company affiliates before it received a thrift 
charter.
    An often-overlooked fact is that a few months earlier, in October 
2006, Citibank converted two thrift charters from OTS supervision to 
the OCC. Those two Citibank charters totaled more than $232 billion--
more than twice the asset size of Countrywide ($93 billion)--We 
strongly believe that Citibank and Countrywide applied to change their 
charters based on their respective business models and operating 
strategies. Any suggestion that either company sought to find a more 
lenient regulatory structure is without merit.
    In the last 10 years (1999-2008), there were 45 more institutions 
that converted away from the thrift charter (164) than converted to the 
thrift charter (119). Of those that converted to the OTS, more than 
half were State-chartered thrifts (64). In dollar amounts during the 
same 10-year period, $223 billion in assets converted to the thrift 
charter from other charter types and $419 billion in assets converted 
from the thrift charter to other charter types.
    We disagree with any suggestion that banks converted to the thrift 
charter because OTS was a more lenient regulator. Institutions chose 
the charter type that best fits their business model.
    If regulatory arbitrage is indeed a major issue, it is an issue 
between a Federal charter and the charters of the 50 States, as well as 
among the States. Under the Administration's Proposal, the possibility 
of such arbitrage would continue.
    The OTS is also concerned that the NBS may tend, particularly in 
times of stress, to focus most of its attention on the largest 
institutions, leaving midsize and small institutions in the back seat. 
It is critical that all regulatory agencies be structured and operated 
in a manner that ensures the appropriate supervision and regulation of 
all depository institutions, regardless of size.
IV. Administration Proposal To Eliminate the Thrift Charter
    The OTS does not support the provision in the Administration's 
Proposal to eliminate the Federal thrift charter and require all 
Federal thrift institutions to change their charter to the National 
Bank Charter or State bank. We believe the business models of Federal 
banks and thrift institutions are fundamentally different enough to 
warrant two distinct Federal banking charters.
    It is important to note that elimination of the thrift charter 
would not have prevented the current mortgage meltdown, nor would it 
help solve current problems or prevent future crises. Savings 
associations generally are smaller institutions that have strong ties 
to their communities. Many thrifts never made subprime or Alt-A 
mortgages; rather they adhered to traditional, solid underwriting 
standards. Most thrifts did not participate in the private originate-
to-sell model; they prudently underwrote mortgages intending to hold 
the loans in their own portfolios until the loans matured.
    Forcing thrifts to convert from thrifts to banks or State chartered 
savings associations would not only be costly, disruptive, and punitive 
for thrifts, but could also deprive creditworthy U.S. consumers of the 
credit they need to become homeowners and the extension of credit this 
country needs to stimulate the economy.
    We also strongly support retaining the mutual form of organization 
for insured institutions. Generally, mutual institutions are weathering 
the current financial crisis better than their stock competitors. The 
distress in the housing markets has had a much greater impact on the 
earnings of stock thrifts than on mutual thrifts over the past year. 
For the first quarter 2009, mutual thrills reported a return on average 
assets (ROA) on 0.42 percent, while stock thrifts reported an ROA of 
0.04 percent. We see every reason to preserve the mutual institution 
charter and no compelling rationale to eliminate it.
    OTS also supports retention of the dual banking system with both 
Federal and State charters for banks and thrifts. This system has 
served the financial markets in the United States well. The States have 
provided a charter option for banks and thrifts that have not wanted to 
have a Federal charter. Banks and thrifts should be able to choose 
whether to operate with a Federal charter or a State charter.
V. Administration Proposal To Eliminate the Exceptions in the Bank 
        Holding Company Act for Thrifts and Special Purpose Banks
A. Elimination of the Exception in the Bank Holding Company Act for 
        Thrifts
    Because a thrill is not considered a ``bank'' under the Bank 
Holding Company Act of 1956 (BHCA), \2\ the FRB does not regulate 
entities that own or control only savings associations. However, the 
OTS supervises and regulates such entities pursuant to the Home Owners 
Loan Act (HOLA).
---------------------------------------------------------------------------
     \2\ 12 U.S.C. 1841(c)(2)(B) and (j).
---------------------------------------------------------------------------
    As part of the recommendation to eliminate the Federal thrift 
charter, the Administration Proposal would also eliminate the savings 
and loan holding company (SLHC). The Administration's draft legislation 
repeals section 10 of the HOLA, concerning the regulation of SLHCs and 
also eliminates the thrift exemption from the definition of ``bank'' 
under the BHCA. A SLHC would become a bank holding company (BHC) by 
operation of law and would be required to register with the FRB as a 
BHC within 90 days of enactment of the act.
    Notably, these provisions also apply to the unitary SLHCs that were 
explicitly permitted to continue engaging in commercial activities 
under the Gramm-Leach-Bliley Act of 1999. \3\ Such an entity would 
either have to divest itself of the thrift or divest itself of other 
subsidiaries or affiliates to ensure that its activities are 
``financial in nature.'' \4\
---------------------------------------------------------------------------
     \3\ 12 U.S.C. 1467a(c)(9)(C).
     \4\ 12 U.S.C. 1843(k).
---------------------------------------------------------------------------
    The Administration justifies the elimination of SLHCs, by arguing 
that the separate regulation and supervision of bank and savings and 
loan holding companies has created ``arbitrage opportunities.'' The 
Administration contends that the intensity of supervision has been 
greater for BHCs than SLHCs.
    Our view on this matter is guided by our key principles, one of 
which is to ensure that changes to the financial regulatory system 
address real problems. We oppose this provision because it does not 
address a real problem. As is the case with the regulation of thrift 
institutions, OTS does not believe that entities became SLHCs because 
OTS was perceived to be a more lenient regulator. Instead, these 
choices were guided by the business model of the entity.
    The suggestion that the OTS does not impose capital requirements on 
SLHCs is not correct. Although the capital requirements for SLHCs are 
not contained in OTS regulations, savings and loan holding company 
capital adequacy is determined on a case-by-case basis for each holding 
company based on the overall risk profile of the organization. In its 
review of a SLHCs capital adequacy, the OTS considers the risk inherent 
in an enterprise's activities and the ability of capital to absorb 
unanticipated losses, support the level and composition of the parent 
company's and subsidiaries' debt, and support business plans and 
strategies.
    On average SLHCs hold more capital than BHCs. The OTS conducted an 
internal study comparing SLHC capital levels to BHC capital levels. In 
this study. OTS staff developed a Tier 1 leverage proxy and conducted 
an extensive review of industry capital levels to assess the overall 
condition of holding companies in the thrift industry. We measured 
capital by both the Equity/Assets ratio and a Tier 1 Leverage proxy 
ratio. Based on peer group averages, capital levels (as measured by 
both the Equity/Assets ratio and a Tier 1 Leverage proxy ratio) at 
SLHCs were higher than BHCs, prior to the infusion of Troubled Asset 
Relief Program funds, in every peer group category. The consistency in 
results between both ratios lends credence to the overall conclusion, 
despite any differences that might result from use of a proxy formula.
    As this study shows, the facts do not support the claim that the 
OTS docs not impose adequate capital requirements on SLHCs. The 
proposal to eliminate the SLHC exception from the BHCA is based on this 
and other misperceptions. Moreover, in our view the measure penalizes 
the SLHCs and thrifts that maintained solid underwriting standards and 
were not responsible for the current financial crisis. The measure is 
especially punitive to the unitary SLHCs that will be forced to divest 
themselves of their thrift or other subsidiaries.
    We believe SLHCs should be maintained and that the OTS should 
continue to regulate SLHCs, except in the case of a SLHC that would be 
deemed to be a Tier 1 Financial Holding Company. These entities should 
be regulated by the systemic risk regulator.
B. Elimination of the Exception in the Bank Holding Company Act for 
        Special Purpose Banks
    The Administration Proposal would also eliminate the BHCA 
exceptions for a number of special purpose banks, such as industrial 
loan companies, credit card banks, [rust companies, and the so-called 
``nonbank banks'' grandfathered under the Competitive Equality Banking 
Act of 1987. Neither the FRB nor OTS regulates the entities that own or 
control these special purpose banks, unless they also own or control a 
bank or thrill. As is the case with unitary SLHCs, the Administration 
Proposal would force these entities to divest themselves of either 
their special purpose bank or other entities. The Administration's 
rationale for the provision is to close all the so-called ``loopholes'' 
under the BHCA and to treat all entities that own or control any type 
of a bank equally.
    Once again our opinion on this aspect of the Administration 
Proposal is guided by the key principle of ensuring that changes to the 
financial regulatory system address real problems that caused the 
crisis. There are many causes of the financial crisis, but the 
inability of the FRB to regulate these entities is not one of them. 
Accordingly, we do not support this provision.
    Forcing companies that own special purpose banks to divest one or 
more of their subsidiaries is unnecessary and punitive. Moreover, it 
does not address a problem that caused the crisis or weakens the 
financial system.
VI. Prudential Supervision of Holding Companies
A. In General
    The Administration's Proposal would provide for the consolidated 
supervision and regulation of any systemically important financial firm 
(Tier 1 FHC) regardless of whether the firm owns an insured depository 
institution. The authority to supervise and regulate Tier 1 FHCs would 
be vested in the FRB. The FRB would be authorized to designate Tier 1 
FHCs if it determines that material financial distress at the company 
could pose a threat, globally or in the United States, to financial 
stability or the economy during times of economic stress. \5\ The FRB, 
in consultation with Treasury, would issue rules to guide the 
identification Tier 1 FHCs. Tier 1 FHCs would be subjected to stricter 
and more conservative prudential standards than those that apply to 
other BHCs, including higher standards on capital, liquidity, and risk 
management. Tier 1 FHCs would also be subject to Prompt Corrective 
Action.
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     \5\ The FRB would be required to base its determination on the 
following criteria:
      (i) the amount and nature of the company's financial assets;
      (ii) the amount and types of the company's liabilities, including 
the degree of reliance on short-term funding;
      (iii) the extent of the company's off-balance sheet exposures;
      (iv) the extent of the company's transactions and relationships 
with other major financial companies:
      (v) the company's importance as a source of credit for 
households, businesses, and State and local governments and as a source 
of liquidity for the financial system;
      (vi) the recommendation, if any, of the Financial Services 
Oversight Council; and
      (vii) any other factors that the Board deems appropriate.
    Title II, Section 204. Administration Draft Legislation.
    http://www.financialstability.gov/docs/regulatoryreform/07222009/
titleII.pdf.
---------------------------------------------------------------------------
    The Proposal also calls for the creation of a Financial Services 
Oversight Council (Council) made up of the Secretary of the Treasury 
and all of the Federal financial regulators. Among other 
responsibilities, the Council would make recommendations to the FRB 
concerning institutions that should be designated as Tier 1 FHCs. Also, 
the FRB would consult the Council in setting material prudential 
standards for Tier 1 FHCs and in setting risk management standards for 
systemically important systems and activities regarding payment, 
clearing and settlement.
    The Administration's Proposal provides a regime to resolve Tier 1 
FHCs when the stability of the financial system is threatened. The 
resolution authority would supplement and be modeled on the existing 
resolution regime for insured depository institutions under the Federal 
Deposit Insurance Act. The Secretary of the Treasury could invoke the 
resolution authority only after consulting with the President and upon 
the written recommendation of two-thirds of the members of the FRB, and 
the FDIC or SEC as appropriate. The Secretary would have the ability to 
appoint a receiver or conservator for the tailing firm. In general, 
that role would be filled by the FDIC, though the SEC could be 
appointed in certain cases. In order to fund this resolution regime, 
the FDIC would be authorized to impose risk-based assessments on Tier 1 
FHCs.
    OTS's views on these aspects of the Administration Proposal is 
guided by our key principle that any financial reform package should 
create the ability to supervise and resolve all systemically important 
financial firms. The U.S. economy operates on the principle of healthy 
competition. Enterprises that are strong, industrious, well-managed and 
efficient succeed and prosper. Those that fall short of the mark 
struggle or fail and other, stronger enterprises take their places. 
Enterprises that become ``too big to fail'' subvert the system when the 
Government is forced to prop up failing, systemically important 
companies in essence, supporting poor performance and creating a 
``moral hazard.''
    The OTS supports this aspect of the Proposal and agrees that there 
is a pressing need for a systemic risk regulator with broad authority 
to monitor and exercise supervision over any company whose actions or 
failure could pose unacceptable risk to financial stability. The 
systemic risk regulator should have the ability and the responsibility 
for monitoring all data about markets and companies, including, but not 
limited to, companies involved in banking, securities, and insurance.
    We also support the establishment of a strong and effective 
Council. Each of the financial regulators would provide valuable 
insight and experience to the systemic risk regulator.
    We also strongly support the provision providing a resolution 
regime for all Tier 1 FHCs. Given the events of recent years, it is 
essential that the Federal Government have the authority and the 
resources to act as a conservator or receiver and to provide an orderly 
resolution of systemically important institutions, whether banks, 
thrifts, bank holding companies or other financial companies. The 
authority to resolve a distressed Tier 1 FHC in an orderly manner would 
ensure that no bank or financial firm is ``too big to fail.'' A lesson 
learned from recent events is that the failure or unwinding of 
systemically important companies has a far reaching impact on the 
economy, not just on financial services.
    The continued ability of banks, thrifts, and other entities in the 
United States to compete in today's global financial services 
marketplace is critical. The systemic risk regulator should be charged 
with coordinating the supervision of conglomerates that have 
international operations. Safety and soundness standards, including 
capital adequacy and other factors, should be as comparable as possible 
for entities that have multinational businesses,
B. Role of the Prudential Supervisor in Relation to the Systemic Risk 
        Regulator
    You have asked for our views on what we consider to be the 
appropriate role of the prudential supervisor in relation to the 
systemic risk regulator. In other words, what is the proper delineation 
of responsibilities between the agencies?
    Generally, we believe that for systemically important institutions, 
the systemic risk regulator should supplement, not supplant, the 
primary Federal bank supervisor. In most cases the work of the systemic 
regulator and the prudential regulator will complement one another, 
with the prudential regulator focused on the safety and soundness of 
the depository institution and the systemic regulator focused more 
broadly on financial stability globally or in the United States.
    One provision in the Proposal provides the systemic risk regulator 
with authority to establish, examine, and enforce more stringent 
standards for subsidiaries of Tier 1 FHCs--including depository 
institution subsidiaries--to mitigate systemic risk posed by those 
subsidiaries. If the systemic risk regulator issues a regulation, it 
must consult with the prudential regulator. In the case of an order, 
the systemic regulator must: (1) have reasonable cause to believe that 
the functionally regulated subsidiary is engaged in conduct, 
activities, transactions, or arrangements that could pose a threat to 
financial stability or the economy globally or in the United States; 
(2) notify the prudential regulator of its belief, in writing, with 
supporting documentation included and with a recommendation that the 
prudential regulator take supervisory action against the subsidiary; 
and (3) not been notified in writing by the prudential regulator of the 
commencement of a supervisory action, as recommended, within 30 days of 
the notification by the systemic regulator.
    We have some concerns with this provision in that it supplants the 
prudential regulator's authority over depository institution 
subsidiaries of systemically significant companies. On balance, 
however, we believe such a provision is necessary to ensure financial 
stability. We recommend that the provision include a requirement that 
before making any determination, the systemic regulator consider the 
effects of any contemplated action on the Deposit Insurance Fund and 
the United States taxpayers.
C. Regulation of Thrifts and Holding Companies on a Consolidated Basis
    You have asked for OTS's views on whether a holding company 
regulator should be distinct from the prudential regulator or whether a 
consolidated prudential bank supervisor could also regulate holding 
companies. \6\
---------------------------------------------------------------------------
     \6\ With respect to this question we express our opinion only 
concerning thrifts and their holding companies. We express no opinion 
as to banks and BHCs.
---------------------------------------------------------------------------
    The OTS supervises both thrifts and their holding companies on a 
consolidated basis. Indeed, SLHC supervision is an integral part of OTS 
oversight of the thrift industry. OTS conducts holding company 
examinations concurrently with the examination of the thrift 
subsidiary, supplemented by offsite monitoring. For the most complex 
holding companies, OTS utilizes a continuous supervision approach. We 
believe the regulation of the thrift and holding company has enabled us 
to effectively assess the risks of the consolidated entity, while 
retaining a strong focus on protecting the Deposit Insurance Fund.
    The OTS has a wealth of expertise regulating thrifts and holding 
companies. We have a keen understanding of small, medium-sized and 
mutual thrifts and their holding companies. We are concerned that if 
the FRB became the regulator of these holding companies, it would focus 
most of its attention on the largest holding companies to the detriment 
of small and mutual SLHCs.
    With regard to holding company regulation, OTS believes thrifts 
that have nonsystemic holding companies should have strong, consistent 
supervision by a single regulator. Conversely, a SLHC that would be 
deemed to be a Tier 1 FHC should be regulated by the systemic 
regulator. This is consistent with our key principle that any financial 
reform package should create the ability to supervise and resolve all 
systemically important financial firms.
VII. Consumer Protection
    The Committee did not specifically request input regarding consumer 
protection issues and the Administration's Proposal to create a 
Consumer Financial Protection Agency (CFPA); however, we would like to 
express our views because adequate protection of consumers is one of 
the key principles that must be addressed by effective reform. Consumer 
protection performed consistently and judiciously fosters a thriving 
banking system to meet the financial services needs of the Nation.
    The OTS supports the creation of a CFPA that would consolidate 
rulemaking authority over all consumer protection regulations in one 
regulator. The CFPA should be responsible for promulgating all consumer 
protection regulations that would apply uniformly to all entities that 
offer financial products, whether a federally insured depository 
institution, a State bank, or a State-licensed mortgage broker or 
mortgage company. Making all entities subject to the same rules and 
regulations for consumer protection could go a long way towards 
accomplishing OTS's often stated goal of plugging the gaps in 
regulatory oversight that led to a shadow banking system that was a 
significant cause of the current crisis.
    Although we support the concept of a single agency to write all 
consumer rules, we strongly believe that consumer protection-related 
examinations, supervision authority and enforcement powers for insured 
depository institutions should be retained by the FBAs and the National 
Credit Union Administration (NCUA). In addition to rulemaking 
authority, the CFPA should have regulation, examination and enforcement 
power over entities engaged in consumer lending that are not insured 
depository institutions. Regardless of whether a new consumer 
protection agency is created, it is critical that, for all federally 
insured depository institutions, the primary Federal safety and 
soundness regulator retain authority for regulation, examination, and 
enforcement of consumer protection regulations.
VIII. Conclusion
    In conclusion, we support the goals of the Administration and this 
Committee to create a reformed system of financial regulation that 
fills regulatory gaps and prevents the type of financial crisis that we 
have just endured.
    Thank you again, Mr. Chairman, Ranking Member Shelby, and Members 
of the Committee for the opportunity to testify on behalf of the OTS.
    We look forward to working with the Members of this Committee and 
others to create a system of financial services regulation that 
promotes greater economic stability for providers of financial services 
and the Nation.
       RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
                      FROM SHEILA C. BAIR

Q.1. What is the best way to decrease concentration in the 
banking industry? Is it size limitations, rolling back State 
preemption, higher capital requirements, or something else?

A.1. We must find ways to impose greater market discipline on 
systemically important institutions. We believe there are 
several ways to decrease concentration levels in the banking 
industry without the Federal Government setting size limits on 
banks. For example, certain requirements, such as higher 
capital and liquidity levels, could be established to mirror 
the heightened risk they pose to the financial system. 
Assessments also could be used as incentives to contain growth 
and complexity, as well as to limit concentrations of risk and 
risk taking.
    However, one of the lessons of the past few years is that 
regulation alone is not enough to control imprudent risk taking 
within our dynamic and complex financial system. You need 
robust and credible mechanisms to ensure that market players 
will actively monitor and keep a handle on risk taking. In 
short, we need to enforce market discipline for systemically 
important institutions. To end ``too big to fail,'' we need an 
orderly and highly credible mechanism that is similar to the 
process we use to resolve FDIC-insured banks. In such a 
process, losses would be borne by the stockholders and 
bondholders of a holding company, and senior managers would be 
replaced. There would be an orderly resolution of the 
institution, but no bail-out. Open bank assistance should not 
be used to prop up any individual firm.

Q.2. Treasury has proposed making the new banking regulator a 
bureau of the Treasury Department. Putting aside whether we 
should merge the current regulators, does placing the new 
regulator in Treasury rather than as a separate agency provide 
enough independence from political influence?

A.2. We believe independence is an essential element of a sound 
supervisory program. Supervisors must have the authority and 
resources to gather and evaluate sufficient information to make 
sound supervisory decisions without undue pressures from 
outside influences. The FDIC and State banking supervisors, who 
often provide a different and unique perspective on the 
operations of community banks, have worked cooperatively to 
make sound supervisory decisions without compromising their 
independence.
    As currently structured, two of the Federal banking 
agencies, the Office of the Comptroller of the Currency (OCC) 
and the Office of Thrift Supervision (OTS) are bureaus within 
the U.S. Department of the Treasury. Although subject to 
general Treasury oversight, the OCC and OTS have a considerable 
amount of autonomy within the Treasury with regard to 
examination and enforcement matters. Unlike Treasury, the 
bureaus within the U.S. Department of OCC and OTS are funded by 
examination and other fees assessed on regulated entities, and 
they have independent litigating authority. The other three 
Federal banking agencies--Governors of the Federal Deposit 
Insurance Corporation, the Board of Governors of the Federal 
Reserve, and the National Credit Union Association, are fully 
independent agencies, self-funded though assessments or other 
fees, and have independent litigating authority. To the extent 
the OTS and OCC would be merged into a single regulator under 
Treasury, continued independence could be maintained through 
nonappropriated funding sources, independent litigating 
authority, and independent decision-making authority, such as 
currently afforded to the OCC and OTS.

Q.3. Given the damage caused by widespread use of subprime and 
nontraditional mortgages--particularly low documentation 
mortgages--it seems that products that are harmful to the 
consumer are also harmful to the banks that sell them. If bank 
regulators do their job and stop banks from selling products 
that are dangerous to the banks themselves, other than to set 
standards for currently unregulated firms, why do we need a 
separate consumer protection agency?

A.3. As currently proposed, the new Consumer Financial 
Protection Agency (CFPA) would be given sole rulemaking 
authority for consumer financial protection statutes over all 
providers of consumer credit, including those outside the 
banking industry. The CFPA would set a floor on consumer 
regulation and guarantee the States' ability to adopt and 
enforce stricter (more protective) laws for institutions of all 
types, regardless of charter. It also is proposed that the CFPA 
would have consumer protection examination and enforcement 
authority over all providers of consumer credit and other 
consumer products and services--banks and nonbanks.
    Giving the CFPA the regulatory and supervisory authority 
over nonbanks would fill in the existing regulatory and 
supervisory gaps between nonbanks and insured depository 
institutions and is key to addressing most of the abusive 
lending practices that occurred institutions and is key to 
addressing most of during the current crisis. In addition, the 
provision to give the CFPA sole rulewriting authority over 
consumer financial products and services would establish 
strong, consistent consumer protection standards among all 
providers of financial products and services and eliminate 
potential regulatory arbitrage that exists because of Federal 
preemption of certain State laws.
    However, the Treasury proposal could be made even more 
effective with a few targeted changes. As recent experience has 
shown, consumer protection issues and the safety and soundness 
of insured institutions go hand-in-hand and require a 
comprehensive, coordinated approach for effective examination 
and supervision. Separating Federal banking agency examination 
and supervision (including enforcement) from consumer 
protection examination and supervision could undermine the 
effectiveness of each with the unintended consequence of 
weakening bank oversight.
    As a Federal banking supervisor and the ultimate insurer of 
$6 trillion in deposits, the FDIC has the responsibility and 
the need to ensure consumer protection and safety and soundness 
are properly integrated. The FDIC and other Federal banking 
agencies should retain their authority to examine and supervise 
insured depository institutions for consumer protection 
standards established by the CFPA. The CFPA should focus its 
examination and enforcement resources on nonbank providers of 
products and services that have not been previously subject to 
Federal examinations and standards. The CFPA also should have 
back-up examination and enforcement authority to address 
situations where it determines the Federal banking agency 
supervision is deficient.

Q.4. Since the two most recent banking meltdowns were caused by 
mortgage lending, do you think it is wise to have a charter 
focused on mortgage lending? In other words, why should we have 
a thrift charter?

A.4. Over several decades, financial institutions with thrift 
charters have provided financing for home loans for many 
Americans. In recent years, Federal and State banking charters 
have expanded into more diversified, full service banking 
operations that include commercial and residential mortgage 
lending. However, it is understandable that the lack of 
diversification and exposure to the housing market could raise 
concerns about the thrift charter. Market forces have reduced 
the demand for thrift charters. Given the dwindling size of the 
Federal thrift industry, it makes sense to consider merging the 
Federal thrift charter into a single Federal depository 
institution charter.

Q.5. Should banking regulators continue to be funded by fees on 
the regulated firms, or is there a better way?

A.5. We believe the banking industry should pay for its 
supervision, but the Federal bank supervision funding process 
should not disadvantage State-chartered depository institutions 
and the dual banking system. State-chartered banks pay 
examination fees to State banking agencies. The Federal banking 
agencies are self-funded through assessments, exam fees, and 
other sources. This arrangement helps them remain independent 
of the political process and separates them from the Federal 
budget appropriations.

Q.6. Why should we have a different regulator for holding 
companies than for the banks themselves?

A.6. We do not believe it is always necessary to have a 
different regulator for the holding company and the bank. 
Numerous one-bank holding companies exist where the bank is 
essentially the only asset owned by the holding company. In 
these cases, there is no reason why bank regulators could not 
also serve as holding company regulators as it is generally 
more efficient and prudent for one regulator to evaluate both 
entities.
    In the case of more complex multibank holding companies, 
one can argue it is more effective for the primary Federal 
regulators to examine the insured depository institutions while 
the Federal Reserve evaluates the parent (as a source of 
strength) and the financial condition of the nonbank 
subsidiaries. Yet even for a separate holding company 
regulator, the prudential standards it applies should be at 
least as strong as the standards applied to insured banks.

Q.7. Assuming we keep thrifts and thrift holding companies, 
should thrift holding companies be regulated by the same 
regulator as bank holding companies?

A.7. Similar to the answer to Question 6, it may not be 
necessary for small thrifts that are owned by what are 
essentially shell holding companies to have a separate holding 
company regulator. While one can argue that more complex 
organizations merit a separate holding company regulator, even 
in this structure we believe prudential standards applied to a 
holding company should be at least as strong as those applied 
to an insured entity.

Q.8. The proposed risk council is separate from the normal 
safety and soundness regulator of banks and other firms. The 
idea is that the council 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 council, 
how would you make sure the rules were being enforced the same 
across the board?

A.8. The proposed risk council would oversee systemic risk 
issues, develop needed prudential policies, and mitigate 
developing systemic risks. A primary responsibility of the 
council should be to harmonize prudential regulatory standards 
for financial institutions, products, and practices to assure 
market participants cannot arbitrage regulatory standards in 
ways that pose systemic risk. The council should evaluate 
different capital standards that apply to commercial banks, 
investment banks, investment funds, and others to determine the 
extent to which these standards circumvent regulatory efforts 
to contain excess leverage in the system. The council should 
ensure that prompt corrective action and capital standards are 
harmonized across firms. For example, large financial holding 
companies should be subject to tougher prompt corrective action 
standards under U.S. law and be subject to holding company 
capital requirements that are no less stringent than those for 
insured banks. The council also should 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. To be successful, the 
council must have sufficient authority to require some 
uniformity and standardization in those areas where 
appropriate.
                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
                       FROM JOHN C. DUGAN

Q.1. What is the best way to decrease concentration in the 
banking industry? Is it size limitations, rolling back State 
preemption, higher capital requirements, or something else?

A.1. The financial crisis has highlighted the importance of 
inter-linkages between the performance of systemically 
important banks, financial stability, and the real economy. It 
has also highlighted the risks of firms that are deemed ``too 
big to fail.'' There are a range of policy options that are 
under active consideration by U.S. and global supervisors to 
address these issues. Given the multifaceted nature of this 
problem, we believe that a combination of policy responses may 
be most appropriate.
    A crucial first step, we believe, is strengthening and 
raising the current capital standards for large banking 
organizations to ensure that these organizations maintain 
sufficient capital for the risks they take and pose to the 
financial system. Part of this effort is well underway through 
initiatives being taken by the Basel Committee on Bank 
Supervision (the ``Committee''). As announced in July, the 
Committee has adopted a final package of measures that will 
strengthen and increase the capital required for trading book 
and certain securitization structures. The results of a recent 
quantitative analysis conducted by the Committee to assess the 
impact of the trading book rule changes suggest that these 
changes will increase average trading book capital requirements 
by two to three times their current levels, although the 
Committee noted significant dispersion around this average.
    The Committee has underway several other key initiatives 
that we believe are also critical to reduce the risks posed by 
large, internationally active banks. These include:

    Strengthening the quality, international 
        consistency, and transparency of a bank's capital base;

    Developing a uniform Pillar -1 based leverage 
        ratio, which, among other requirements, would apply a 
        100 percent credit conversion factor to certain off-
        balance sheet credit exposures;

    Introducing a minimum global standard for funding 
        liquidity that includes a stressed liquidity coverage 
        ratio requirement, underpinned by a longer-term 
        structural liquidity ratio; and

    Developing a framework for countercyclical capital 
        buffers above the minimum requirement. The framework 
        will include capital conservation measures such as 
        constraints on capital distributions. The Basel 
        Committee will review an appropriate set of indicators, 
        such as earnings and credit-based variables, as a way 
        to condition the build up and release of capital 
        buffers. In addition, the Committee will promote more 
        forward-looking provisions based on expected losses.

The OCC has been actively involved in, and strongly supports, 
these initiatives. In addition to these actions, there are 
other policy initiatives under consideration, including the 
development of incremental capital surcharges that would 
increase with the size and/or risk of the institution, and 
measures to reduce the systemic impact of failure, such as 
reduced interconnectedness and resolution planning.
    As noted in my testimony, the OCC also endorses domestic 
proposals to establish a Financial Stability Oversight Council 
that would identify and monitor systemic risk, gather and share 
systemically significant information, and make recommendations 
to individual regulators. This council would consist of the 
Secretary of the Treasury and all of the Federal financial 
regulators, and would be supported by a permanent staff. We 
also endorse enhanced authority to resolve systemically 
significant financial firms.
    We believe that a multipronged approach, as outlined above; 
is far more appropriate than relying on a single measure, such 
as asset size, to address the risks posed by large 
institutions. We also believe that to ensure the 
competitiveness of U.S. financial institutions in today's 
global economy, many of these policy initiatives need to be 
coordinated with, and implemented by, supervisors across the 
globe.
    Finally, we strongly disagree with any suggestion that 
Federal preemption was a root cause of the financial crisis or 
that rolling back preemption would be a solution. In this 
regard, we would highlight that the systemic risk posed by 
companies such as AIG, Lehman Brothers, and Bear Stearns were 
outside of the OCC's regulatory authority and thus not affected 
by the OCC's application of Federal preemption decisions.

Q.2. Treasury has proposed making the new banking regulator a 
bureau of the Treasury Department. Putting aside whether we 
should merge the current regulators, does placing the new 
regulator in Treasury rather than as a separate agency provide 
enough independence from political influence?

A.2. It is critical that the new agency be independent from the 
Treasury Department and the Administration to the same extent 
that the OCC and OTS are currently independent. For example, 
current law provides the OCC with important independence from 
political interference in decision making in matters before the 
Comptroller, including enforcement proceedings; provides for 
funding independent of political control; enables the OCC to 
propose and promulgate regulations without approval by the 
Treasury; and permits the agency to testify before Congress 
without the need for the Administration's clearance of the 
agency's statements. It is crucial that these firewalls be 
maintained in a form that is at least as robust as current law 
provides with respect to the OCC and the OTS, to enable the new 
regulator to maintain comparable independence from political 
influence. In addition, consideration should be given to 
providing the new regulator the same independence from OMB 
review and clearance of its regulations as is currently 
provided for the FDIC and the Federal Reserve Board. This would 
further protect the new agency's rulemaking process from 
political interference.

Q.3. Given the damage caused by widespread use of subprime and 
nontraditional mortgages--particularly low documentation 
mortgages--it seems that products that are harmful to the 
consumer are also harmful to the banks that sell them. If bank 
regulators do their job and stop banks from selling products 
that are dangerous to the banks themselves, other than to set 
standards for currently unregulated firms, why do we need a 
separate consumer protection agency?

A.3. In the ongoing debate about reforming the structure of 
financial services regulation to address the problems 
highlighted by the financial crisis, relatively little 
attention has been paid to the initial problem that sparked the 
crisis: the exceptionally weak, and ultimately disastrous, 
mortgage underwriting practices accepted by lenders and 
investors. The worst of these practices included:

    The failure to verify borrower representations 
        about income and financial assets (the low 
        documentation loans mentioned in this question);

    The failure to require meaningful borrower equity 
        in the form of real down payments;

    The acceptance of very high debt-to-income ratios;

    The qualification of borrowers based on their 
        ability to afford artificially low initial monthly 
        payments rather than the much higher monthly payments 
        that would come later; and

    The reliance on future house price appreciation as 
        the primary source of repayment, either through 
        refinancing or sale.

The consequences of these practices were disastrous not just 
for borrowers and financial institutions in the United States, 
but also for investors all over the world due to the 
transmission mechanism of securitization. To prevent this from 
happening again, while still providing adequate mortgage credit 
to borrowers, regulators need to establish, with additional 
legislative authorization as necessary, at least three minimum 
underwriting standards for all home mortgages:

    First, underwriters should verify income and 
        assets.

    Second, borrowers should be required to make 
        meaningful down payments.

    Third, a borrower should not be eligible for a 
        mortgage where monthly payments increase over time 
        unless the borrower can afford the later, high 
        payments.

It is critical that these requirements, and any new mortgage 
regulation that is adopted, apply to all credit providers to 
prevent the kind of competitive inequity and pressure on 
regulated lenders that eroded safe and sound lending practices 
in the past. Prudential bank supervisors, including the OCC, 
are best positioned to develop such new underwriting standards 
and would enforce them vigorously with respect to the banks 
they supervise. A separate regulatory mechanism would be 
required to ensure that such standards are implemented by 
nonbanks. While the proposed new Consumer Financial Protection 
Agency would have consumer protection regulatory authority with 
respect to nonbanks, they would not have--and they should not 
have--safety and soundness regulatory authority over 
underwriting standards.

Q.4. Since the two most recent banking meltdowns were caused by 
mortgage lending, do you think it is wise to have a charter 
focused on mortgage lending? In other words, why should we have 
a thrift charter?

A.4. When there are systemwide problems with residential 
mortgages, institutions that concentrate their activities in 
those instruments will sustain more losses and pose more risk 
to the deposit insurance fund than more diversified 
institutions. On the other hand, there are many thrifts that 
maintained conservative underwriting standards and have 
weathered the current crisis. The Treasury proposal would 
eliminate the Federal thrift charter--but not the State thrift 
charter--with all Federal thrifts required to convert to a 
national bank, State bank, or State thrift, over the course of 
a reasonable transition period. (State thrifts would then be 
treated as State ``banks'' under Federal law.) An alternative 
approach would be to preserve the Federal thrift charter, with 
Federal thrift regulation being conducted by a division of the 
merged agency. With the same deposit insurance fund, same 
prudential regulator, same holding company regulator, and a 
narrower charter (a national bank has all the powers of a 
Federal thrift plus many others), it is unclear whether 
institutions will choose to retain their thrift charters over 
the long term.

Q.5. Should banking regulators continue to be funded by fees on 
the regulated firms, or is there a better way?

A.5. Funding bank regulation and supervision through fees 
imposed on the regulated firms is preferable to the alternative 
of providing funding through the appropriations process because 
it ensures the independence from political control that is 
essential to bank supervision.
    For this reason, fee-based funding is the norm in banking 
regulation. In the case of the OCC and OTS, Congress has 
determined that assessments and fees on national banks and 
thrifts, respectively, will fund supervisory activities, rather 
than appropriations from the United States Treasury. Since 
enactment of the National Bank Act in 1864, the OCC has been 
funded by various types of fees imposed on national banks, and 
over the more than 145 years that the OCC has regulated 
national banks, this funding mechanism has never caused the OCC 
to weaken or change its regulation or supervision of national 
banks, including with respect to national banks' compliance 
with consumer protection laws. Neither the Federal Reserve 
Board nor the FDIC receives appropriations. State banking 
regulators typically also are funded by assessments on the 
entities they charter and supervise.

Q.6. Why should we have a different regulator for holding 
companies than for the banks themselves?

A.6. Combining the responsibilities for prudential bank 
supervision and holding company supervision in the same 
regulator would be a workable approach in the case of those 
holding companies whose business is comprised solely or 
overwhelmingly of one or more subsidiary banks. Elimination of 
a separate holding company regulator in these situations would 
remove duplication, promote simplicity and accountability, and 
reduce unnecessary compliance burden for institutions as well.
    Such a consolidated approach would be more challenging 
where the holding company has substantial nonbanking activities 
in other subsidiaries, such as complex capital markets 
activities, securities, and insurance. The focus of a 
dedicated, strong prudential banking supervisor could be 
significantly diluted by extending its focus to substantial 
nonbanking activities. The Federal Reserve has unique resources 
and expertise to bring to bear on supervision of these sorts of 
activities conducted by bank affiliates in a large, complex 
holding company. Therefore, a preferable approach would be to 
preserve such a role for the Federal Reserve Board, but to 
clearly delineate the respective roles of the Board and the 
prudential bank supervisors with respect to the holding 
company's activities.

Q.7. Assuming we keep thrifts and thrift holding companies, 
should thrift holding companies be regulated by the same 
regulator as bank holding companies?

A.7. Yes. Thrift holding companies, unlike bank holding 
companies, currently are not subject to consolidated 
regulation; for example, no consolidated capital requirements 
apply at the holding company level. This difference between 
bank and thrift holding company regulation created arbitrage 
opportunities for companies that were able to take on greater 
risk under a less rigorous regulatory regime. Yet, as we have 
seen--AIG is the obvious example--large nonbank firms can 
present similar risks to the system as large banks. This 
regulatory gap should be closed, and these firms should be 
subject to the same type of oversight as bank holding 
companies. The Treasury Proposal would make these types of 
firms subject to the Bank Holding Company Act and supervision 
by the Federal Reserve Board. We support this approach, 
including a reasonable approach to grandfathering the 
activities of some thrift holding companies that may not 
conform to the activities limitations of the Bank Holding 
Company Act.

Q.8. The proposed risk council is separate from the normal 
safety and soundness regulator of banks and other firms. The 
idea is that the council will set the 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 council, 
how would you make sure the rules were being enforced the same 
across the board?

A.8. The Treasury proposal establishes the Financial Services 
Oversight Council to identify potential threats to the 
stability of the U.S. financial system; to make recommendations 
to enhance the stability of the U.S. financial markets; and to 
provide a forum for discussion and analysis of emerging issues. 
Based on its monitoring of the U.S. financial services 
marketplace, the Council would also play an advisory role, 
making recommendations to, and consulting with, the Board of 
Governors of the Federal Reserve System. As I understand the 
Treasury proposal, however, the Council's role is only 
advisory; it will not be setting any rules. Therefore, we do 
not anticipate any conflicting enforcement issues to arise from 
the Council's role.

Q.9. Mr. Dugan, in Mr. Bowman's statement he says Countrywide 
converted to a thrift from a national bank after it had written 
most of the worst loans during the housing bubble. That means 
Countrywide's problems were created under your watch, not his. 
How do you defend that charge and why should we believe your 
agency will be able to spot bad lending practices in the 
future?

A.9. In evaluating the Countrywide situation, it is important 
to know all the facts. Both Countrywide Bank, N.A., and its 
finance company affiliate, Countrywide Home Loans, engaged in 
mortgage lending activities. While the national bank was 
subject to the supervision of the OCC, Countrywide Home Loans, 
as a bank holding company subsidiary, was subject to regulation 
by the Federal Reserve and the States in which it did business.
    Mortgage banking loan production occurred predominately at 
Countrywide Home Loans, \1\ the holding company's finance 
subsidiary, which was not subject to OCC oversight. Indeed, all 
subprime lending, as defined by the borrower's FICO score, was 
conducted at Countrywide Home Loans and not subject to OCC 
oversight. The OCC simply did not allow Countrywide Bank, N.A., 
to engage in such subprime lending.
---------------------------------------------------------------------------
     \1\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).
---------------------------------------------------------------------------
    When Countrywide Financial Corporation, the holding 
company, began to transition more of the mortgage lending 
business from Countrywide Home Loans to the national bank, the 
OCC started to raise a variety of supervisory concerns about 
the bank's lending risk and control practices. Shortly 
thereafter, on December 6, 2006, Countrywide Bank applied to 
convert to a Federal savings bank charter.
    Countrywide Bank became a Federal savings bank on March 12, 
2007. Going forward, Countrywide Bank, FSB, was regulated by 
OTS, and Countrywide Home Loans was regulated by the OTS and 
the States in which it did business. Countrywide Financial 
Corporation continued to transition its mortgage loan 
production to the Countrywide Bank, FSB. By the end of the 
first quarter of 2008, over 96 percent of mortgage loan 
production of Countrywide Financial Corporation occurred at 
Countrywide Bank, FSB. \2\
---------------------------------------------------------------------------
     \2\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).
---------------------------------------------------------------------------
    Bank of America completed its acquisition of Countrywide 
Financial Corporation on June 30, 2008.
    Countrywide Bank, N.A., was not the source of toxic 
subprime loans. The OCC raised concerns when Countrywide began 
transitioning more of its mortgage lending operations to its 
national bank charter. It was at that point that Countrywide 
flipped its national bank charter to a Federal thrift charter. 
The facts do not imply lax supervision by the OCC, but rather 
quite the opposite.
    The OCC continues to identify and warn about potentially 
risky lending practices. On other occasions, the OCC has taken 
enforcement actions and issued guidance to curtail abuses with 
subprime credit cards and payday loans. Likewise, the Federal 
banking agencies issued guidance to address emerging compliance 
risks with nontraditional mortgages, such as payment option 
ARMs, and the OCC took strong measures to ensure that that 
guidance was effectively implemented by national banks 
throughout the country.

Q.10. 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.10. As noted in our response to Question 1, the global nature 
of today's financial institutions increasingly requires that 
supervisory policies and actions be coordinated and implemented 
on a global basis. The OCC is an active participant in various 
international supervisory groups whose goal is to coordinate 
supervisory policy responses, to share information, and to 
coordinate supervisory activities at individual institutions 
whose activities span national borders. These groups include 
the Basel Committee on Bank Supervision (BCBS), the Joint 
Forum, the Senior Supervisors Group (SSG), and the Financial 
Stability Board. In addition to coordinating capital and other 
supervisory standards, these groups promote information sharing 
across regulators.
    For example, the SSG recently released a report that 
evaluates how weaknesses in risk management and internal 
controls contributed to industry distress during the financial 
crisis. The observations and conclusions in the report reflect 
the results of two initiatives undertaken by the SSG. These 
initiatives involved a series of interviews with firms about 
funding and liquidity challenges and a self-assessment exercise 
in which firms were asked to benchmark their risk management 
practices against recommendations and observations taken from 
industry and supervisory studies published in 2008.
    One of the challenges that arise in resolving a cross-
border bank crisis is that crisis resolution frameworks are 
largely designed to deal with domestic failures and to minimize 
the losses incurred by domestic stakeholders. As such, the 
current frameworks are not well suited to dealing with serious 
cross-border problems. In addition to the fact that legal 
systems and the fiscal responsibility are national matters, a 
basic reason for the predominance of the territorial approach 
in resolving banking crises and insolvencies is the absence of 
a multinational framework for sharing the fiscal burdens for 
such crises or insolvencies.
    To help address these issues, the BCBS has established a 
Cross-border Bank Resolution Group to compare the national 
policies, legal frameworks and the allocation of 
responsibilities for the resolution of banks with significant 
cross-border operations. On September 17, 2009, the BCBS issued 
for comment a report prepared by this work group that sets out 
10 recommendations that reflect the lessons from the recent 
financial crisis and are designed to improve the resolution of 
a failing financial institution that has cross-border 
activities. The report's recommendations fall into three 
categories including:

    The strengthening of national resolution powers and 
        their cross-border implementation;

    Ex ante action and institution-specific contingency 
        planning, which involves the institutions themselves as 
        well as critical home and host jurisdictions; and,

    Reducing contagion and limiting the impact on the 
        market of the failure of a financial firm by actions 
        such as further strengthening of netting arrangements.

We believe adoption of these recommendations will enhance 
supervisors' ability to deal with many of the issues posed by 
resolving a cross-border bank.
                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
                     FROM DANIEL K. TARULLO

Q.1. What is the best way to decrease concentration in the 
banking industry? Is it size limitations, rolling back State 
preemption, higher capital requirements, or something else?

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

Q.2. Treasury has proposed making the new banking regulator a 
bureau of the Treasury Department. Putting aside whether we 
should merge the current regulators, does placing the new 
regulator in Treasury rather than as a separate agency provide 
enough independence from political influence?

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

Q.3. Given the damage caused by widespread use of subprime and 
nontraditional mortgages--particularly low documentation 
mortgages--it seems that products that are harmful to the 
consumer are also harmful to the banks that sell them. If bank 
regulators do their job and stop banks from selling products 
that are dangerous to the banks themselves, other than to set 
standards for currently unregulated firms, why do we need a 
separate consumer protection agency?

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

Q.4. Since the two most recent banking meltdowns were caused by 
mortgage lending, do you think it is wise to have a charter 
focused on mortgage lending? In other words, why should we have 
a thrift charter?

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

Q.5. Should banking regulators continue to be funded by fees on 
the regulated firms, or is there a better way?

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

Q.6. Why should we have a different regulator for holding 
companies than for the banks themselves?

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

Q.7. Assuming we keep thrifts and thrift holding companies, 
should thrift holding companies be regulated by the same 
regulator as bank holding companies?

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

Q.8. The proposed risk council is separate from the normal 
safety and soundness regulator of banks and other firms. The 
idea is that the council 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 council, 
how would you make sure the rules were being enforced the same 
across the board?

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


       RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
                      FROM JOHN E. BOWMAN

Q.1. What is the best way to decrease concentration in the 
banking industry? Is it size limitations, rolling back State 
preemption, higher capital requirements, or something else?

A.1. There are several ways to decrease the concentration in 
the banking industry, including:

  1.  Restricting further increases in concentrations. The 
        largest banks in the U.S. have principally achieved 
        their concentration dominance by mergers and 
        acquisitions. Hence, slight changes to the current 
        rules regarding the regulatory review and approval of 
        mergers/acquisitions could play a large part in 
        restricting further concentration. There could be 
        modest changes made to the Herfindahl Hirschman Index 
        (HHI) analysis when reviewing merger/acquisition 
        applications of very large banks to restrict increases 
        in concentrations.
  2.  Reduce current concentrations. Options could range from 
        severe, such as forced break-ups, to less severe such 
        as requiring largest banks to increase their regulatory 
        capital and/or tangible capital levels.
  3.  Reduce the advantages of ``Too Big To Fail'' (TBTF). 
        Having the U.S. Government as an implicit backstop for 
        liquidity and capital reserves allowed the largest 
        banks to raise capital at less expensive rates than 
        could smaller, community banks. Large banks were able 
        to use that capital to fund the acquisition of other 
        banks. Removing the U.S. Government as a backstop by 
        implementing explicit take over authority and 
        procedures for TBTF institutions would help eliminate 
        this moral hazard.
  4.  Improve the outlook for community banks and thrifts. 
        Efforts to make it easier to organize new or de novo 
        banks and thrifts, as well as for smaller institutions 
        to increase capital levels, would help level the 
        playing field between community institutions and large 
        banks.

Q.2. Treasury has proposed making the new banking regulator a 
bureau of the Treasury Department. Putting aside whether we 
should merge the current regulators, does placing the new 
regulator in Treasury rather than as a separate agency provide 
enough independence from political influence?

A.2. OTS has stated publicly that it does not support the 
elimination of the thrift charter or the Administration's 
Proposal to establish a new agency, the National Bank 
Supervisor (NBS), by eliminating the Office of the Comptroller 
of the Currency, which charters and regulates national banks, 
and the OTS, which charters Federal thrifts and regulates 
thrifts and their holding companies. However, if a new NBS is 
established to be the Federal chartering and supervisory 
authority for Federal depository institutions, such new agency 
should be independent from the Department of Treasury rather 
than bureau of the Department.
    Among the Federal banking agencies, the Board of Governors 
of the Federal Reserve System and the Federal Deposit Insurance 
Corporation each are independent from Treasury for all 
purposes. A similar separation for any new banking regulator 
would assure that the agency would be free from any possible 
constraints on rulemaking, enforcement, or litigation matters. 
An example of recently established agency that is independent 
of the Department of Treasury or any other Department is the 
Federal Housing Finance Agency, which was created by the 
Housing and Economic Recovery Act in July 2008.
    To the extent that it is determined that the new NBS should 
be part of the Department of Treasury, if it is granted 
explicit independence in a number of areas, it would be 
insulated from political influence to the same degree that the 
OTS currently is. Examples of the type of activities of the new 
supervisor that must remain independent include the ability of 
the agency to testify and to make legislative recommendations. 
Another important area of independence is the agency's 
authority to litigate. The current OTS authority provides that 
Secretary of Treasury may not intervene in any matter or 
proceeding before OTS, including enforcement matters, and not 
prevent the issuance of any rule or regulation by the agency. 
Any new agency should have the same authority that OTS 
currently does. The operations of the NBS should be funded by 
assessments and not through the appropriations process.

Q.3. Given the damage caused by widespread use of subprime and 
nontraditional mortgages particularly low documentation 
mortgages--it seems that products that are harmful to the 
consumer are also harmful to the banks that sell them. If bank 
regulators do their job and stop banks from selling products 
that are dangerous to the banks themselves, other than to set 
standards for currently unregulated firms, why we need a 
separate consumer protection agency?

A.3. The OTS examines institutions to ensure that they are 
operating in a safe and sound manner. OTS does not believe that 
Federal regulators should dictate the types of products that 
lenders must offer. Although we believe strongly that 
Government regulators should prohibit products or practices 
that are unfair to consumers, the Government should not be 
overly prescriptive in defining lenders' business plans or 
mandating that certain products be offered to consumers.
    Defining standards for financial products would put a 
Government seal of approval on certain favored products and 
would effectively steer lenders toward products. It could have 
the unintended consequence of fewer choices for consumers by 
stifling innovation and inhibiting the creation of products 
that could benefit consumers and financial institutions. We are 
concerned about the consumer protection agency defining 
standards for financial products and services that would 
require institutions to offer certain products (e.g., 30-year 
fixed rate mortgages). The imposition of such a requirement 
could result in safety and soundness concerns and stifle credit 
availability and innovation.
    The OTS supports consolidating rulemaking authority over 
all consumer protection regulation in one Federal regulator 
such as the proposed consumer protection agency. This regulator 
should be responsible for promulgating all consumer protection 
regulations that would apply uniformly to all entities that 
offer financial products, whether an insured depository 
institution, State-licensed mortgage broker or mortgage 
company. Any new framework should be to ensure that similar 
bank or bank-like products, services, and activities are 
treated in the same way in a regulation, whether they are 
offered by a chartered depository institution, or an 
unregulated financial services provider. The product should 
receive the same review, oversight, and scrutiny regardless of 
the entity offering the product.
    To balance the safety and soundness requirements of 
depository institutions with these important functions of the 
consumer protection agency, the OTS recommends retaining 
primary consumer-protection-related examination and supervision 
authority for insured depository institutions with the FBAs and 
the NCUA. The OTS believes that the CFPA should have primary 
examination and enforcement power over entities engaged in 
consumer lending that are not under the jurisdiction of the 
FBAs.
    Safety and soundness and consumer protection examination 
and enforcement powers should not be separated for insured 
depository institutions because safety-and-soundness 
examinations complement and strengthen consumer protection. By 
separating safety-and-soundness functions from consumer 
protection, the CFPA and an FBA could each have gaps in their 
information concerning an institution.

Q.4. Since the two most recent banking meltdowns were caused by 
mortgage lending, do you think it is wise to have a charter 
focused on mortgage lending? In other words, why should we have 
a thrift charter?

A.4. Beginning with the enactment of the Home Owners Loan Act. 
Congress has several times acted to reinforce a national 
housing policy. Over the years, Congress has taken steps to 
ensure that a specialized housing lender is retained among the 
charter options available tor insured institutions. The causes 
of any banking crisis are difficult to identify because of the 
interconnected nature of financial services. The crisis that we 
currently are working through is different in several important 
ways from the banking crisis of the 1980s and early 1990s. In 
the early months of the current crisis, there appeared to be 
similarities in its origins to the crisis of the 1980s and 
appeared to have been caused by mortgage lending. Even if the 
early obvious causes of the current crisis are found in the 
mortgage market, the industry has evolved and changed since the 
earlier crisis. The elimination of a dedicated mortgage lending 
charter would not have eliminated the current crisis.
    In the 1980s, the thrift industry was more limited in the 
activities in which it could engage and in the loan products 
institutions could offer to consumers. In a period of rapidly 
rising interest rates, many thrift institutions held long term 
fixed rate mortgages on their books while at the same time 
paying high rates on deposits to meet competition. The mortgage 
banking industry was not mature and the use of the secondary 
mortgage market was not widespread, therefore the long term 
fixed rate assets originated by thrifts created an interest 
rate mismatch on the books of the institutions. As a result of 
the earlier crisis, the OTS developed a proprietary interest 
rate risk model and expertise in supervision of institutions 
likely to have interest rate risk concerns. Throughout varied 
interest rate environments, the industry has not experienced 
the problems of the 1980s.
    However, interest rate risk was not a primary cause of the 
current crisis and the mortgage related causes of the current 
crisis are already the subject of revised guidance at the OTS 
and the other Federal banking agencies. Unlike the problems of 
the 1980s, there are a number of causes of the mortgage related 
problems that surfaced in the current crisis.
    First, during the recent housing boom, credit was extended 
to too many borrowers who lacked the ability to repay their 
loans when interest rates rose on the adjustable rate loans. 
For home mortgages, some consumers received loans based on 
their ability to pay introductory teaser rates, an unfounded 
expectation that home prices would continue to rise, inflated 
income figures, or other underwriting practices that were not 
as prudent as they should have been.
    In addition, mortgage related problems are in part the 
result of inadequate supervision of State entities that had no 
Federal oversight. Another factor was the growth of the 
secondary market and the ability of lenders of any charter type 
or organizational form to fund lending activities with sales of 
originated loans. Whether it was the entities that originated 
the loans or the numerous entities that packaged the loans and 
sold them as part of securities, the entities involved were not 
always supervised by Federal banking regulators and that lack 
of supervision is a more direct contributor to the crisis than 
the existence of a charter that focuses on mortgage lending.
    There are many lessons learned from the current crisis, but 
one of them is not that Congress should eliminate the thrift 
charter or a charter that focuses on housing finance. 
Homeownership continues to be an important policy objective for 
Congress. Consumers deserve to have the option of obtaining a 
loan from a dedicated home and consumer lender that is able to 
offer products that meet that consumer's needs.

Q.5. Should banking regulators continue to be funded by fees on 
the regulated firms, or is there a better way?

A.5. As a general matter, we believe that bank regulatory 
agencies (agencies) be funded by the institutions that they 
regulate. The alternative, funding the agencies with tax payer 
dollars through the appropriations process, is inherently 
problematic. Funding the agencies in this manner creates a 
taxpayer subsidy for the institutions. Moreover, subjecting the 
agencies to the appropriations process will make the agencies 
more vulnerable to political influence.
    Now more than ever it is critical that the agencies be 
independent and free of political influence. However, funding 
the agencies through appropriations will do just the opposite. 
The Office of Federal Housing Enterprise Oversight (OFHEO) was 
subject to the appropriations process and as such was very 
vulnerable to political influence. For example, in 2004 OFHEO 
investigated accounting improprieties at Fannie Mae and that 
entity used the appropriations process to hinder the agency, 
portraying it as over its head on complex financial matters. 
This resulted in the Senate Appropriations Committee voting to 
hold back $10 million of a proposed funding increase until 
OFHEO got a new director. (S. Rep. No. 108-353, at 71.)
    It is critical that the agencies have the resources 
necessary to effectively regulate institutions. As was the case 
with OFHEO, Congress can withhold or threaten to withhold such 
funds. Even in the absence of such actions, Continuing 
Resolutions (CR) and other appropriations law requirements may 
hinder the agencies in achieving their mission. Beginning in 
October of every year and until a yearly appropriations bill is 
passed, agencies under the appropriations process are typically 
under a hiring freeze and are severely restricted in their 
expenditures under a CR. On January 21, 2004, Annando Falcon, 
then Director of OFHEO testified that Congress' protracted FY04 
appropriations process placed ``severe constraints'' on OFHEO's 
capacity to implement reforms at Freddie Mac and carry out 
other oversight responsibilities. Director Falcon told the 
House Financial Services Capital Markets Subcommittee that 
``[t]he short-term continuing resolutions we are operating 
under prevent us from hiring the additional examiners, 
accountants and analysts we need to strengthen our oversight. 
In addition, we are unable to hire the help we need to conduct 
our review of Fannie Mae. If the long term [continuing 
resolution] is enacted which freezes our budget at 2003 levels, 
we will need to scale back oversight at a time when greater 
oversight has never been more urgent.'' (Special Examination of 
Freddie Mac: Hearing Before the Subcommittee on Capital 
Markets, Insurance and Government Sponsored Enterprises of the 
H. Comm. on Financial Services, 108th Cong. 8-9 (January 21, 
2004) (statement of Armando Falcon, Director of Office of 
Federal Housing Enterprise Oversight.))
    Some believe that a banking agency may supervise an 
institution less vigorously if it fears that the institution 
will switch charters and the agency will lose a funding source.
    However, there is no evidence that this is the case and we 
strongly disagree with this suggestion.

Q.6. Why should we have a different regulator for holding 
companies than for the banks themselves?

A.6. Since the establishment of the savings and loan holding 
company, the OTS and its predecessor have regulated savings 
associations and their holding companies. Regulators have 
greater oversight into an institution and the holding company 
if they have the same supervisor. OTS disagrees that the 
institution and the holding company should have a different 
regulator. An exception to this general statement is if the 
holding company is so large or interconnected with other 
financial services companies that a systemic regulator also 
will provide oversight.
    OTS has long had authority to charter and regulate thrift 
institutions and the companies that own or control them. The 
agency has a comprehensive program for assessing and rating the 
overall enterprise as well as the adequacy of capital, the 
effectiveness of the organizational structure, the 
effectiveness of the risk management framework for the firm and 
the strength and sustainability of earnings. OTS performs 
capital adequacy assessments on an individualized basis for the 
firms under our purview with requirements as necessary, 
depending on the company's risk profile, its unique 
circumstances and its financial condition.
    The net effect of this approach has been a strong capital 
cushion for the holding companies OTS supervises and the 
ability for the firms under our purview to support the insured 
depositories within their corporate structures. It is because 
the agency supervises the institution and the holding company 
that the impact of the holding company activities on the 
institution can be assessed on a regular basis.

Q.7. Assuming we keep thrifts and thrift holding companies, 
should thrift holding companies be regulated by the same 
regulator as bank holding companies?

A.7. As explained more fully in the answer above, thrifts and 
thrift holding companies should continue to have the same 
supervisor. The regulatory framework that has been developed 
for the institution and its holding company provides a seamless 
supervisory process for savings associations and their holding 
companies. The benefits of having the same regulator for the 
institution and the holding company include the supervisor's 
ability to view the institution and the holding company as a 
whole and judgments based on all of the information.

Q.8. The proposed risk council is separate from the normal 
safety and soundness regulator of banks and other firms. The 
idea is that the council 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 council, 
how would you make sure the rules were being enforced the same 
across the board?

A.8. The Administration has proposed the creation of the 
Financial Services Oversight Council (Council) to be chaired by 
the Secretary of the Treasury and to include the heads of the 
Federal banking agencies and other agencies involved in the 
regulation of financial services. The Council will make 
recommendations to the Board of Governors of the Federal 
Reserve System (FRB) concerning entities that should be 
designated as systemically significant (Tier 1 FHCs). The FRB 
will consult the Council in setting material prudential 
standards for Tier 1 FHCs and in setting risk management 
standards for systemically important payment, clearing, and 
settlement systems and activities. The Council will also 
facilitate information sharing, provide a forum for discussion 
of cross-cutting issues and prepare an annual report to 
Congress on market developments and emerging risks. Under the 
Administration's proposal, the Council would not be authorized 
to promulgate rules.

Q.9. Mr. Bowman, in your statement you defend your agency's 
regulation of thrifts and thrift holding companies, however you 
never mention AIG. How do you defend your agency's performance 
with that company?

A.9. Commencing in 2005, OTS actions demonstrated a progressive 
level of supervisory criticism of AIG's corporate governance 
culminating in a communication to the company in 2008 which 
discussed the supervisory rating downgrade and a requirement to 
provide OTS with a remediation plan to address the risk 
management failures. OTS criticisms addressed AIG's risk 
management, corporate oversight, and financial reporting.
    It is critically important to note that AIG's crisis was 
caused by liquidity problems, not capital inadequacy. AIG's 
liquidity was impaired as a result of two of AIG's business 
lines: (1) AIGFP's ``super senior'' credit default swaps (CDS) 
associated with collateralized debt obligations (CDO), backed 
primarily by U.S. subprime mortgage securities and (2) AIG's 
securities lending commitments. While much of AIG's liquidity 
problems were the result of the collateral call requirements on 
the CDS transactions, the cash requirements of the company's 
securities lending program also were a significant factor.
    AIG's securities lending activities began prior to 2000. 
Its securities lending portfolio is owned pro rata by its 
participating, regulated insurance companies. At its highest 
point, the portfolio's $90 billion in assets comprised 
approximately 9 percent of the group's total assets. AIG 
Securities Lending Corp, a registered broker-dealer in the 
U.S., managed a much larger, domestic securities lending 
program as agent for the insurance companies in accordance with 
investment agreements approved by the insurance companies and 
their functional regulators.
    The securities lending program was designed to provide the 
opportunity to earn an incremental yield on the securities 
housed in the investment portfolios of AIG's insurance 
entities. These entities loaned their securities to various 
third parties, in return for cash collateral, most of which AIG 
was obligated to repay or roll over every 2 weeks, on average. 
While a typical securities lending program reinvests its cash 
in short duration investments, such as treasuries and 
commercial paper, AIG's insurance entities invested much of 
their cash collateral in AAA-rated residential mortgage-backed 
securities with longer durations.
    Similar to the declines in market value of AIGFP's credit 
default swaps, AIG's residential mortgage investments declined 
sharply with the turmoil in the housing and mortgage markets. 
Eventually, this created a tremendous shortfall in the 
program's assets relative to its liabilities. Requirements by 
the securities lending program's counterparties to meet margin 
requirements and return the cash AIG had received as collateral 
then placed tremendous stress on AIG's liquidity.

Q.10. I asked Chairman Bair this question a few weeks ago, so 
this is for the rest of you. 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.10. OTS exercises its supervisory responsibilities with 
respect to complex holding companies by communicating with 
other functional regulators and supervisors who share 
jurisdiction over portions of these entities and through our 
own set of specialized procedures. With respect to 
communication, OTS is committed to the framework of functional 
supervision Congress established in Gramm-Leach-Bliley. Under 
Gramm-Leach-Bliley, the consolidated supervisors are required 
to consult on an ongoing basis with other functional regulators 
to ensure those findings and competencies are appropriately 
integrated into the assessment of the consolidated enterprise 
and, by extension, the insured depository institution.
    As a consolidated supervisor, OTS relies on effective 
communication and strong cooperative relationships with the 
relevant primary supervisors and functional regulators. 
Exchanging information is one of the primary regulatory tools 
to analyze a holding company and to ensure that global 
activities are supervised on a consolidated basis. 
Approximately 85 percent of AIG, as measured by allocated 
capital, is contained within entities regulated or licensed by 
other supervisors. AIG had a multitude of regulators in over 
100 countries involved in supervising pieces of the AIG 
corporate family. OTS established relationships with these 
regulators, executed information sharing agreements where 
appropriate, and obtained these regulators' assessments and 
concerns for the segment of the organization regulated.
    As part of our supervisory program for AIG, OTS began in 
2005 to convene annual supervisory college meetings. Key 
foreign supervisory agencies, as well as U.S. State insurance 
regulators, participated in these conferences. Part of the 
meetings was devoted to presentations from the company. In this 
portion, supervisors had an opportunity to question the company 
about any supervisory or risk issues. Another part of the 
meeting included a ``supervisors-only'' session, which provides 
a venue for participants to ask questions of each other and to 
discuss issues of common concern regarding AIG. OTS also used 
the occasion of the college meetings to arrange one-on-one side 
meetings with foreign regulators to discuss in more depth 
significant risk in their home jurisdictions.
    This notion of consolidated supervision in a cross-border 
context is a widely accepted global standard implemented by 
most prudential supervisors. The key concepts of cross-border 
consolidated supervision have been supported by the Basel 
Committee on Banking and reflected in numerous publications. 
This framework has been embraced by the International Monetary 
Fund and World Bank and utilized in connection with their 
Financial Sector Assessment Program (FSAP) which is an 
assessment of countries' financial supervisory regimes.


       STRENGTHENING AND STREAMLINING PRUDENTIAL BANK SUPERVISION

                              ----------                              


                      TUESDAY, SEPTEMBER 29, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 2 p.m. in room SD-538, Dirksen Senate 
Office Building, Senator Christopher J. Dodd (Chairman of the 
Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. The Committee will come to order.
    Let me inform my colleagues here, my good friend, Richard 
Shelby, is stuck in an airport in Birmingham trying to get 
back, and so I left a message for him that when he arrives 
about 10 or 11 this evening, that Senator Corker will call him 
and read him the entire testimony today. He would like that. He 
would appreciate that.
    [Laughter.]
    Chairman Dodd. So what we will do here is I will make a few 
opening comments and I will ask if either of my colleagues 
would like to be heard at all and we will get right to our 
witnesses. We thank them for joining us here today in this 
hearing on ``Prudential Bank Regulation: Should There Be 
Further Consolidation?''
    I know we have had a lot of informal conversations with 
each other over many, many months on this subject and many 
others related to the reform of the financial regulatory 
structure. As I have said over and over again, while I think 
some of us are getting closer to firmer ideas, I believe most 
of us here are still very anxious to hear from people who bring 
a particular knowledge and expertise, as our witnesses do here 
today, on this subject matter. So we are interested in your 
thoughts.
    We all understand here how important this subject matter 
is. We also understand how important it is that we do it right 
and that we realize we are doing things here that have not been 
done in years, and so as we chart forward, we want to make sure 
that we are doing so carefully and thoughtfully. So while I 
know there are those who are impatient, that while we haven't 
answered all the questions, even though the problems that 
emerged a year ago have not been entirely solved, I think it is 
important that we do it carefully and right, and that is our 
determination on this Committee.
    This afternoon, we will have a chance to hear from four 
very knowledgeable witnesses on the subject matter. I have read 
all of your testimony. I think it has been tremendously 
helpful. I think you go beyond, in some cases, talking about 
the single prudential regulator or the consolidation of 
regulation to other areas, as well, so while we are talking 
about that subject matter, certainly my colleagues don't need 
any advice from me on the subject matter, but clearly, the 
expertise is at this table. We would invite questions regarding 
a wide subject matter, in addition to the one that is the title 
of the hearing today.
    So with that, this afternoon we examine how best to ensure 
the strength and security of our banking system. I would like 
to thank our witnesses again for returning to share your 
expertise after the last hearing was postponed.
    Today, we have a convoluted system of bank regulators 
created by an almost historical accident. I think most experts 
would agree that no one would have designed a system that 
worked like this. For over 60 years, Administrations of both 
political parties, Members of Congress across the political 
spectrum, commissions, and scholars have proposed streamlining 
this irrational system.
    Last week, I suggested further consolidation of bank 
regulators would make a lot of sense. We could combine the 
Office of the Comptroller of the Currency and the Office of 
Thrift Supervision while transferring bank supervision 
authorities from the Federal Deposit Insurance Corporation and 
the Federal Reserve and leaving them to focus on their core 
functions.
    Since that time, I have heard from many who have argued 
that I should not push for a single bank regulator. The most 
common argument is not that it is a bad idea, but rather, 
consolidation is too politically difficult to achieve. That 
argument doesn't work terribly well with me, nor, I suspect, 
with many, if not most, of my colleagues.
    Just look what the status quo has given us. In the last 
year, some of our largest banks needed billions of dollars of 
taxpayer money to prop them up and dozens of smaller banks have 
failed outright. It is clear that we need to end charter 
shopping, where institutions look around for the regulator that 
will go easiest on them. It is clear that we must eliminate the 
overlaps, redundancies, and additional red tape created by the 
current alphabet soup of regulators. We don't need a super-
regulator with many missions, but a single Federal bank 
regulator whose sole focus is the safe and sound operation of 
our Nation's banks. A single operator would ensure 
accountability and end, I think, the frustrating ``pass the 
bucket'' excuses that we have been faced with over these many, 
many months.
    We need to preserve our dual banking system, and I feel 
just as strongly about that point as I do the earlier point. 
State banks have been a source of innovation and a source of 
strength, tremendous strength, in our communities. A single 
bank regulator can work, I think, with the 50 State bank 
regulators. Any plan to consolidate bank regulations would have 
to ensure community banks are created appropriately. Community 
banks did not cause the crisis and they should not have to bear 
the cost or burden of increased regulation necessitated by 
others. Regulation should be based on risk. Community banks do 
not present the same type of supervisory challenges that large 
counterparts do.
    But we need to get this right, as I said a moment ago, 
which is why you are all here today. I am working again with 
Senator Shelby and other Members of the Committee and 
colleagues here to find a consensus that we can craft on this 
incredibly important bill.
    So with that, unless one of my other colleagues wants to be 
heard for a few minutes on opening up, I will turn to our 
witnesses.
    Our first witness--and I will introduce all of them briefly 
here--Eugene Ludwig, is the Chief Executive Officer of the 
Promontory Financial Group. Before assuming that 
responsibility, Gene served as the Vice Chairman and Senior 
Control Officer of Bankers Trust Corporation, which he joined 
in 1998. He served as the Comptroller of the Currency from 1993 
to 1998, and prior to joining the OCC, was a partner in the law 
firm of Covington and Burling.
    Martin Baily is a Senior Fellow for Economics at the 
Brookings Institution. Dr. Baily also serves as the Cochair of 
the Pew Task Force on Financial Sector Reform and is a senior 
advisor to McKinsey and Company. He served as Chairman of the 
Council of Economic Advisors under the Clinton administration 
from 1999 to 2001, and prior to that was a member of the same 
Council from 1994 to 1996.
    Richard Carnell is an Associate Professor at the Fordham 
University School of Law. He previously served as the Assistant 
Secretary for Financial Institutions at the Treasury from 1993 
to 1999. And prior to that, Mr. Carnell was also a Senior 
Counsel to this very Committee, from 1989 to 1993.
    Richard Hillman is the Managing Director of the Financial 
Markets and Community Investment Team of the U.S. Government 
Accountability Office. He has been with GAO for 31 years and 
his team looks at the effectiveness of regulatory oversight in 
the financial and housing markets and the management of 
community development programs.
    We are honored that all four of you are with us today. We 
thank you for your service, your past service, and your 
willingness to participate in today's conversation.
    All of you have been before this Committee many times in 
the past and I will not limit you in a strict fashion to the 
time, but if you would try to keep it in that 5 to 7 minutes--
and I know your testimony goes on longer than that, and the 
testimony, the full testimony and comments and supporting data, 
we will include as part of the record, as well.
    Gene, we welcome you back to this Committee.

    STATEMENT OF EUGENE A. LUDWIG, CHIEF EXECUTIVE OFFICER, 
                PROMONTORY FINANCIAL GROUP, LLC

    Mr. Ludwig. Chairman Dodd, and to Ranking Member Shelby, 
who is not here, and other distinguished Members of this 
Committee, I am honored to be here today and I want to commend 
you and the staff for the thoughtful way in which you have 
examined the causes of the financial crisis and the need for 
reform in this area. Under your leadership, Chairman Dodd and 
Ranking Member Shelby, the bipartisan and productive traditions 
of the Senate Banking Committee have continued.
    In this regard, it should be noted that the need for an 
end-to-end independent consolidated banking regulator, the 
subject you have asked me to address today, has been championed 
over the years by Members of the Senate Banking Committee, 
including its Chairman, as well as Treasury Secretaries from 
both sides of the aisle.
    Consistent with this tradition, the Administration's white 
paper is directionally helpful and commendable. While 
refinements to the white paper are needed, this is an 
inevitable part of the policymaking process.
    I also want to commend the Treasury Department of former 
Secretary Henry Paulson for having developed its so-called 
``Blueprint,'' which also has added important and positive 
developments to the debate in this area.
    Lamentably, the financial regulatory problem we face is not 
just the current crisis. Over the past 20-plus years, we have 
witnessed the failure of hundreds of U.S. banks and bank 
holding companies, supervised by every one of our regulatory 
agencies. By the end of this year alone, well over 100 U.S. 
banks will have failed, costing the Deposit Insurance Fund tens 
of billions of dollars. Before this crisis is over, we will 
witness the failure of hundreds more.
    In the face of this irrefutable evidence, it is impossible 
to say there is not a very serious problem with our regulation 
of financial services organizations. There are three things, 
however, this problem is not. It is not about the lack of 
talented people in our regulatory agencies. It is not about 
weak regulation or weaker bankers. The problem is in large 
part--the problem stems from a dysfunctional regulatory 
structure, a structure that exists nowhere else in the world 
and no one wants to copy, a structure that reflects history, 
not deliberation.
    The recent financial crisis has accentuated many of the 
shortcomings of the current regulatory system. Needless burdens 
that weaken safety and soundness focus, lack of scale needed to 
address problems in technical areas, regulatory arbitrage where 
the ability to select or threaten to select a weaker supervisor 
tears at the fabric of solid regulation, delayed rulemaking, 
regulatory gaps, limitations on investigations, where one 
agency cannot seamlessly examine and resolve a problem from a 
bank to its nonbank affiliate, and diminished international 
leadership. What is needed and what would resolve these 
problems is an end-to-end independent consolidated banking 
supervisor.
    Now, there have been a number of misconceptions about what 
a consolidated end-to-end institutional bank regulator is and 
what it is not. First, an end-to-end supervisor is not a super-
regulator along the lines of Britain's FSA. The end-to-end 
consolidated institutional supervisor would not regulate 
financial markets like the FSA, would not establish consumer 
protection rules like the FSA, would not have resolution 
authority, would not have deposit insurance authority or any 
central banking functions.
    The consolidated end-to-end institutional regulator would 
focus only on the prudential issues applicable to financial 
institutions, and this model has been quite successful 
elsewhere in the world. I think this is really quite important.
    For example, the Office of the Superintendent of Financial 
Institutions, OSFI, in Canada, and the Australian Prudential 
Regulatory Authority, called APRA, in Australia have been quite 
successful consolidated supervisors even in the current crisis, 
where Canadian and Australian banks have fared much better than 
our own.
    There has been a second misconception that a consolidated 
regulator that regulates enterprises chartered at the national 
level cannot fairly supervise smaller community organizations 
and that it would do violence to our dual banking system. I 
might say as an aside, I, like the Chairman, believe the dual 
banking system is alive and well and an important fabric of our 
banking system and this would not do violence to it.
    In fact, interesting enough, even today, the OCC supervises 
well over a thousand community banking organizations whose 
businesses are local in character. That is, the national 
supervisor supervises over a thousand small banks. In fact, it 
is the majority of the banks it supervises, the vast majority, 
and they choose that as a matter of their own predilection, not 
by rule. Indeed, today, all our Federal regulators regulate 
large institutions and smaller institutions. A new consolidated 
supervisor at the Federal level would merely pick up the FDIC 
and Federal Reserve examination and supervisory authorities.
    To emphasize, all the consolidated supervisor would do is 
take the Federal component and move it to another Federal box. 
It would not change the regulation or the fabric of that 
supervision.
    Third, some have claimed that a consolidated institutional 
supervisor would not have the benefit of other regulatory 
voices. This would clearly not be the case, as a consolidated 
institutional supervisor would fulfill only one piece of the 
regulatory landscape. The Federal Reserve, Treasury, SEC, FDIC, 
CFTC, FINRA, FINCEN, OFAC, and the FHFA would continue to have 
important responsibilities with respect to the financial 
sector.
    In addition, proposals are being made to add additional 
elements to the U.S. financial regulatory landscape, the 
Systemic Risk Council and a new financial consumer agency. This 
would leave multiple financial regulators at the Federal level 
and 50 bank regulators, 50 insurance regulators, and 50 
securities regulators at the State level. It seems to me that 
is a lot of voices.
    Fourth, some have also claimed that the primary work of the 
Federal Reserve--monetary policy, payment system, and acting as 
the bank of last resort--and the FDIC--deposit insurance--would 
be seriously hampered if they did not have supervisory 
responsibility. The evidence does not support these claims.
    One, a review of FOMC minutes does not suggest much, if 
any, use is made of supervisory data in monetary policy 
activities. In the case of the FDIC, it has long relied on a 
combination of publicly available data and examination data 
from the other agencies.
    Two, there are not now, to my knowledge, any limitations on 
the ability of the Federal Reserve or the FDIC to collect any 
bank supervisory data. Indeed, if need be, the Federal Reserve 
or the FDIC can accompany another agency's examination team to 
obtain relevant data or review relevant practices.
    Three, if the FDIC or the Federal Reserve does not have 
adequate cooperation on gathering information, Congress can 
make clear by statute that this must be the case.
    And four, even if the FDIC were not the supervisor of State 
chartered banking entities, the FDIC would continue to have 
back-up supervisory authority and be able to be resident--
resident--in any bank it chose.
    Finally, I would note that it is important that the new 
consolidated supervisor be an independent agency for at least 
three reasons. First, banking supervision should not be subject 
to political influence.
    Second, the agency and the agency head needs the stature of 
the Federal Reserve, SEC, or FDIC to attract talented people 
and to be taken seriously by the other agencies.
    Third, and this, I think, is critically important, 
Congress, in fulfilling its oversight function--its critical 
oversight function--must hear the unfettered truth about the 
banking system from the head of its supervisory agency, not 
views filtered through another department or agency. And 
indeed, I would go further. I think it is incredibly difficult 
for you to fulfill your oversight responsibilities with an 
alphabet soup of regulators. Indeed, having regulators that 
have clear missions, it seems to me, makes it possible for you 
to exercise your critical function in a more effective way. If 
one pushed these together even more, as has been suggested by 
some, I think it becomes almost unmanageable for Congress.
    In sum, our country greatly needs a consolidated 
independent end-to-end institutional regulator. Without one, we 
will not have financial stability, in my view, and we will 
continue to be victimized by periods of bank failures and 
follow-on credit crunches that deteriorate our economy.
    Thank you very much.
    Chairman Dodd. Thank you very much, Gene Ludwig. We 
appreciate it very much.
    Dr. Baily, we thank you, as well, for being with us.

STATEMENT OF MARTIN N. BAILY, SENIOR FELLOW, ECONOMIC STUDIES, 
                   THE BROOKINGS INSTITUTION

    Mr. Baily. Well, thank you, Chairman Dodd and Members of 
the Committee, to give me a chance to talk about this issue.
    The summary of my testimony is, number one, I think that 
the best guide to financial reform is the objectives approach, 
which divides up regulation into microprudential, 
macroprudential, and conduct of business regulation. So we have 
to make sure that all parts of the financial sector are 
adequately supervised, we don't have gaps in regulation. We 
also want to make sure we don't have duplicative agencies. 
After all, there were plenty of regulators. There were rooms 
full of regulators. They didn't prevent this crisis.
    My second point is that the quality of regulation must be 
improved regardless of where it is done, and I don't want to 
denigrate anybody in the regulatory agencies, but I do think 
there is a problem that they may not always be well enough 
paid, have enough experience, or have the kind of stature that 
they need to deal with our very complex financial sector, 
particularly the large global banks. I don't think we want a 
situation where people are in Government jobs for a while and 
then they move over to the financial sector, viewing that as 
sort of where they are going to make their money. I think we 
want the regulatory jobs to be desirable and stable jobs and 
get the best people we can.
    I agree with the Chairman and very much with Gene Ludwig 
that we need a single Federal microprudential regulator, 
combining the supervisory functions currently carried out at 
the Fed, the OCC, the OTS, the SEC, and the FDIC. I think this 
regulator should partner closely with State regulators. You 
mentioned the importance of the community banks, and I agree 
with you on that. I would say, however, that some of the State 
chartered nonfinancial institutions were a source of a lot of 
the bad mortgages that were made, so I think having the right 
partnership between the Federal regulator and the State 
chartered enterprises is important. I think there should be a 
sharing of information there and perhaps of standards and 
appropriate methods and data.
    I do think, and this is going a little beyond the immediate 
discussion of this hearing, but I do think the U.S. does need 
an effective conduct of business regulator. That is an 
important part. As Gene said, that has been combined in the 
U.K., where the FSA was both the prudential regulator and the 
conduct of business regulator, and cobbling it all, the whole 
lot that was done there, I think that is a mistake. I think 
having a separate conduct of business regulator is a good idea.
    My own view is it would be nice to have that in a single 
agency, and I think the SEC is probably the place to put it, 
although the SEC, I must say, did not do a very good job in 
this crisis. But I think potentially the SEC should be the 
place that looks after small shareholders and also looks after 
consumers, so it would have a CFPA division within the SEC. 
Now, I know there is a case for having a separate consumer 
agency and I am not diametrically opposed to that. I think 
there are some advantages to the consolidation of having 
conduct of business regulation in one place, but a good CFPA on 
its own would be fine.
    Now, this structure that we are describing takes away from 
the Fed an important part of its existing power, which is what 
has been to supervise the bank holding companies, most of the 
large banks and a number of the smaller banks. I think that is 
the right thing to do. I agree with Gene. I don't think this is 
something that the Fed has done particularly well. They are 
obviously paying a lot more attention to it now than they used 
to, but historically, I don't think that is something that they 
have done very well.
    I share that view with my colleague, Alice Rivlin, who I 
think has testified to this Committee, and she was there and 
saw the point that Gene Ludwig made, which is that the 
prudential people haven't typically had a lot of say on Open 
Market Committee meetings. That hasn't been a main thing.
    I do think it is very important that the Fed, as the lender 
of last resort to the financial sector, does have to have 
information about what is going on in the banks. I think that 
was a significant failure in the U.K., where the FSA and the 
Bank of England were so separate and were not talking to each 
other, and I think Mervyn King, the head of the Bank of 
England, thought it was inappropriate for him to talk too much 
to the FSA. He wanted the independence of the Bank of England 
when they were making monetary policy. You know, I see his 
argument, but I think that was a big mistake and one of the 
things that got them into trouble.
    So I think we should have a lot of lines of communication 
shared between the regulators and the Federal Reserve so that 
they can set monetary policy with the adequate amount of 
information and that they are aware of what is going on in the 
banks, and if they need to be a lender of last resort, that is 
not suddenly sprung on them. But I think they don't have to be 
the people that are doing the day-to-day supervision.
    Another point I would like to make in this regard is that 
the big bank holding companies, or the big banks, as we know, 
both investment banks or the traditional commercial banks, are 
run as single entities. So the idea that you had a bank holding 
company which was sort of a separate entity from the bank 
itself really is not the way things operate. These were run 
from the top and these banks would sort of come up with a new 
line of business, something that was going to be profitable, 
and they would discuss it, and then as someone was walking 
about the door, they would sort of say, well, which legal 
entity shall we put this in, and the answer to that was 
typically, well, where would they get the most favorable tax 
treatment? Where would they get the most favorable regulatory 
treatment? It is not as if these things were really different 
entities.
    So I think another advantage of having a single prudential 
regulator is that they would regulate these businesses top to 
bottom as single companies, which is what they are.
    I have used up my time. The last thing I want to say is to 
reinforce the point that Gene made. I think we both had the 
same reaction when we attended the hearing in August. You know, 
it is natural for regulators to say, well, don't close my 
agency. Mine is all right. When you came back and some of the 
other Members of the Committee came back and said, well, 
shouldn't we consolidate, shouldn't we make this a more 
rationally organized regulatory structure, the answer came 
back, well, the U.K. had trouble and they had this single 
regulator, so we don't see why that should do any good.
    That prompted, I think, both of us to go take a look--Gene 
probably knew already, but I actually went to take a look at 
regulation around the world, not covering every country, but 
trying to cover several countries, and particularly the 
English-speaking countries which tend to have some similarity 
of their institutions, and you are right.
    Canada, I think, did a much better job. They do actually 
have quite a few different agencies, so they weren't my ideal. 
I think Australia, which actually the Paulson Blueprint pointed 
to, is to be commended. They took quite a while. They decided, 
what is the best way to regulate. They took their time in doing 
it. They consolidated in an appropriate way.
    What happened in the U.K.--and I grew up in the U.K., I am 
fond of the U.K., but they didn't do this very well--Gordon 
Brown came in as Chancellor of the Exchequer and he said, it is 
crazy to have all these agencies. I think he was right about 
that. That the functions that these different companies are 
performing are crossing boundaries and we want to have a single 
agency. But they hadn't made any preparation. They hadn't 
really laid the groundwork for doing it. They hadn't figured 
out how to do it well. And, in fact, the FSA remained really 
quite divided. There were a lot of different subagencies within 
that, so they weren't communicating well, and as I said 
earlier, they weren't communicating with the Bank of England.
    So I think the examples that were given last time to say, 
oh, other countries--a single agency doesn't work in other 
countries, I think that is wrong. I think if you look in the 
right place, you will find that having a single prudential 
regulator is pretty much what is the right choice to make, 
based on international experience.
    Let me stop there. Thank you.
    Chairman Dodd. Thank you very much, Dr. Baily.
    Dr. Carnell? Thank you very much, Doctor, for being with 
us.

 STATEMENT OF RICHARD S. CARNELL, ASSOCIATE PROFESSOR, FORDHAM 
                    UNIVERSITY SCHOOL OF LAW

    Mr. Carnell. Mr. Chairman and Members of the Committee, our 
current bank regulatory structure is and remains a source of 
serious problems. Its defects are significant and longstanding. 
The system is needlessly complex, needlessly expensive, and 
imposes needless compliance burdens on banks. It impedes--it 
blunts regulators' accountability with a tangled web of 
overlapping jurisdictions and responsibilities, and it gives 
credence to the old saying, when everyone is responsible, no 
one is responsible.
    The system wastes time, wastes energy. It hinders timely 
action by regulators. It brings policy down to the lowest 
common denominator that four agencies can agree on. And it 
takes a particular toll on far-sighted action, action aimed at 
preventing future problems. That is because so often in 
policymaking, there is someone who says, if it ain't broke, 
don't fix it. So it is a lot easier to get agreement when you 
wait until you are confronted with a problem than when you are 
trying to look ahead and head off problems to begin with.
    Now, there is a straightforward solution to the problems we 
see from our fragmented regulatory system, and that solution is 
to unify the supervision of FDIC-insured depository 
institutions, banks and thrifts, in a single agency. Treasury 
Department Lloyd Bentsen offered that solution here in this 
room 15 years ago and it made sense at the time. I worked with 
him in preparing that proposal, and I think the events of the 
last 15 years bear out the wisdom of that approach.
    This new agency would take on the existing bank regulatory 
responsibilities of the OCC, OTS, Federal Reserve, and FDIC. 
The Federal Reserve would retain all its existing central 
banking functions, including monetary policy, the discount 
window, and the payment system. The FDIC would retain all its 
deposit insurance powers and responsibilities, including back-
up examination and enforcement authority.
    On top of that, under the approach I propose, the Fed and 
the FDIC would be on the board of the new agency, let us say a 
five- or seven-member board with those two agencies 
represented. The Fed and FDIC could have their examiners 
participate in examinations conducted by the new agency, and 
they would have full access to supervisory information. So the 
Fed and FDIC would get all the information they get now and 
their examiners could be part of teams in all FDIC-insured 
banks, which is more access than they customarily enjoy now.
    This straightforward structure would be a major improvement 
over the current fragmented structure. It would promote 
clarity, efficiency, accountability, and timely action. Equally 
important, it would give the bank regulator greater 
independence from special interest pressure. That is, this new 
agency would regulate the full spectrum of FDIC-insured 
institutions. There wouldn't be the sort of subspecialization 
category like we see with thrift institutions.
    Now, if you look at the thrift debacle, for example, you 
see that thrift regulation was better when it was done by 
agencies that had a broad jurisdiction than when it was done by 
specialized thrift-only regulators. So, for example, at the 
Federal level, we had thrifts regulated by both the FDIC, which 
regulated the traditional savings banks, and we had thrifts 
regulated by the specialized Federal Home Loan Bank Board. 
FDIC-regulated thrifts were much less likely to fail and, if 
they did fail, caused smaller losses than the Home Loan Bank 
Board-regulate thrifts, and we see the same thing at the State 
level.
    At the State level, in about two-thirds, three-quarters of 
the States, the State Banking Commissioners supervise thrifts, 
and in those States, the losses to the insurance fund were much 
lower than we saw in States with specialized thrift regulators, 
and that is basically because the thrift regulators had no 
reason for being if there wasn't a thrift industry, and so they 
looked for every way to keep thrift institutions going, even 
when, in fact, it was unrealistic at that point. The result was 
a failure to deal effectively with troubled thrifts, much 
larger losses to the Deposit Insurance Fund.
    A unified structure would have another major advantage. It 
would recognize the reality of how banking organizations 
actually operate, and Dr. Baily already touched on this, as 
well. Under the existing system, each agency looks at only part 
of the organization. But in these organizations, you may, in 
fact, have the various parts doing business with each other 
extensively, and to evaluate risk, you need to look at the 
whole, think about the whole, and it sure helps in doing that 
to be responsible for the whole.
    So the fragmented system hinders the agency from getting 
the full picture. Here is how Secretary Bentsen described the 
problem. Under our current system, any one regulator may see 
only a limited piece of a dynamic, integrated banking 
organization when a larger perspective is crucial, both for 
effective supervision of the particular organization and for an 
understanding of broader industry conditions and interests.
    Mr. Chairman, if I could, I wanted to speak a bit to the 
question of holding company regulation, which came up earlier. 
First, I want to note something that may not be widely 
appreciated, and that is that holding companies as a major 
subject of regulation, that thing is unique to the United 
States. In other countries, the regulation focuses on the bank. 
Regulators look out, reach out, but it is not like we have got 
people devoting their careers to the Bank Holding Company Act.
    And here is what two of the leading experts, Pauline Heller 
and Melanie Fein, say. Bank holding companies have no inherent 
necessity in a banking system. They developed in the United 
States only because of our unique banking laws which 
historically limited geographic location and activities of 
banks. Their only material purpose has been to serve as 
vehicles for getting into things banks couldn't get into 
directly.
    So this puts it into perspective. There is nothing magical. 
There is nothing high priestly about bank holding company 
regulation. There is no need for a separate holding company 
regulator. A bank regulator can fully handle all the functions 
of a holding company regulator, policing the banks' 
transactions with the banks and looking at overall risk.
    In conclusion, Secretary Bentsen, speaking from this table 
in 1994, underscored the risk of continuing to rely on what he 
called ``a dilapidated regulatory system that is ill-defined to 
prevent future banking crises and ill-equipped to cope with 
crises when they occur.'' He observed in words eerily 
applicable to the present that our country had just emerged 
from its worst financial crisis since the Great Depression, a 
crisis that our bank regulatory system did not adequately 
anticipate or resolve.
    And he issued this warning, which we would yet do well to 
heed. If we fail to fix the system now, the next financial 
crisis we face will again reveal its flaws, and who suffers 
then? Our banking industry, our economy, and potentially the 
taxpayers. You have the chance to help prevent that result.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much for your testimony. I 
was very fond of Lloyd Bentsen, served with him here. He was a 
wonderful Member of the Senate and a very good Secretary of the 
Treasury as well. So thank you for being with us.
    Welcome, Mr. Hillman. Nice to see you, and thank you for 
being here. Thank you for your service to the GAO, 31 years. 
Congratulations on that contribution.

 STATEMENT OF RICHARD J. HILLMAN, MANAGING DIRECTOR, FINANCIAL 
       MARKETS AND COMMUNITY INVESTMENT TEAM, GOVERNMENT 
                     ACCOUNTABILITY OFFICE

    Mr. Hillman. Thank you very much. Mr. Chairman and Members 
of the Committee, I am pleased to be here today to discuss 
issues relating to efforts to reform the regulatory structure 
of our Nation's financial system.
    In January 2009, we reported on gaps and limitations in our 
current structure, and we presented a framework for evaluating 
proposals to modernize the U.S. financial regulatory system. 
Given the importance of the U.S. financial sector to the 
domestic and international economies, we also added 
modernization of the outdated regulatory structure as a new 
area to our high-risk list because the fragmented and outdated 
regulatory structure was ill-suited to meeting the challenges 
of the 21st century.
    My statement today, which is based on prior reports that we 
have completed, focuses on how regulation has evolved and 
recent work that further illustrates the significant 
limitations and gaps in the existing regulatory structure, the 
experiences of countries with other types of varying regulatory 
structures and how they fared during the financial crisis, and 
our reviews on certain aspects and proposals to reform the 
regulatory system.
    I would like to make the following points:
    First, the current U.S. financial regulatory system is a 
fragmented and complex arrangement of Federal and State 
regulation that has been put into place over the past 150 years 
but has not kept pace with major developments in financial 
markets and products in recent decades. My prepared statement 
details numerous examples from our prior work identifying major 
limitations of the Nation's fragmented banking regulatory 
structure. For example, in July, we reported that less 
comprehensive oversight by various regulators responsible for 
overseeing fair lending laws intended to prevent lending 
discrimination may allow many violations by independent 
mortgage lenders to go undetected. That same month, we also 
reported that regulatory capital measures did not always fully 
capture certain risks and that none of the multiple regulators 
responsible for individual markets or institutions had clear 
responsibility to assess the potential effects or the build-up 
of systemwide leverage.
    Recent proposals to reform the U.S. financial regulatory 
system include some elements that would likely improve 
oversight of the financial markets and make the system more 
sound, stable, and safer for consumers and investors. For 
example, under proposals under the Administration and others, 
new regulatory bodies would be created that would be 
responsible for assessing threats that could pose systemic 
risks. Our past work has clearly identified the need for a 
greater focus on systemwide risks in the regulatory system.
    In addition, the Administration and others are proposing to 
create a new entity that would be responsible for ensuring that 
consumers of financial services are adequately protected. Our 
past work has found that consumers often struggled to 
understand complex financial products, and the various 
regulators responsible for protecting them have not always 
performed effectively. As a result, the creation of a separate 
consumer protection regulator is one sound way for ensuring 
that consumers are better protected from unscrupulous sales 
practices and inappropriate financial products.
    However, our analysis indicates that additional 
opportunities for further consolidating the number of Federal 
regulators exist that would decrease fragmentation, reduce the 
potential for differing regulatory treatment, and improve 
regulatory independence. For example, the Administration's 
proposal would only combine the current regulators for national 
banks and thrifts into one agency while leaving the three other 
depository institution regulators--the Federal Reserve, FDIC, 
and the regulator for credit unions, NCUA--intact. Our work has 
revealed that multiple regulators who perform similar functions 
can be problematic. When multiple regulators exist, variations 
in their resources and expertise can limit their effectiveness.
    The need to coordinate their actions can hamper their 
ability to quickly respond to market events, and institutions 
engaging in regulatory arbitrage by changing regulators through 
reduced scrutiny or their activities or to threaten to change 
regulators in order to weaken regulatory actions against them.
    Having various regulators that are funded by assessments 
from the institutions they regulate can also in such regulators 
become overly dependent on individual large institutions for 
funding, which could compromise their independence in 
overseeing such firms. As a result, we would urge the Congress 
to consider additional opportunities to consolidate regulators 
as it deliberates reform of our regulatory system.
    Finally, regardless of any regulatory reforms that are 
adopted, we urge the Congress to continue to actively monitor 
the progress of such implementation and be prepared to make 
legislative adjustments to ensure that any changes in the U.S. 
financial regulatory system are as effective as possible. In 
addition, we believe that it is important that Congress provide 
for appropriate GAO oversight of any regulatory reforms to 
ensure accountability and transparency in any new regulatory 
system, and GAO stands ready to assist the Congress in its 
oversight capacity and evaluate the progress agencies are 
making implementing any changes.
    Mr. Chairman and Members of the Committee, I appreciate the 
opportunity to discuss these critical issues and would be happy 
to respond to any questions at the appropriate time.
    Chairman Dodd. Thank you very, very much. Let me thank all 
of you on behalf of the Committee for your testimony and your 
observations. They have been very, very helpful this afternoon.
    Let me pick up on the issue of the community banks and the 
issue of a single regulator, because I think this is where 
maybe the most contentious political problems arise. I want to 
underscore the point--I think, Gene, you made it, others may 
have made it as well--that we have a lot of community banks 
that are operating under Federal charters and, in fact, are 
regulated at the Federal level. I think you mentioned 1,000 or 
a number like that. And at a time, obviously, when they could 
have easily, under the present system, decided to migrate from 
that to a State charter--they may have had their own reasons 
for not doing so, but the fact that so many have stayed with a 
Federal regulator indicates a relatively high degree of 
satisfaction in terms of how they were being handled, in the 
midst of that same institution handling the Chases, the 
JPMorgans, and Bank of America and other large institutions. So 
you have the largest number of community banks in many ways 
maintaining a regulatory structure where there is duality. But 
it is of concern, and I think we need to address it in ways 
that are practical.
    There have been some suggestions, something along this 
line, and I would like to maybe get a little more in the weeds 
on this. How do you envision, if we had a single regulator, a 
division within that regulator to be able to handle the 
concerns of the community banks, particularly ones that would 
be State chartered, how they would handle that in a way that 
would give them some degree of satisfaction that they are not 
going to be lumped together in a way that would diminish their 
capacity to be able to function and get lost in the shuffle? 
How do you do that?
    I would ask all of you, and if you have got any ideas on 
that, I would be interested in your thoughts.
    Mr. Ludwig. Well, Mr. Chairman, I think that it is 
important for the new regulatory agency to have departments 
that are specialized in dealing with institutions of a 
particular size. The Comptroller's office currently has three 
segments: one deals with small banks, one midsized, one large. 
I think that there are specialized techniques, ability to 
simplify supervision for community banks, and I think it is 
important.
    In that regard, I think the same kind of sensitivity to 
small bank supervision can be found both at the Federal Reserve 
and the FDIC. Remember, the only thing that one would do in 
terms of this new agency would be to move the Federal component 
of the supervisory authority to the new agency. It would not 
change the component. But I think one can have a separate 
division that focuses on simplifying it. I think that Congress, 
in writing these rules itself, ought to mandate that simplified 
treatment--that one of the responsibilities of the new agency 
is to reduce burden wherever possible, particularly in terms of 
community and regional financial institutions.
    Chairman Dodd. Dr. Baily.
    Mr. Baily. Yes, I agree very much with what Gene said. I 
think that can be handled within a single regulator. The 
Federal Reserve currently supervises the bank holding 
companies, and you think of them as the big ones. But, 
actually, some of them are pretty small. They have got quite a 
range. So they have been supervising both big and small banks.
    So I think it is certainly possible to have a separate 
division within the prudential regulator that looks to the 
needs of community banks, and I think it is very important that 
small banks not be overburdened with regulation. One wants 
different requirements, perhaps, different capital requirements 
for a bank that has large overseas operations, subsidiaries. 
That has become--it seems too big to fail, although I hope we 
can overcome that problem. The needs there are very different 
than the community banks, and I think that should be part of 
the legislation taking account of that.
    Chairman Dodd. I should have asked this of Gene as well. In 
your examination of global examples, you mentioned Australia 
and Canada, and I do not know this, so I apologize for my 
ignorance on this. I do not know what the Australian banking 
system looks like. Is there duality there at all? Or is this 
all one system? Is there any place you looked at that has a 
comparable duality of systems that would----
    Mr. Baily. Well, there certainly are countries that have 
small banks. Germany has a lot of small banks, actually many of 
them State-owned banks that ended up buying quite a bit of CDOs 
as a matter of fact. So they did not always make good 
decisions.
    Typically, in Canada, you have some small banks, but really 
the market is dominated by about five or half a dozen very 
large banks. So I do not think they are quite comparable to the 
U.S., which, as you say, or somebody said earlier, grew up 
because of geographical limitations.
    I do not know whether you want to add to it.
    Chairman Dodd. Do you have anything on that, Gene?
    Mr. Ludwig. First, Canada does have a Federal system, and 
there are some smaller institutions. But there is no place on 
Earth that really quite has the number of commercial banking 
institutions that we do.
    Having said that, the point is well taken that Germany does 
have a good many landesbanks, and I think a survey of the world 
would reveal other consolidated supervisory mechanisms that 
deal with small banks and large banks and do it effectively. 
And I think Canada is probably a pretty good example, actually, 
though they are not as numerous.
    Chairman Dodd. Well, Germany is sort of the antithesis of 
ours. That is a highly decentralized system in many ways in 
Germany.
    Dr. Carnell.
    Mr. Carnell. Yes, three things. First, Secretary Bentsen's 
legislative proposal included a statutory requirement 
establishing a community banking division within the agency 
seeking to institutionalize a sensitivity to the ways community 
banks are different and the ways they should not be treated 
just the same as larger institutions.
    And I think--and this is my second point--that something 
like that, even though in a sense it is just an outline of an 
idea, it sends a signal that Congress cares about it, that it 
is something that needs to be done. I think that is a signal 
that the agency will clearly hear.
    And then, third, in any event the new agency would have 
every incentive to foster a healthy community banking system. 
The agency has no reason to favor large over small, and there 
are advantages to the agency when bankers come in, for example, 
to talk to Members of Congress, that people are having a 
positive experience with the new agency.
    So there is absolutely no reason for the regulator to hold 
back from doing the best job it can. There is no reason why a 
unified regulator would do any less of a good job than what we 
see now where an agency like the OCC regulates from the largest 
banks down to some of the smallest.
    Finally, you mentioned duality, and in case you were asking 
about a dual banking system, that is not something that you see 
abroad. That is, to my knowledge, a quirk of U.S. regulation 
having to do basically with some developments in the 1860s and 
1870s.
    Chairman Dodd. Thank you very much.
    Mr. Hillman.
    Mr. Hillman. There clearly are ways to provide a voice for 
State banks or community banks and still achieve great 
consolidation of the banking regulatory structure. I agree with 
Rick that one of the ways in which you could achieve that would 
be to establish a division within that prudential regulator to 
serve the needs of community and State member institutions.
    Another way of achieving that goal would also be, like the 
FDIC currently has with its board structure, to ensure that 
membership of that board might include members that have a 
background or might have been a prior community banker in the 
past. That would give that regulator the opportunity to have 
that voice heard at the highest levels of the institution.
    Chairman Dodd. Good idea. Good suggestion.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I thank each 
of you for your testimony. I know Gene and Marty we have talked 
with--a great deal about this and certainly appreciate the two 
of you coming in.
    I am going to ask some questions that do not necessarily 
reflect my point of view but just to probe. I am open on all of 
these issues and am still, like many Members on this Committee, 
trying to figure out what is the best route or have you all 
propose something, and maybe a hybrid of that is best, who 
knows? But hopefully we will get to that--I know we will--
before we regulate.
    You mentioned the issue of having an alphabet soup of 
people coming to talk to us, and it is not unlike having 
witnesses come before our Committee with differing points of 
views in many ways. I have to tell you, I have enjoyed that. 
Each of the regulators, sometimes gleefully, sometimes not, 
points out the deficiencies of the other regulator. And I have 
to tell you, there is some merit in that. Just for what it is 
worth, you know, to have a captive regulator, much like we have 
with the GSEs, which would be the case with all banks, to me, 
could be very problematic. I think having feet on the ground 
sometimes gives you a sense--I know in my business it was very 
important to be in various States where we were building. As 
Senators, we go back home to our States to not be 
Washingtonized, and there is just some benefit of having feet 
on the ground, as the FDIC has argued and as the Fed has 
argued.
    And then the OCC to me is the most procyclical--which what 
we are talking about is a super OCC. Let us face it. They are 
the most procyclical organization that we have. They move 
quickly in a direction that creates bubbles, and now they are 
out throughout the country. Anybody that has got a commercial 
real estate loan or anything like it is being criticized, and 
so they are creating, I think strongly creating a self-
fulfilling prophecy.
    So I would love to hear your comments about the RUBs being 
helpful in some cases and the competition being helpful, but 
also what would be in this to keep the OCC--super OCC, if you 
will--from being so procyclical as they are now.
    Mr. Ludwig. Well, Senator, a couple of comments. I agree 
with your comment that if one were to homogenize the entire 
regulatory system down to one, there would be something that 
would be lost. But we are not homogenizing it down to one.
    First, the FDIC itself has back-up supervisory authority, 
which means the FDIC would have on-site continued 
responsibilities.
    Second, as I mentioned, both the FDIC and the Fed would 
have serious information gathering and review authorities.
    Senator Corker. But that does not happen now. I mean, they 
do not share information now. I know you said we could put that 
in law, but that is problematic.
    Mr. Ludwig. Well, I am not honestly sure that is the case. 
There are certainly claims that that is the case. If it is the 
case, it is heart-stopping because in the midst of this crisis, 
one would assume that the information the Fed and the FDIC and 
other agencies need to do the job would be forthcoming or they 
would be squawking, I mean big time, to you and others.
    In addition, we are talking about a systemic regulator. 
There is the SEC, the CFTC, FINRA. There are all these other 
agencies, and in terms of giving you the kind of diversity you 
need to hear other points of view, you will still have the 50 
State bank supervisors that can be called up. So you get quite 
a--even with a simplified Federal regulatory mechanism, you get 
quite a cacophony of other voices that I think is available.
    As to your comment on procyclicality, I think that there is 
the nature of all regulators, and I think that actually if you 
looked at all the agencies, both at the Federal and State 
level, you would find that in times of stress they become 
tougher. You see the calls at the G-20 and others for more 
capital right now, sort of in a crisis.
    Senator Corker. Which creates a bigger crisis.
    Mr. Ludwig. Which has a tendency to be procyclical, which 
is not desirable. The Spanish had it right in terms of their--
through their cycle provisioning and through their cycle 
capital rules, which I am very hopeful that will be adopted in 
this country.
    But I do not think that is limited just to the OCC. It is 
something, I agree with you, that deserves criticism because an 
evenhanded effort and a push to an evenhanded effort is highly 
desirable.
    Senator Corker. And let me just--I know my time is about 
up. The clock must have been on 2 minutes today.
    Chairman Dodd. Your questions are so eloquent.
    Senator Corker. OK. There you go.
    If you would--and I know Marty is getting--and this is my 
last, just to advance this a little bit, the procyclical piece 
to me is a huge problem that you do not necessarily create by 
your formula, but it is something that has not served us well. 
The same thing happens in 1990 and 1991, and we just do a 
really poor job of it.
    There is nothing in your proposal that, for instance, 
changes--I mean, much of this is about rearranging the deck 
chairs and just getting different people--it is almost a family 
squabble. We sometimes refer to the insurance industry's issue 
the same way. But what they do is also very important, and, you 
know, the--for instance, the counterparty risk, I mean, is 
this--is there anything about any of this that changes their 
ability to really look to those deficiencies that really are 
the heart of the problem here, that really are causing us right 
now to be doing what we are doing? And, Marty, you may answer 
that, and I will stop.
    Mr. Baily. Well, I agree with you very much, Senator, that 
simply creating a single prudential regulator is not going to 
solve all our problems. The deficiencies of our system are 
greater than that, and there were a lot of private failures. We 
need to try to improve private incentives so that people do not 
get to play with other people's money and they take on the risk 
if the risk is there.
    So I agree with you completely. This is not by any means 
going to solve all our problems. I think it does help, though, 
because it allows for the kind of consolidated regulation that 
can, if necessary, stand up to the big banks and make sure that 
they are following the right rules. It can respond, it has got 
the resources and the stature to respond to innovation because 
one of the problems with regulation is you are always sort of 
one step behind what the private market is trying to do. And we 
want to encourage that innovation, but at the same time, we do 
not want it to be in the direction of making things less safe.
    So on the procyclicality side, we need to get rid of that. 
First of all, I think we need higher capital requirements so 
that in good times there is plenty of capital, and in bad times 
we can sort of cushion that shock. So that needs to be part of 
the reform, too, is how we deal with cyclicality, and there are 
some proposals there for so-called ``contingent capital'' or 
``convertible capital'' that allow you to do that. So I think 
that should be an important part of the regulatory changes.
    I just think also on the diversity of views, the way I 
would put it is that we need to make sure that our prudential 
regulator is accountable. I mean, there are a lot of people--
again, I do not want to impugn anybody in particular, but some 
regulators made some very bad decisions in this process. And, 
you know, do they still have jobs? Maybe they should not.
    We need to set up this structure in a way that preserves 
accountability whether it is a single prudential regulator or 
more than one.
    Mr. Carnell. Mr. Chairman, could I just add two quick 
points here?
    Chairman Dodd. Yes, certainly.
    Mr. Carnell. First, that the agency, Senator Corker, would 
incorporate a diversity of views because under what I am 
proposing it would have the Fed and the FDIC on its board. They 
would share in making policy. But even so, they are likely to 
have some disagreement with what comes out, and they will let 
you know about the disagreement. You would have more diversity 
within such a board than you would at most any independent 
agency and the rest of the Government.
    Second, it is key in preventing crisis to look ahead and 
fix the roof while the sky is still blue, not to wait until the 
thunderstorm is brewing up.
    Now, as for being procyclical--and I am building on that 
point--the Federal Reserve has actually tried to get rid of one 
of the existing two capital standards: the leverage limit. It 
has tried at least twice in the past 15 years. The existing 
capital standards were set in 1986 and 1992. We had years of 
enormous, unprecedented prosperity, record profits, and nothing 
was done to raise capital standards that had been set as the 
second best during a crisis.
    So I think the existing system, including the Fed's role in 
it, does not look good at all there.
    Senator Corker. Chairman Dodd, Senator Warner and I had a 
summit last night down at Johnny's Half Shell, and----
    Chairman Dodd. Why weren't we invited?
    Senator Corker. This whole issue, I think, of leverage is 
one that certainly we need to look at. You know, we actually 
urge people in this country to use leverage, but we penalize 
equity. And I hope that as we move through this, that is 
something that we will look at more closely.
    I am sorry to take so much time.
    Chairman Dodd. Not at all.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman. Thank you, 
gentlemen, very much for your testimony.
    It seems that you are coalescing around the advice of the 
single consolidated regulator, and I just want to understand 
what the landscape will look like afterwards in simple terms.
    There will be essentially two banking regulators--the FDIC 
and the Federal regulator. Is that your approach, Mr. Ludwig, 
focused on----
    Mr. Ludwig. Well, first there would be an----
    Senator Reed. No, I know the SEC is there and other things.
    Mr. Ludwig. But in terms of bank lending, you would have a 
highly professionalized institutional regulator, and to Senator 
Corker's concerns about procyclicality and also--I do not think 
it would be a super OCC.
    One of the problems with the current alphabet soup is 
nobody is large enough, professional enough that there is 
really the kind of study, focus, or stature for these 
supervisors to be able to go head to head adequately on things 
like derivatives, emerging new capital structures, et cetera.
    So I think that you would have two that would be at the 
Federal level close to supervision, but the Federal Reserve by 
nature, with its information gathering, study, and concern 
would be actively involved in thinking about these issues and 
prescribing solutions. And the new systemic council or systemic 
enterprise would also be very much a backstop to the banking 
supervision, as it would be a backstop to other regulatory 
issues throughout the Federal and State systems.
    Senator Reed. Well, let me just take a step further and 
focus on the point that Professor Baily made about the top-to-
bottom bank holding company regulation. Would that be the 
Federal Reserve, or would that be the new----
    Mr. Ludwig. Oh, no, that absolutely has to be the new 
institutional supervisor. The notion, the stopping at the 
border, I think Mr. Baily said it really quite eloquently. 
Stopping at the border is absolutely pernicious, because if you 
have an examination issue and you really want to follow that 
through, you cannot basically have a situation where it 
migrates to another enterprise and the investigator cannot get 
to it, cannot see it, cannot enforce it. It must be holistic.
    Senator Reed. No, I accept that, but typically bank holding 
companies today are deposit-taking institutions, investment 
banks, proprietary traders, wealth management, et cetera. SEC 
has a responsibility, the CFTC. So just give me an idea of how 
this new Federal regulator who has got top-to-bottom 
responsibilities interacts with SEC, CFTC, and everybody else. 
That would have to be done, correct?
    Mr. Ludwig. Yes, it would, and to the point that there 
would not only be one. It would have the ability to investigate 
in detail and would have the responsibility to be an expert in 
all the financial issues that are important to the institution. 
But it would have, if you will, a colook, a coexamination, 
coconcerns from these other agencies.
    Senator Reed. You know, it goes to the point that was made, 
which is that when everyone is in charge, who is in charge? And 
we saw that so many times.
    Mr. Ludwig. But it would be primarily in charge, Senator.
    Senator Reed. So it would be very clear that this regulator 
would be the primary regulator of all these functions, even if 
they feel under the range of CFTC or SEC.
    Mr. Ludwig. In my view, yes.
    Senator Reed. OK.
    Mr. Baily. Yes, in my view, also.
    Now, I do think the systemic regulator, whether it is a 
council or whether it is the Federal Reserve--I think myself I 
would prefer it to be the Federal Reserve, but whichever--does 
have, I think, the need to look across our whole financial 
sector because the prudential regulator is basically saying, Is 
this institution safe and sound? And we then have a consumer 
protection agency that is saying, ``Is it behaving itself with 
respect to the consumer?'' But we need to have a systemic 
regulator that says, ``Do we have within our financial system a 
buildup of risky assets? Are we seeing a huge rise in risks 
being taken?''
    Paul Volcker remarked that one of the clearest signs that a 
financial institution was going to get into trouble was that it 
was building a fancy new headquarters.
    So I think, you know, if you see somebody making lots of 
money doing something that--that may be because they are very 
good, or it may be because they are taking a lot of risk.
    Senator Reed. Just a quick question. The FDIC is supported 
by its own fundraising activities, to put it mildly. One of our 
problems, frankly, is that we have underresourced at critical 
moments our bank regulators, our SEC. It goes to the point that 
you have all made. Where is the expertise? Where are the 
computer systems? How can you keep up with five Ph.D.s when you 
are, you know, a recent law school graduate?
    So should we have this agency dedicated funding, not 
through the appropriations process?
    Mr. Ludwig. It should be dedicated funding by the industry. 
I do not think it needs to cost the taxpayer a nickel, and it 
ought to have, as is true today with the Federal Reserve, 
plenty of deep pockets to be able to do its job correctly.
    Senator Reed. If I may, one final question. We have talked 
about one Federal regulator for Federal institutions. Should 
there be one Federal charter? Should we eliminate the Federal 
thrift charter, the Federal savings bank charter, et cetera?
    Mr. Ludwig. I do not think you need to do that. I think the 
issue of the Federal thrift charter is an issue that is 
fundamentally steeped in the housing policy of the United 
States. That is, do we want to foster housing as a special 
goal. That decision need not be made if you have a single 
consolidated institutional supervisor.
    Senator Reed. Thank you, gentlemen.
    Mr. Baily. My inclination might be to create a single 
charter for these Federal institutions. I do not think I will 
fall on my sword on that one, but that would be my inclination.
    And to go back to Senator Corker's point, we do have a lot 
of provisions in our tax law and our laws to promote 
homeownership, and I think that is a good idea. I think 
homeownership is a good thing. But as part of that, we also 
promote borrowing. I mean, we really do, and maybe we have gone 
too far in that direction.
    Senator Reed. Just one final point. Professor Baily, you 
made, I think, a very cute observation. Most of the decisions 
where to stick these functions were a function of regulatory 
preference and tax law. And as we sort of look at reforming our 
regulatory system, I do not think we can be sort of oblivious 
to tax provisions that----
    Mr. Baily. Absolutely.
    Senator Reed. ----can form behavior more than our 
regulators. And as we go forward systematically, I think we 
really have to look at the Tax Code as well as the Federal 
regulations and Federal banking law.
    Mr. Baily. Absolutely.
    Chairman Dodd. That is very good. And good suggestions, by 
the way.
    Senator Warner.
    Senator Warner. Thank you, Mr. Chairman. I appreciate the 
panel. It is a little challenging. You have raised a lot of the 
issues I was hoping to. I guess that is the challenge of being 
far down the table here. But I will try to re-ask the same 
questions perhaps.
    As somebody who has been an advocate, as I think some of 
the panel knows, of a single end-to-end regulator, you know, I 
want to go back to what the Chairman raised around some of the, 
I think, legitimate concerns that the community banks and 
smaller banks have offered, and I would be happy to have any 
member of the panel comment on this.
    I do think there is--the notion of a separate division 
makes some sense, but in any large organization is not the bias 
going to be toward the larger institutions? Is the best 
personnel going to want to seek out serving the larger 
institutions? And could you--what other protections could we 
ensure to make sure that the smaller banks do not get the short 
end of the stick? And I believe a couple of you mentioned--
Martin, you mentioned as well that you could have different 
regulatory standards. And I guess I would like you to touch a 
little bit on that. How do we make sure that if we were to go 
with the single end-to-end regulator you would not be imposing 
the same overly burdensome set of regulations on a very small 
community-based bank that you might be on a major bank holding 
company?
    Mr. Ludwig. First, I would say----
    Mr. Baily. Go ahead.
    Mr. Ludwig. Oh, I am sorry, Martin.
    Mr. Baily. No, no. Go ahead. No, please, you start, and it 
gives me more time to think.
    Mr. Ludwig. First, I would say, Senator, that I do think 
that it makes sense to enact protections so that community 
banks--one, it is a comfort that they are protected in terms of 
having a simplified, specialized regulatory approach that best 
suits their needs.
    Having said that, my own experience at the OCC, where there 
are--in my day, I think over 2,000 community banks. It may be 
actually true today. I used the word a thousand--is that you do 
have the quality people at the agency devoting their attention 
to the community banking sector. Indeed, one of the advantages 
of having a consolidated regulator is, as people come up, you 
have similar talent available for both sides of the aisle, and 
you find--today, for example, the gentleman in charge of small 
bank supervision at the OCC was a large bank supervisor during 
his time, and he is one of the most talented people there. I 
think you will find that interplay.
    The danger, I think, works the other way, that if you 
separate the two, you will only have second-class supervisors 
at the smaller institutions as opposed to having the cross-
fertilization you do with the larger institutions.
    The other thing I think worth pointing out is just because 
you are smaller or larger does not necessarily mean you are 
more complex or less complex. Some of the smaller institutions 
by choice get involved in fairly complex issues, and there is 
going to be a tendency as we go into the future, because of the 
Internet, because of technology, because of the structured 
products available, that smaller institutions will indeed get 
involved with these more complex activities, and the supervisor 
not only needs to supervise that adequately, A, but it also 
needs to have the sophistication to help the small bank with 
these products. I think it is perfect doable, and I think you 
will just have a higher-quality supervision generally.
    One cannot also overstate in this whole discussion the 
pernicious nature of regulatory arbitrage. I know that is not 
your question. But both having----
    Senator Warner. That was my next question.
    Mr. Ludwig. As a supervisor, whether it is your examiners 
that get threatened by the offhand, intended remark of some bad 
actor banks saying, look, we do not have to put up with this, 
we can move to another regulator, and how that--even if you are 
being tough at headquarters to do the right thing, how that can 
degrade the quality of supervision generally. That is not just 
theoretical, but if you have to do it every day, it is real.
    Senator Warner. Before Marty answers, I do think that is a 
valid point, that we sometimes look at the arbitrage in terms 
of banks that have actually switched charters and some of those 
that were very much engaged in the crisis, but I think that is 
a very important point you raised, that if simply the implied 
threat of switching may end up utilizing that regulatory 
arbitrage and consequently not having the----
    Mr. Ludwig. When I was Comptroller, Senator, I had bankers 
in my office when they were unhappy threaten me, and my 
examiners, I know, had to live it in the field during their 
time, and I think most folks who have experienced that would 
have that, and that is really--it degrades the quality of 
supervision.
    Mr. Baily. I would like to reinforce that view, and I think 
it is why--you know, in general, I am a big fan of competition 
as a means of making things more efficient and creating 
diversity, but competition among regulators can have this 
downside of regulatory arbitrage.
    Let me comment on the point about maybe different 
requirements. You know, Senator Dodd mentioned that it may be 
difficult politically. That shouldn't govern what decision is 
made. It may be difficult politically to do consolidation, so I 
think one thing that needs to be sure to be in the legislation 
is that we satisfy the community banks that we are looking 
after them, because otherwise, there is going to be a lot of 
resistance to this legislation.
    And obviously, as individuals, we all like the devil we 
know, so to speak, and people want to hold on to the regulator 
they have, and that is another reason they are resistant to 
this consolidation. So I think it is very important that we 
carve out for the community banks a sense that they will be 
looked after, they won't be subject to burdensome regulations.
    On the other end of the scale, for the----
    Senator Warner. Can you speak to that for a moment?
    Mr. Baily. Yes----
    Senator Warner. I know my time is running out, but just how 
could we put in place, or what kind of guidelines so that you 
wouldn't perhaps have the same level of burdensome regulation 
for a small community bank versus a major bank holding company?
    Mr. Baily. Well, I think I would defer to my colleagues on 
the details. The part of it that I think I would like to 
comment on is the capital requirements. I actually don't like 
the idea of designating Tier 1 institutions. I don't like the 
idea of trying to cap the size of institutions. But clearly, we 
need to do something so that we don't end up bailing out these 
great big institutions.
    So having a sort of sliding scale, that the bigger you are 
or the more interconnected you are or depending on the kind of 
activity you do, that the capital requirements and potentially 
the extent of supervision--how often, the nature, the 
information you have to report, how frequently you have to 
report it--those kinds of things could increase as an 
institution becomes larger or more important to the system, and 
I think that is also a way of taking some of the burden off of 
the community banks.
    Mr. Ludwig. If I might, Senator, I would reserve the right 
to come back to the Committee with a list of suggestions, 
because I come from a small town myself, and I am a huge 
believer in community banks. I think it is one of the great 
benefits here in the United States, one of the great forces for 
good and innovation, and I think the consolidated supervisor at 
the end of the day will do more to support community banking 
than the current system.
    Senator Warner. And it may even get down to not simply 
capital requirements, but literally forms and volume of forms 
they have to----
    Mr. Ludwig. Right. Right.
    Senator Warner. I know my time is expiring. One final 
point, Mr. Chairman. I won't ask the question, but I just want 
to follow up on Senator Reed's comments, and again, it is part 
of what the panel has made mention of. When we have seen these 
kind of closed doors take place that you have had before this 
panel, clearly the most visible example of that with the 
enormous scandal of Mr. Madoff and the fact that regulators 
were not able to go beyond their prescribed jurisdiction, and 
that clearly--thank goodness we have not had that same kind of 
travesty take place in the banking system, but this fact that 
we have got one focus looking at the bank holding company 
level, another looking at the bank depository piece, could 
create that same kind of--and as Senator Reed mentioned, the 
securities piece--failing to have that single end-to-end 
regulator that can look at the whole bank holding company and 
all of its operations would prevent that.
    Chairman Dodd. Let me just, before I turn to Senator 
Merkley, it is a related question. Maybe Mark asked this in a 
way. Maybe he addressed it when I stepped out for a second, and 
that is on the issue of assessments, for instance. I don't know 
if you raised that or not, but do you see some? Because, 
clearly, if I am sitting back as a community banker, I am 
going, well, wait, yes, it is nice to have the division in all 
of this, but am I going to be assessed? I presume you wouldn't 
be, but I wonder if you would address that question, because 
clearly it is one of the concerns I would have. Could you 
address the issue of assessments?
    Mr. Baily. I think you must have a system that is 
countercyclical, while our current system is procyclical, and 
one that doesn't penalize the best community banks, which the 
current system does, and pay for the sins of the bad ones. So 
the system of assessments that funds this agency has to be one 
that takes into account not increasing the assessment for 
community banks and certainly not increasing the assessment for 
any banks in the storm, and I think that is achievable in terms 
of the way the institution is funded.
    Chairman Dodd. Legislatively, in some way, though, right?
    Mr. Baily. Yes, sir. So, for example, the reserves on 
deposit at the Fed are currently used to fund the Federal 
Reserve's regulatory activities, I believe. One could use the 
reserves similarly to fund the regulatory activities of the new 
consolidated supervisor, if that was Congress's predilection, 
or part of it could be used to make sure that the community 
banks had a particularly fair opportunity to pay what was 
appropriate for them. I think there is a lot of plasticity in 
the way one could construct this to be fair and countercyclical 
in terms of the funding mechanism.
    Chairman Dodd. Thank you very much.
    Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair, and thank 
you all for your testimony.
    When Mr. Bernanke was before us, he made an argument that 
the Fed should be the principal entity both for monetary 
policy, prudential policy, consumer policy, and systemic risk--
everything----
    [Laughter.]
    Senator Merkley. and I raised my concern that some of these 
would be in conflict with each other and he made the best case 
he could that they fit very well together.
    I think the article that was in the Washington Post on 
Sunday that pointed out some of the failure to address consumer 
issues over a significant period of time in many ways goes to 
my concerns. I believe that what I am hearing from you all is 
summed up in part by what is in the GAO report, that the twin 
peaks model is viewed as advantageous by some because the two 
principle objectives of financial regulation, systemic 
protection and consumer protection, are fundamentally in 
conflict, and putting these objectives in different agencies 
institutionalizes the distinction and ensures that each agency 
focuses on a particular objective. It goes on. But does that 
fundamentally underlie the perspective that all four of you are 
bringing to the table?
    Mr. Baily. Well, I think--I am an admirer of Ben Bernanke. 
I am not a close friend of his, but I have known him for a long 
time and I admire the way he handled this crisis. As I said in 
my testimony, I don't think the Fed--I am also an admirer of 
Alan Greenspan, who is a friend of mine, and I don't think--
leading up to this crisis, I think they made some very 
substantial mistakes when they didn't give enough consumer 
protection and they didn't react to some of the bad lending 
that was going on. So I think there were certainly a lot of 
mistakes that were made prior to this crisis that would have 
mitigated it.
    So, you know, I understand why, obviously, the Fed wants to 
hold on to the authorities it has, but I think what we are 
suggesting is that you take away the prudential regulation 
part, because that may be in conflict. You make sure that it 
still has access to the information it needs, but it is no 
longer the prudential regulator.
    I think the thing that the Federal Reserve has done well is 
monetary policy, not that they haven't made any mistakes, but 
if you look over the last, oh, 20, 30 years, I think they have 
done a good job, and typically when you pick people to serve on 
the Fed, you tend to pick economists or people with expertise 
in monetary policy, and that is the thing they should do, and I 
think they should also, since monetary policy is key to the 
stability of the economy, I think they should also be concerned 
with systemic stability.
    But I don't see why--they certainly haven't done a great 
job on prudential regulation and I don't see--what is the point 
of the Chairman of the Federal Reserve sitting around worrying 
about details of credit card regulation? That is what he is 
doing right now, and I think that is a mistake and not a good 
use of his time.
    Senator Merkley. Does anyone else want to comment?
    Mr. Carnell. Yes. A couple of things, Senator Merkley, if I 
could. First, the Federal Reserve argument that it needs to be 
a primary Federal bank regulator to do its monetary policy 
responsibilities are just not credible, based on facts at 
several levels. First, right now, the Federal Reserve only has 
supervisory responsibility for 13 percent of FDIC-insured 
assets and 10 percent of FDIC-insured institutions, so it is 
not a significant proportion at all.
    And then on top of that, our whole commercial banking 
system only accounts for 18 percent of credit market assets. 
Gone are the days when banks held 50 percent of those assets, 
as would have been true when I was born. There is just a big 
change in the growth of other financial markets and it is just 
out of touch with reality for someone to suggest that that Fed 
connection to being a primary Federal bank regulator is 
essential.
    Senator Merkley. I want to get into some other questions 
before I run out of time here, but Mr. Carnell, to follow up, 
you made a comment in regard to bank holding companies, that 
they exist to allow banks to get into businesses that are, and 
I am not sure if I caught this quite right, but incompatible 
with banking or very distinct from banking. Should we be 
eliminating bank holding companies? I mean, do they serve a--
what purpose do they serve----
    Mr. Carnell. Well, just so----
    Senator Merkley. ----more risk than value?
    Mr. Carnell. I don't think we need to eliminate them, but I 
do think our system has put much too much emphasis on them. I 
think our focus in banking policy should be on what can banks 
do and how should they go about doing it.
    I wouldn't want to leave the impression that bank holding 
companies had this role as letting do something nefarious. I 
mean, we are talking about things like opening an office in the 
next county, opening a bank in the next State. These were 
things that restrictive laws of 50 years ago didn't allow. And 
then getting into nonbanking activities, many of which are not 
allowed in the bank or Congress has passed a law saying they 
could be in the same corporate family.
    So it is not that the activities were inherently 
problematic, but it is that we have this enormous growth of 
holding company regulation that is really unrelated to any real 
need other than the fact that we sort of built it up in these 
loophole-based ways.
    Mr. Ludwig. If I might, Senator, go a little farther, I 
would say that the comment--I forget whether it was Senator 
Corker or someone made, that, in fact, what happens when you 
have to make a decision at the corporate level, you ultimately 
decide what box to put it in for capital reasons or tax 
reasons, et cetera, and what happens then at the supervisory 
level--so I find something wrong in the bank. I can't go to 
that other entity. That other entity is not being supervised, 
and in fact, if you look at this current debacle, a great deal 
of the problem in the larger financial institutions was not in 
the technical bank. The bank was infected by it. It was 
actually in the nonbank affiliates that were hard to get to and 
it was hard to look at the animal as a whole. And if you are 
really going to be an effective supervisor--after all, 
everybody has the same interest, a healthier institution--you 
have got to do the whole piece.
    Senator Merkley. Thank you all. I am over my time. I will 
just close by echoing concerns about the community banks and 
also about our credit union system, where they have rules that 
have constrained their risk, not using prepayment penalties, 
having interest rate caps, and so forth. They are a little 
nervous about being rolled into a system with an unfamiliar 
regulator and perhaps paying fees disproportionate to the risk 
they impose on the system, and so our community banks and our 
credit unions may--are a little disturbed that they might not 
have been so much of the problem but may get rolled into a 
disadvantageous set of rules, and so of great interest. Thank 
you.
    Chairman Dodd. One of these things that is going to be 
important for us, this is not being punitive. I think that is 
one of the things we are getting into, this notion that because 
some have been good actors and bad actors, I think we have some 
history of that. So I think it is really important as we look 
at all of this, this is not to punish some or discipline some, 
but rather to try to think in 21st century architectural terms. 
How do we create an architecture and a structure that makes 
sense in all of this?
    And the only thing I was getting at on the assessment 
issue, because I think putting aside the question of who was 
responsible for what, just given the magnitude and size and 
complexity of institutions, I mean, the idea that you would 
level sort of the same assessments across the board because you 
have one regulator, to me would be offensive. I mean, you have 
got to clearly make some distinguishing features. But I hope we 
can stay away from the punitive quality here as we look at all 
of this.
    We can go back and examine, how did we get here and what we 
are trying to do, and I think all of us agree that, in part, it 
was this patchwork out there that contributed, certainly, among 
other things. It is not the only thing. I think somebody made 
that point, that there are a lot of issues we need to look at. 
This is one of one.
    And it isn't going to solve everything, either. I think Bob 
Corker made the point, and I agree with him on this, is the 
assumption that if you solve this, you would solve the problem, 
I think would be false.
    But clearly I want to get away--because I think you can see 
that developing, that argument that somehow we are laying--we 
are blaming institutions by putting them in this. That is not 
the argument at all. The question is whether or not this makes 
sense.
    Let me raise one other question I have for you, and then I 
will see if anyone has interest in a second round. I wonder if 
you agree with the Administration's proposal regarding the 
systemically important financial companies that have a parent 
or significant affiliate engaged in commercial activities, 
whether they should be regulated as a bank holding company and 
forced to divest commercial activities. This is a big issue 
that is going to be before us. It sort of follows on with 
Jeff's question, I think, that he raised. Does anyone want to 
jump into this one? Professor, you sound like you have got some 
strong views on this, so----
    Mr. Carnell. I do. I think this is a very troublesome 
aspect of the Administration's proposal. I should emphasize 
that I am troubled mainly on its use of political capital. I 
don't know that--I don't think the substantive stakes are very 
large here. I will make that more clear in a moment.
    Go back to the point I made earlier about how bank holding 
company regulation as a really big deal is unique to the United 
States. It is a historical quirk of our system. It is something 
the Federal Reserve got hold of in a context where the 
Congressional objectives were completely different from what we 
have now and the Fed was able to expand its authority and make 
it into a very big deal.
    Let me actually just make that a bit more clear. The bank 
holding--there is something in my written statement about this, 
but the Bank Holding Company Act was passed in 1956 in a 
populist effort to limit bigness and also to split up some 
affiliations, like Bank of America and TransAmerica were 
affiliated at the time. But basically we had--Chairman Wright 
Patman of the House Banking Committee believed that everything 
was too big, including $100 million banks, and so he responded 
with the Bank Holding Company Act. He got trade association 
support for people who were concerned about banks getting into 
their business.
    We are not talking about something that was a safety and 
soundness statute in its origin. It was a kind of populist 
antimonopoly statute in its origin. We see safety and soundness 
come in as a criterion in 1970 as a basis for exceptions on 
some things. But this was not originally a safety and soundness 
statute. It was not a statute relating to bank policy. And yet 
it becomes what my old boss, Jerry Hawk, Under Secretary of the 
Treasury, said, a matter of theology, where there are people 
invested in a certain kind of outcome here.
    And so what they are wanting to do, then, is to conform the 
existing nonfinancial owners of financial institutions to sort 
of a very pure version of how they would like things to come 
out. Now, in fact, nonfinancial institution ownership has saved 
the taxpayers money. Ford Motor Company put about $1 billion, 
as I recall, into a thrift institution that had acquired 
trouble. So there has been positive results. I don't think 
there have been significant negative results. And this 
ownership, like General Electric and so forth, was not a source 
of the current crisis.
    So the idea of making a big deal out of this is sort of 
like, as we have seen from some quarters, is sort of like 
trying to protect us from the Mexican mafia by building a wall 
on the Canadian border. It is just not related to the major 
problems.
    Chairman Dodd. Well, thank you for that observation. I want 
to make the point, I just mentioned to Senator Merkley as he 
was walking out, I heard him say credit unions. Credit unions 
are not part of this consideration at all. We are talking about 
banks. And before we start getting inundated with e-mails and 
messages from across the country, credit unions, you are OK on 
this.
    [Laughter.]
    Chairman Dodd. Let the word go forth from all of this.
    Senator Corker, any----
    Senator Corker. No. I think you have just given evidence as 
to where the real political clout is.
    [Laughter.]
    Senator Corker. I referred earlier to sot of a super-OCC, 
and I realize it is sort of that, what you are proposing. As we 
have looked at the resolution mechanisms that need to be in 
place so that we don't have the same kind of problem, I think 
we all understand part of the reason we had the problems we had 
was there was no resolution mechanism for highly complex bank 
holding entities and one of the only solutions was to prop them 
up artificially.
    So the OCC has argued strongly to keep in place the ability 
to use taxpayer monies to prop up institutions that fail. The 
FDIC, on the other hand, has argued strongly against that. I 
happen to have fallen on their side of the equation and think 
that having any institution that is too big to fail creates 
tremendous problems, and I really appreciate what Paul Volcker 
has said about that recently.
    But hand-in-hand with this is the notion of how we 
resolve--in other words, we have the regulator--how we resolve 
that. You all have already made a great case for this type of 
arrangement that you want to have. I don't think there is any 
point in going down that path anymore. I understand what it is 
you would like to see happen. But what should we do as a it 
relates to a resolution mechanism and how should that be set 
up?
    Mr. Ludwig. Well, Senator Corker, I couldn't agree with you 
more that resolving the largest institutions is a critical 
issue and I am not in favor of propping them up. That is, if we 
don't resolve them, we basically create two problems. One is we 
have public utilities if we don't have an ability to resolve 
them. And we also disadvantage the community and regional 
institutions.
    Rather, this whole structure ought to be one that creates 
sufficient stability and focuses in a professional way on 
proper supervision so as to minimize burden and increase the 
ability of all these institutions to support the economy of the 
United States. And where one of these institutions is not doing 
its job correctly and it gets into problems, we have to have a 
private sector component here--this is really a private sector 
activity--where it fails, and we have to have the ability to 
fail it without creating a systemic crisis. If we don't have 
that, I think we also have the danger that these largest 
institutions end up controlling the economy and the 
Governmental mechanism, not vice-versa.
    Mr. Baily. Can I throw in a comment? I think Gene is 
absolutely right and you are right. We don't want to have 
institutions that are too big to fail. We want to be able to 
have a mechanism by which they can go bankrupt when they make 
bad decisions. Otherwise, this is not a good system at all. But 
realistically, I mean, if an airline goes into bankruptcy, you 
can still have the planes fly, or if a railroad goes into 
bankruptcy, you can still have the trains go on the tracks. The 
trouble with a financial institution is that it may get to a 
certain point where it really can't function without some kind 
of funding or some kind of support to keep it going.
    Now, to some extent, that was the justification for giving 
money to General Motors. You needed money for the suppliers, 
and I don't want to get into that case which I don't know the 
ins and outs of.
    But clearly, we need a mechanism, whether it is a 
bankruptcy or a resolution mechanism, that has a certain amount 
of money available to make sure that you don't just close the 
doors and people can't get at their money. Now, what is in the 
Treasury proposal is a sort of open-ended checkbook that 
somebody can write a check for any amount to prop up an 
institution. So I think that is--I don't agree with that. I 
think that Treasury proposal is too open-ended, and I think the 
House and the Senate need to make sure taxpayers are protected 
and that they have a control over the purse.
    But I don't think we can, at the same time, just say, no, 
we are never going to put taxpayer money in again, because the 
fact of the matter is we will come into another financial 
crisis and we will end up putting in a lot of money, and it is 
better to have a resolution mechanism or a special bankruptcy 
court that has the resources to let this thing down gently, 
although letting it down.
    Mr. Carnell. Senator, be wary of anyone who puts a lot of 
stress on the notion that we need a new resolution mechanism. 
By and large, we had the resolution mechanisms that we needed. 
I could be a little more specific about that, but just to put 
it in the perspective.
    There certainly are some things that could be helpful here, 
but basically, we had the mechanisms. There were two problems. 
First, the system had been allowed to go in the direction of 
internal weakness to such a degree that problems piled up and 
happened quickly. But mainly----
    Senator Corker. And how did that happen, by the way?
    Mr. Carnell. Well, I mean, we are talking about a decade in 
which--or more specifically, from about 2002 to 2007 in which 
market participants became increasingly complacent about credit 
risk and where regulators were not taking the opportunity to 
strengthen things like capital standards while the sky was blue 
and the sun was shining, take advantage of that time to build 
bank capital up. Those would be some examples of things that 
could have been done in the context.
    But the key thing is that most of the laws we needed were 
already in place, and in the case of something that is a bank 
or thrift, the Federal Deposit Insurance Act is the model for 
the world in terms of doing resolution, and----
    Senator Corker. And we used it, but what about in the other 
examples of how they kind of--I won't name the entities, but 
our largest entities in the country, what about in those cases?
    Mr. Carnell. Well, if you----
    Senator Corker. What type of mechanisms existed that we 
didn't use?
    Mr. Carnell. Well, I should emphasize that many of the 
largest entities in the country are bank holding companies 
where the biggest part of the firm is the bank. So the law was 
there available for that. Now, with a bank holding company----
    Senator Corker. Or the FDIC to come into the bank component 
itself.
    Mr. Carnell. That is correct, and let me just emphasize 
that this does not require--it certainly doesn't require a pot 
of taxpayer money and it doesn't necessarily--FDIC money is not 
the only thing that is available, because you can--the FDIC 
needs to satisfy insured deposits. But other creditors can have 
a haircut applied to their claims and you close the bank one 
day and it opens the next business day with a new charter, but 
the same tellers and so forth there.
    Now, as for the nonbank part of organizations, we do have 
the bankruptcy courts. There are some changes that would make 
sense for bankruptcy courts dealing with nonbank financial 
institutions, for example, to make sure that you can't shop for 
the court that you think is best, say shop between New York and 
Delaware or something like that, to make sure that these cases 
go to judges who have some expertise and some other things to 
expedite that. But basically, the law is there.
    Senator Corker. I would like for you, if you would, to 
schedule some time to come in and talk about some of the tweaks 
on the bankruptcy side. And again, I just want to point out 
that in many ways on this regulatory piece, we are looking at 
sort of rearranging the deck chairs, and I think the 
suggestions that each of you have made have been very helpful, 
but even after you make those changes, it is that lack of--it 
is that procyclical thinking that drove us to where we were. 
The sun was shining and so we were continuing to do more and 
more instead of reserving up more. And I still haven't heard of 
a way--it seems like to me that what we are going to do is 
create sort of a super-regulatory entity, but we still haven't 
yet figured out a way to cause them to actually not be 
procyclical. So again----
    Mr. Carnell. If I could come back to you on that one, 
Senator, it is a very difficult challenge, and I do not mean to 
suggest that there is any simple solution to the problem that 
you--the challenge you pose there.
    I do emphasize in my testimony the importance of looking at 
the incentives that regulators have, because the fact is: bank 
regulators had the tools that they needed, but they did not 
take action that they could have here. Part of it is a 
foresight problem, but part of it is also an incentive problem. 
That is, if you look at it from the standpoint of the 
particular people making the decisions, what makes sense from 
their standpoint?
    Now, in a four-regulator system where there is squabbling 
over turf, where there is competition for regulatory clientele, 
it is tougher to look ahead--if you are the person who is 
looking ahead and said--to take the example--let us go for 
higher capital standards now, let us raise the standard in 
terms of your exposure to systemic risk from other 
institutions. If you look ahead and you are doing the thing 
that is not considered obvious at the time, you are more open 
to criticism. And in a multiregulator system, the friction 
among regulators provides something of a disincentive there. On 
top of that, where you need to do joint rulemaking with 
regulators--and that is a requirement under various laws--you 
know, you run into other ones who say, ``If it ain't broke, 
don't fix it.''
    Mr. Baily. Since you want people to be wary of folks like 
me that think----
    Mr. Carnell. I do not mean you.
    Mr. Baily. Well, you should, because I think you need to 
have a certain amount of money available. However good a system 
you set up, a big financial institution is going to get into 
trouble at some point in the future. That has always been true, 
and I suspect it is going to be true again. We can improve 
regulation as much as we like, but somewhere somebody is going 
to get into trouble again. And I think we need to make sure 
that we have a mechanism, whether it is--I think it should be a 
special bankruptcy court. I do not think you can just pick any 
judge. I mean, this has to be a judge with special expertise. 
Or you have a resolution mechanism, and there has to be a way--
you know, this is not just FDIC, because this is not just 
banks. It is financial institutions more generally. And we have 
to have a way in which we can keep them operating and that they 
do not bring the rest of the system down while we are doing it. 
And if we do not set up that now, then you are going to end 
up--taxpayers are going to cost a lot of money down the road.
    Mr. Ludwig. Two points, Senator. One is that these systemic 
problems are really, by and large, governmental problems. They 
are not institutional problems. So when you say who is going to 
be looking out, one of the reasons you want to have somebody 
with a systemic responsibility for looking for systemic 
problems--i.e., bubbles--that is independent is because if you 
look historically, it has really been governmental problems 
into which institutions are dragged, by and large.
    The second thing is the point you made and the point that 
Rick made about a single consolidated regulator being less 
given to arbitrage and, therefore, more likely to be 
conservative. To some degree, the proof of the pudding is in 
Canada and Australia. In both those systems, they are both 
English-speaking countries with consolidated prudential 
supervisors, and that is all they did. And in both systems, 
they were quite conservative as regulators in terms of their 
institutions.
    Now, I just came back from Canada. I was up a couple weeks 
ago and spent some time with their finance minister and their 
head of the central bank and their bankers. And they will all 
say that their supervisor was a restraining force on them 
getting into a lot of the problems that our institutions got 
into.
    Senator Reed [presiding]. Senator Warner.
    Senator Warner. Mr. Chairman, I will not ask a question. I 
would just like to make a request to the panel, because it is 
clear that the panel has got a lot of ideas here.
    As I think I said earlier, I would love to see more 
specificity about how we can ensure community banks, smaller 
banks, are inside a single end-to-end regulator, from 
assessments to less regulatory, less paperwork. What are the 
protections we could give beyond division, number one?
    Number two, Senator Corker and I believe that there needs 
to be expanded resolution authority at least to bank holding 
companies, with the FDIC, and the FDIC has raised--and I know 
you have addressed today, but has raised the concern that if 
they were--if we took away their prudential supervision, would 
back-up supervision be enough to have them have their pulse on 
the status of all of the institutions that they might cover in 
this expanded jurisdiction. So I would love to have some 
specific suggestions on how we could address that concern.
    And then, third, obviously, you know, the Federal Reserve 
will make the point that, as lender of last resort, they still 
need to keep their hands in this pie in terms of at least with 
these larger institutions on the bank holding companies. And I 
think you have made some very--the whole panel has made a 
number of valid points about the bank holding companies, but I 
would love--and, again, Martin, you made the comment about the 
fact that FDIC and the Fed would be on the board. But what are 
other ways that we could ensure that the Fed, as lender of last 
resort, would not lose the expertise that they have?
    Thank you, Mr. Chairman.
    Senator Reed. Thank you very much, gentlemen. I just have 
one or two quick questions since I have got the opportunity 
with this panel, which is rare.
    Going back to the landscape after we adopt a single 
regulator, at least hypothetically, should the Federal Reserve 
continue to have any regulatory authority with respect to State 
member banks if that is all they are doing in the regulatory 
sphere? Mr. Ludwig.
    Mr. Ludwig. I would not think so, Senator. I think there is 
huge advantage to having, just like companies, entities that do 
things that they do well and focus on them. I think it is 
better for oversight for the Congress. I think it is better for 
the agencies themselves. And I think to Martin Baily's 
excellent point, monetary policy is so essential in central 
banking functions. Do we really want our Chairman of the 
Federal Reserve sitting around thinking about either consumer 
rules or bank supervision rules? Which are not unimportant, but 
how much can you do in a day?
    I think one of the problems we have with CEOs generally is 
how much can you actually accomplish in a day, and I think that 
is an enterprise that they should give up.
    Senator Reed. Another general question is that this is an 
opportunity, obviously, and a necessity to look across the 
board in terms of the Federal regulatory structure, and I think 
not just in concept of how you regulate banks, but the 
structure itself of the Federal Reserve. As we cut back, 
presumably, some of their responsibilities, does their present 
structure still need to remain the same with regional banks 
located sort of because the way America was in 1930, not 2010? 
Does anyone have any comments?
    Mr. Carnell. I would not try to defend the location of 
Federal Reserve banks, including, you know, the old thing about 
why are there two in Missouri. But I do think the Federal 
Reserve banks play a valuable role in Federal Reserve 
policymaking. That is, they are not just regional offices that 
receive top-down directives from Washington. And I think in 
monetary policy and in a great many other things, they provide 
a diversity of perspective that is desirable.
    I would note, by the way, that where a significant 
proportion of supervisory personnel are currently located in 
Reserve banks, that same space could be used, if desired, by 
employees of the new agency, and you would still have, you 
know, interaction of proximity there. So I would keep the 
Reserve banks. I would encourage cross-fertilization like that. 
I do not think----
    Mr. Ludwig. I think that is an excellent--I mean, a 
consolidated supervisor does not mean that everything should be 
in Washington. And, indeed, with the majority of the banks 
being located everywhere, you would assume there would be 
substantial regional offices and duty stations really all over 
the place. But the advantage of being able to filter it back 
and have cross-fertilization I think is huge.
    Mr. Baily. I agree.
    Senator Reed. Let me ask you if there is a final comment by 
any of the panelists that you would like to make before I thank 
you very much and--yes?
    Mr. Carnell. Actually, I would like to say, if I could, 
some words in favor of a consumer financial protection agency. 
I support creating a new independent agency. As I would 
propose, it would have full responsibility for writing rules 
implementing consumer protection legislation, financial 
consumer legislation. And I would also agree with the 
Administration that it should have primary enforcement 
authority over nonbank lenders.
    Now, I differ with the Administration on a couple of 
points. I think it should have only back-up enforcement 
authority over FDIC-insured banks and their affiliates. I think 
that is enough. I think that will do the job. And I also do not 
support slashing the preemptive effect of the National Bank 
Act. The State regulators had primary responsibility for 
dealing with nonbank lenders that were the epicenter of 
predatory lending. They did a poor job, and yet what they talk 
about is national bank preemption, which was not the practical 
problem there.
    On top of that, I point out that the Supreme Court issued a 
major decision earlier this year, Cuomo v. Clearing House, that 
cut back on some of the preemptive claims made for the National 
Bank Act. So I do not think there is a need for action in the 
preemption area, certainly not what the Administration has 
proposed. But the agency is a good idea.
    Senator Reed. Thank you, gentlemen, very much for this 
excellent testimony, and thank you very much.
    Mr. Baily. Thank you for having us.
    [Whereupon, at 3:55 p.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]
           PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
    This afternoon, we will examine how best to ensure the strength and 
security of our banking system. I would like to thank our witnesses for 
returning to share your expertise after the last hearing was postponed.
    Today, we have a convoluted system of bank regulators created by 
historical accident. Experts agree that nobody would have designed a 
system that worked like this. For over 60 years, Administrations of 
both parties, members of Congress, commissions, and scholars have 
proposed streamlining this irrational system.
    Last week I suggested further consolidation of bank regulators 
would make a lot of sense. We could combine the Office of the 
Comptroller of the Currency and the Office of Thrift Supervision while 
transferring bank supervision authorities from the Federal Deposit 
Insurance Corporation and the Federal Reserve, leaving them to focus on 
their core functions.
    Since that time, I have heard from many who have argued that I 
should not push for a single bank regulator. The most common argument 
is not that it's a bad idea--it's that consolidation is too politically 
difficult. That argument doesn't work for me.
    Just look what the status quo has given us. In the last year some 
of our biggest banks needed billions of dollars of taxpayer money to 
prop them up, and dozens of smaller banks have failed outright.
    It's clear that we need to end charter shopping, where institutions 
look around for the regulator that will go easiest on them.
    It's clear that we must eliminate the overlaps, redundancies, and 
additional red tape created by the current alphabet soup of regulators.
    We don't need a super-regulator with many missions, but a single 
Federal bank regulator whose sole focus is the safe and sound operation 
of the Nation's banks. A single operator would ensure accountability 
and end the frustrating pass the buck excuses we've been faced with.
    We need to preserve our dual banking system. State banks have been 
a source of innovation and a source of strength in their communities. A 
single Federal bank regulator can work with the 50 State bank 
regulators.
    Any plan to consolidate bank regulators would have to ensure 
community banks are treated appropriately. Community banks did not 
cause this crisis and they should not have to bear the cost or burden 
of increased regulation necessitated by others.
    Regulation should be based on risk--community banks do not present 
the same type of supervisory challenges their large counterparts do.
    But we need to get this right, which is why you are all here today. 
I am working with Senator Shelby and my colleagues on the Committee to 
find consensus as we craft this incredibly important bill.
                                 ______
                                 
                 PREPARED STATEMENT OF EUGENE A. LUDWIG
        Chief Executive Officer, Promontory Financial Group, LLC
                           September 29, 2009
Introduction
    Chairman Dodd, Ranking Member Shelby, and other distinguished 
Members of the Senate Banking Committee; I am honored to be here today 
to address the important subject of financial services regulatory 
reform. I want to commend you and the other Members of the Committee 
and staff for the serious, thoughtful, and productive way in which you 
have examined the causes of the financial crisis and the need for 
reform in this area.
    Today, there are few subjects more important than reform of the 
financial services regulatory mechanism. Notwithstanding the fine men 
and women who work tirelessly at our financial regulatory agencies, the 
current outdated structure of the system has failed America. At this 
time last year, we were living through a near meltdown of the world's 
financial system, triggered by weaknesses generated here in the United 
States. Two of our largest investment banks and our largest insurance 
company failed. Our two giant GSE's failed. Three of our largest 
banking organizations were merged out of existence to prevent them from 
failing.
    But the problem is not just about an isolated incident of 1 year's 
duration. Over the past 20-plus years we have witnessed the failure of 
hundreds of U.S. banks and bank holding companies. The failures have 
included national banks, State member banks, State nonmember banks and 
savings banks, big banks and small banks, dozens if not hundreds of 
banks supervised by every one of our regulatory agencies. By the end of 
this year alone, I believe over 100 U.S. banks will have failed, 
costing the deposit insurance fund tens of billions of dollars. And, I 
judge that before this crisis is over we will witness the failures of 
hundreds more. In the face of this irrefutable evidence, it is 
impossible to say something is not seriously wrong.
    Now is the time to act boldly and bring American leadership back to 
this system. A failure to act boldly and wisely will condemn America 
either to a loss of leadership in this critical area of our economy 
and/or additional instances of the kinds of financial system failures 
that we have been living through increasingly over the past several 
decades, the most pronounced instance of which is currently upon us.
    No one should underestimate the complexity of accomplishing the 
needed reforms, though in truth the changes that are needed are 
surprisingly straightforward from a conceptual perspective. The 
Administration's financial services regulation White Paper is 
commendable and directionally correct. It identifies the major issues 
in this area and provides momentum for reform. In my view, certain 
essential refinements to the plan laid out in the White Paper are 
needed; the need for revisions and refinements is an inevitable part of 
the policymaking process. I also want to commend the Treasury 
Department of former Secretary Henry Paulson for having developed its 
so-called ``blueprint,'' which also has added important and positive 
elements to the debate in this area.
    Financial services regulatory reform is not fundamentally a 
partisan issue. It is fundamentally a professional issue. And, under 
the leadership of you and your staffs Chairman Dodd and former Ranking 
Member Shelby the traditions of the Senate Banking Committee, which for 
decades has prided itself on a balanced bipartisan look at the facts 
and the needs of the country has continued. In this regard, it should 
be noted that many of the matters I cover below, including importantly 
the need for an end-to-end consolidated banking regulator, have been 
championed over the years by Members of the Senate Banking Committee, 
including its Chairmen, from both sides of the aisle. Similarly, many 
of these concepts, including the need for an end-to-end consolidated 
institutional supervisor, have been championed by Treasury Secretaries 
over the years from both political parties.
    I have set out below the seven critical steps that are needed to 
fix the American Financial Regulatory system and to refine the 
approaches put forth by both the current and previous Treasury 
Departments. Being so direct is no doubt somewhat presumptuous on my 
part, but I have been fortunate in my career to have worked in multiple 
capacities with the financial services industry and consumer 
organizations in this country and abroad, including as a regulator, 
money-center bank executive, board member, major investor in community 
banks, and chairman and board member of community development and 
consumer-related organizations.
    So what has gone so wrong? Let me begin by saying what the problem 
is not.

    First, the problem is not the failure to have thousands of 
        talented people working in bank and bank holding company 
        supervision. I can testify from personal experience that we do 
        indeed have exceptionally fine and able men and women in all 
        our regulatory agencies.

    Second, our banks and bank holding companies are not 
        subject to weak regulations. On the contrary, though not 
        without flaws, our codes of banking regulations are no less 
        stringent than those in countries that have weathered the 
        current and past crises well.

    Third, it is not because America has weaker bankers than in 
        the countries that have been more successful at dealing with 
        the current crisis. On the contrary, we have a right to take 
        pride in America's banks and bankers many of whom work harder 
        than their peers abroad, have higher standards than their peers 
        abroad and contribute more to their communities in civic 
        projects than their peers abroad.

    Of course, we have had isolated cases of regulators and bankers 
that failed in their duties. However, 20-plus years with hundreds of 
bank failures through multiple economic cycles is not the result of a 
few misguided souls.
    So what is the problem with financial institution safety and 
soundness in the United States and how can we fix it? To my mind, the 
answer is relatively straightforward, and I have outlined it in the 
seven areas I cover below.
Needed Reforms
1. Streamline the current ``alphabet soup'' of regulators by creating a 
        single world class financial institution specific, end to end, 
        regulator at the Federal level while retaining the dual banking 
        system.
    a. Introduction. We must dramatically streamline the current 
alphabet soup of regulators. The regulatory sprawl that exists today 
is, as this Committee well knows, a product of history, not 
deliberation. The recent financial crisis has accentuated many of the 
shortcomings of the current regulatory system.
    Indeed, it is worth noting that our dysfunctional regulatory 
structure exists virtually nowhere else. And, I am not aware of any 
scholar or any country that believes it is the paradigm of financial 
regulatory structuring; nor am I aware of one country anywhere that 
wants to copy it.
    b. How Our Regulatory Structure Fails: There are at least seven 
ways in which our current regulatory structure fails:

    Needless Burdens That Weaken Safety and Soundness Focus. 
        First, a profusion of regulators, such as we have in the United 
        States, adds too much needless burden to the financial services 
        system. Additional burdens where they do not add value are not 
        neutral. They actually diminish safety and soundness. Many 
        banking organizations today have several regulatory agencies to 
        contend with and dozens--in a few cases--hundreds of annual 
        regulatory examinations with which to cope. At the same time, 
        top management's time is not infinite. It is important to 
        streamline and target regulatory oversight, and accordingly top 
        management talent's focus to address those issues that most 
        threaten safety and soundness.

    Lack of Scale Needed To Address Problems in Technical 
        Areas. Second, under our current regulatory structure, not one 
        of the institutional regulators is sufficiently large or 
        comprehensive enough in their supervisory coverage to 
        adequately ensure institutional safety and soundness. 
        Typically, no regulator today engages in end-to-end supervision 
        as different parts of the larger financial organizations are 
        supervised by different regulatory entities. And gaining scale 
        in regulatory specialties of importance, for example, risk 
        metrics, or capital markets activities, is severely hampered by 
        the too small and fractured nature of supervision today in 
        America.

    Regulatory Arbitrage. Third, the existence of multiple 
        regulatory agencies is fertile ground for regulatory arbitrage, 
        thereby seriously undercutting strong prudential regulation and 
        supervision.

    Delayed Rulemaking. Fourth, rulemaking while often 
        harmonized at least among the banking supervisors is slow to 
        advance because of squabbles among the financial services 
        regulators that can last for years at a time.

    Regulatory Gaps. Fifth, because our regulatory structure is 
        a hodgepodge, for all its multiple regulators and 
        inefficiencies, it is not truly ``end-to-end'' and has been 
        prone to serious gaps between regulatory agency 
        responsibilities where there is little or no supervision. And 
        these gaps are often exploited by financial institutions, 
        overburdened by too much regulation in other areas--weeds take 
        root and flourish in the cracks of the sidewalk.

    Limitations on Investigations. Sixth, where an experienced 
        and talented bank regulator believes he or she has found a 
        problem in the bank, that individual or his or her regulatory 
        agency cannot follow the danger beyond the legalistic confines 
        of the chartered bank itself. ``Hot pursuit'' is not allowed in 
        bank regulation today. We count on our bank examiners to 
        function as a police force of sorts. But even when our bank 
        detectives and cops sniff out trouble, they may have to quit 
        following the trail when they hit ``the county line'' where 
        another agency's jurisdiction begins. Like county sheriffs, 
        examiners sometimes can do little more than plead with the 
        examiners in the neighboring jurisdiction to follow up on the 
        matter.

    Diminished International Leadership. Seventh, our hydra-
        headed regulatory system, with periodic squabbles among its 
        various components, increasingly undercuts our moral force 
        around the world, leading to a more fractured and less 
        hospitable regulatory environment for U.S.-based financial 
        services providers.

Let me elaborate on two of these points--the counterproductive nature 
of excess burdens and regulatory arbitrage:

    Counterproductive Burdens. Today, a large financial 
        institution that has a bank in its chain is in almost all cases 
        subject to regulation by a bank regulator, the Federal bank 
        regulator, (the Federal component of which will be the Office 
        of the Comptroller of the Currency, the Federal Reserve Board, 
        the Federal Deposit Insurance Corporation, or the Office of 
        Thrift Supervision) and in many cases by a State bank 
        regulator. Many banking organizations have national banks, 
        State banks and savings banks in their chains, so they are 
        subject to all these bank supervisors.

    In addition, every institution with a bank in its chain must have 
        either the Federal Reserve or the OTS as its bank holding 
        company and nonbank affiliate regulator.

    In all cases, financial services companies with bank affiliates are 
        subject to the FDIC as an additional supervisor.

    But the list does not stop there. Additional supervision may be 
        performed by the State Attorneys General, the Securities and 
        Exchange Commission, and the Financial Industry Regulatory 
        Authority. For Bank Secrecy Act, Foreign Corrupt Practices Act, 
        and anti-money-laundering matters there is a supervisory role 
        for the Financial Crimes Enforcement Network and Office of 
        Foreign Asset Control. Also, the insurance company subsidiaries 
        of bank holding companies may be subject to regulation by State 
        insurance regulators in each of the States. In addition, at 
        times, even the Federal Trade Commission serves as a 
        supervisor. And, the Justice Department sometimes becomes 
        involved in what historically might have been considered civil 
        infractions of various rules. Even the accounting standard 
        setting agencies directly or through the SEC, get into the act.

    This alphabet soup of regulators results in multiple enforcement 
        actions, often for the same wrong, and dozens of examinations, 
        which as I have noted for our largest institutions may 
        literally total in the hundreds in a year. There are so many 
        needless burdens caused by this cacophony of regulators, rules, 
        examinations and enforcement activities that many financial 
        services companies shift their business outside the United 
        States whenever possible.

    But the burden is not in and of itself what is most concerning. The 
        worst feature of our current system is that for all the 
        different regulators, the back-up supervision and the volumes 
        of regulation has not produced superior safety and soundness 
        results. On the contrary, based on the track record of at least 
        the last 20-plus years, it has produced less safety and 
        soundness than some simplified foreign systems. As the current 
        crisis and the past several debacles have shown, our current 
        expensive and burdensome system does not work.

    Regulatory Arbitrage. Financial institutions that believe 
        their current regulator is too tough can change regulatory 
        regimes by simply flipping charters and thus avoid strong 
        medicine prescribed by the previous prudential supervisor. 
        Indeed, even where charter flipping does not actually occur, 
        the threat of it has pernicious implications. Sometimes stated 
        directly, sometimes indirectly, often by the least well-run 
        banking organization, the threat of charter flipping eats away 
        at the ability of examiners and ultimately the regulatory 
        agency to be the clear-eyed referee that the system needs them 
        to be.

    And, regulatory arbitrage is greatly increased by the funding 
        disequilibrium in our system whereby the Comptroller's office 
        must charge its banks more since State-chartered banks are in 
        effect subsidized by the FDIC or the Fed. The practical 
        significance of this disequilibrium cannot be overstated.

    c. Misconceptions. There have been a number of misconceptions about 
what a consolidated end-to-end institutional supervisor is and what it 
is not, as well as the history of this kind of prudential regulator.

    Not a Super Regulator. First, an end-to-end consolidated 
        institutional supervisor is not a ``super regulator'' along the 
        lines of Britain's FSA. A consolidated institutional prudential 
        regulator does not regulate financial markets like the FSA. The 
        SEC and the CFTC do that. A consolidated institutional 
        regulator does not establish consumer protection rules like the 
        FSA. A new consumer agency or the Federal Reserve does that. A 
        consolidated institutional supervisor does not itself have 
        resolution authority or authority with respect to the financial 
        system as a whole. The FDIC does, and perhaps the Fed, the 
        Treasury and a new systemic council would also do that. The 
        consolidate institutional regulator would focus only on the 
        prudential issues applicable to financial institutions like The 
        Office of the Superintendent of Financial Institutions (OSFI) 
        in Canada and the Australian Prudential Regulatory Authority 
        (APRA), both of which have been successful regulators, 
        including during this time of crisis, something I discuss in 
        greater detail below.

    An Agency That Charters and Supervises National Entities 
        Cannot Regulate Smaller Institutions. Second, there has been a 
        misconception that a consolidated regulator that regulates 
        enterprises chartered at the national level cannot fairly 
        supervise smaller community organizations. In fact, even today 
        the OCC currently supervises well over 1,000 community-banking 
        organizations whose businesses are local in character. And, it 
        is worth adding that these small, community organizations that 
        are supervised by the OCC, choose this supervision when they 
        clearly have the right to select a State charter with a 
        different supervisory mechanism. The OCC, it must also be 
        noted, supervises some of the largest banks in the United 
        States. If the OCC unfairly tilted supervision toward the 
        largest institutions or otherwise, it is hard to imagine that 
        it would have smaller institutions volunteer for its 
        supervision.

    Entity That Regulates Larger Institutions Cannot Regulate 
        Smaller Institutions. Third, there is a misconception that a 
        consolidated regulator that regulates larger enterprises cannot 
        regulate smaller enterprises or will tilt the agency's focus in 
        favor of larger enterprises. In fact, whether consolidated or 
        not, all our current financial regulators regulate financial 
        institutions with huge size disparities. Today, all our Federal 
        regulators make meaningful accommodations so that they can 
        regulate large institutions and smaller institutions, 
        recognizing that often the business models are different. In 
        fact, as will be discussed in greater detail, it is important 
        to regulate across the size perspective for several reasons. It 
        means the little firms are not second-class citizens with 
        second-class regulation. It means that the agency has 
        regulators sufficiently sophisticated who can supervise complex 
        products that can exist in some smaller institutions as well as 
        larger institutions.

    Checks and Balances. Fourth, some have worried that a 
        consolidated institutional supervisor would not have the 
        benefit of other regulatory voices. This would clearly not be 
        the case as a consolidate institutional supervisor would 
        fulfill only one piece of the regulatory landscape. The Federal 
        Reserve, Treasury, SEC, FDIC, CFTC, FINRA, FINCEN, OFAC, and 
        FHFA would continue to have important responsibilities with 
        respect to the financial sector. In addition, proposals are 
        being made to add additional elements to the U.S. financial 
        regulatory landscape, the Systemic Risk Council and a new 
        Financial Consumer agency. This would leave 8 financial 
        regulators at the Federal level and 50 bank regulators, 50 
        insurance regulators and 50 securities regulators at the State 
        level. I would think that this is a sufficient number of voices 
        to ensure that the consolidated institutional supervisor is not 
        a lone voice on regulatory matters.

    Need To Supervise for Monetary Authority and Insurance 
        Obligations. Fifth, some have also claimed that the primary 
        work of the Federal Reserve (monetary policy, payments system 
        and acting as the bank of last resort) and the FDIC (insurance) 
        would be seriously hampered if they did not have supervisory 
        responsibilities. The evidence does not support these claims.

    1.  A review of FOMC minutes does not suggest much if any use is 
        made of supervisory data in monetary policy activities. In the 
        case of the FDIC, it has long relied on a combination of 
        publicly available data and examination data from other 
        agencies.

    2.  There are not now to my knowledge any limitations on the 
        ability of the Federal Reserve or the FDIC to collect any and 
        all information from the organizations they are now 
        supervising, whether or not they are supervising them.

    3.  And whether or not the Federal Reserve or the FDIC is 
        supervising an entity, it can accompany another agency's 
        examination team to obtain relevant data or review relevant 
        practices.

    4.  If the FDIC or the Federal Reserve does not have adequate 
        cooperation on gathering information, Congress can make clear 
        by statute that this must be the case.

    5.  The Federal Reserve's need for data goes well beyond the 
        entities it supervises and indeed where the majority of the 
        financial assets have been located. Hedge funds, private equity 
        funds, insurance companies, mortgage brokers, etc., etc., are 
        important areas of the financial economy where the Fed has not 
        gathered data to date and yet these were important areas of the 
        economy to understand in the just ended crisis. Should not 
        these be areas where Federal Reserve Data gathering power are 
        enhanced? Is this not the first order of business? Does the 
        Federal Reserve need to supervise all of these institutions to 
        gather data?

    6.  Even if the FDIC were not the supervisor of State chartered 
        banking entities, the FDIC would have backup supervisory 
        authority and be able to be resident in any bank it chose.

    7.  There is scant information that suggests the Federal Reserve or 
        FDIC's on-site activities, were instrumental in stemming the 
        current crises or bank failures. Again, it is important to 
        emphasize, this is not a reflection on these two exceptional 
        agencies or their extraordinarily able and dedicated 
        professionals. It is a reflection of our dysfunctional, 
        alphabet soup supervisory structure.

    No Evidence That Consolidated Supervision Works. Sixth, 
        some have claimed that because the U.K.'s FSA has had bank 
        failures on its watch, a consolidated institutional regulator 
        does not work and would not work in the U.S. As noted above, 
        the U.K. FSA is a species of super-regulator with much broader 
        authorities than a mere consolidated regulator. It is also 
        worth noting that neither in the U.K. nor elsewhere is the 
        debate over supervision one that extols the U.S. model. Rather, 
        the debate tends to be simply over whether the consolidated 
        supervisor should be placed within the central bank or 
        elsewhere.

    More importantly, it should be emphasized that there are regulatory 
        models around the world that have been extremely successful 
        using a consolidated institutional regulator model. Indeed, two 
        countries with the most successful track record through the 
        past crisis, Canada and Australia, have end-to-end, consolidate 
        regulators. In Canada the entity is OSFI and in Australia APRA. 
        Both entities perform essentially the same consolidated 
        institutional prudential supervisory function in their home 
        countries. In both cases they exist in governmental structures 
        where there are also strong central banks, deposit insurance, 
        consumer protections, separate securities regulators and strong 
        Treasury Departments. Canada and Australia's regulatory systems 
        work very well and indeed, that they have not just a successful 
        consolidated end-to-end supervisor but a periodic meeting of 
        governmental financial leaders that has many of the attributes 
        systemic risk council, discussed below.

    Would It Do Damage To The Dual Banking System? Seventh, 
        there was considerable concern in the 1860s and 1870s that a 
        national charter and national supervision would do away with 
        the State banking system. It did not. Similar fears arose when 
        the Federal Reserve and FDIC became a Federal examination 
        supervisory component of State-chartered banking. These fears 
        were also unfounded. Both the Federal Reserve and the FDIC are 
        national instrumentalities that provide national examination 
        every other year and more frequently when an institution is 
        troubled. A new consolidated supervisor at the Federal level 
        would merely pick up the FDIC and Federal Reserve examination 
        and supervisory authorities.

    d. Proposal. Accordingly, I strongly urge the Congress to create 
one financial services institutional regulator. In urging the Congress 
to take this step, I believe that several matters should be clarified:

    Institutional Not Market Regulator. I am not suggesting 
        that we merge the market regulators--the Commodities Futures 
        Trading Commission, the SEC, and FINRA--into this new 
        institutional regulatory mechanism. The market regulators 
        should be allowed to continue to regulate markets--as a 
        distinct functional task with unique demands and delicate 
        consequences. Rather, I am suggesting that all examination, 
        regulation, and enforcement that focus on individual, 
        prudential financial regulation of financial institutions 
        should be part of one highly professionalized agency.

    Issue Is Structure Not People. As a former U.S. Comptroller 
        of the Currency, who would see his former agency and position 
        disappear into a new consolidated agency, the creation of this 
        new regulator is not a proposition I offer lightly. I fully 
        understand the pride each of our Federal financial regulatory 
        agencies takes in its unique history and responsibility. As I 
        have said elsewhere in this testimony, I have nothing but the 
        highest regard for the professionalism and dedication the hard-
        working men and women who make up these agencies bring to their 
        jobs every day. The issue is not about individuals, nor is it 
        about historic agency successes. Rather, it is all about a 
        system of regulation that has outlived the period where it can 
        be sufficiently effective. Indeed, perpetuating the current 
        antiquated system makes it harder for the fine men and women of 
        our regulatory agencies to fully demonstrate their talents and 
        to advance as far professionally as they are capable of 
        advancing.

    Retention of Dual Banking System. In proposing a 
        consolidated regulatory agency, I am not suggesting that we 
        should do harm to our dual banking system as noted above. 
        Chartering authority is one thing; supervision and regulation 
        are quite another matter. The State charter can and should be 
        retained; the power of the States to confer charters is deeply 
        imbedded in our federalist system. There is nothing to prevent 
        States from examining the institutions subject to their 
        charters. On the contrary, one would expect the States to 
        perform the same regulatory and supervisory functions in which 
        they engage today. As noted, the new consolidated regulatory 
        agency would simply pick up the Federal component of the State 
        examination and regulation, currently performed by the Federal 
        Reserve and the FDIC.

    Funding. This new consolidated financial institutional 
        regulatory agency should be funded by all firms that it 
        examines, eliminating arbitrage, which often masquerades as 
        attempts to save examination fees.

    Importance of Independence. Importantly, this new 
        consolidated supervisory agency needs to be independent. It 
        needs to be a trusted, impartial, professional referee. This is 
        important for several reasons. It is absolutely essential for 
        the agency to be taken seriously that it be free from the 
        possible taint of the political process. It must not be 
        possible for politically elected leader to decide how banking 
        organizations are supervised because of political 
        considerations. Time and again, when the issue of bank 
        supervision and the political process has been considered by 
        Congress, Congress has opted to keep the regulatory mechanisms 
        independent.

    Independence also bespeaks of attracting top talent to head the 
        agency, and this is of considerable importance. If the head of 
        the agency is not someone who is as distinguished and 
        experienced as the head of the SEC, Treasury Secretary or 
        Chairman of the Federal Reserve, if it is not someone with this 
        level of Government seniority and distinction, the agency will 
        not function at the level it needs to function to do the kind 
        of job we need in a complex world.

    e. Architecture of Reform Proposals/Congressional Oversight. 
Enterprises perform best where they have clear missions, and there are 
not other missions to add confusion. The consolidated end-to-end 
supervisor would have a clear mission and would fit nicely with the 
proposals below where the roles and responsibilities of all parts of 
our regulatory system would be simplified and targeted. The Federal 
Reserve would be in charge of monetary policy, back-stop bank and 
payments system activities. The FDIC would continue to be the deposit 
insurer. The SEC and CFTC market regulators. The Systemic Council would 
identify and seek to mitigate potential systemic events. And a consumer 
organization would be responsible for consumer issue rule setting.
    This allows for much more effective Congressional oversight. 
Congress will be able to focus on each agency's responsibilities with 
greater effectiveness when one agency engages in a disparate set of 
activities.
2. Avoid a two-tier regulatory system that elevates the largest ``too-
        big-to-fail'' institutions over smaller institutions.
    Eliminating the alphabet soup of regulators should not give rise to 
a two-class system where our largest banking organizations, deemed 
``too big to fail,'' are regulated separately from the rest. To do that 
has several deleterious outcomes:

  a.  Public Utilities or Favored Club. A two-class system means either 
        the largest institutions become, in essence, public utilities 
        subject to rules--such as higher capital charges, inflexible 
        product and service limitations, and compensation 
        straitjackets--or, they become a special favored club that 
        siphons off the blue chip credits, the best depositors, the 
        safest business, the best examiners and supervisory service 
        whereby the community banking sector has to settle for the 
        leftovers. Both outcomes are highly undesirable.

  b.  Smaller Institutions Should Not Be Second Class Citizens. I can 
        assure you that over time, condemning community banking to the 
        leftovers will make them less safe, less vibrant and less 
        innovative. Even today, tens, indeed hundreds of billions of 
        dollars have been used to save larger institutions, even 
        nonbanks, and yet we think nothing of failing dozens of 
        community banks. Over 90 banks have failed since the beginning 
        of 2009, and they were overwhelmingly community banks; the 
        number is likely to be in the hundreds before this crisis is 
        over.

  c.  Two-Tier Supervisory System Exacerbates ``Too-Big-To-Fail'' 
        Problem. Creating a two tier supervisory system and designating 
        some institutions, as ``too big to fail'' is a capitulation to 
        the notion that some institutions should indeed be allowed to 
        function in that category. To me, this is a terrible mistake. 
        We are enshrining some institutions with such importance due to 
        their size and interconnected characteristics that we are 
        implicitly accepting the notion that our Nation's economic 
        well-being is in their hands, not in the hands of the people 
        and their elected officials.

  d.  Danger of Second Class Supervisory System for Smaller 
        Organizations. As a practical matter, a two-tier system makes 
        it less likely that top talent will be available to supervise 
        smaller institutions. At the end of the day, who wants to work 
        for the second regulator that has no ability to ever regulate 
        the institutions that are essentially defined as mattering most 
        to the Nation?

  e.  Size Is Not the Only Differentiating Characteristic. Finally, 
        just because we might have one prudentially oriented financial 
        services supervisor does not mean that we should not 
        differentiate supervision to fit the size and other 
        characteristics of the institutions being supervised. On the 
        contrary, we should tailor the supervision so that community 
        banks and other kinds of organizations--for example, trust 
        banks or credit card banks--are getting the kind of 
        professional supervision they need, no more and no less. But 
        such an avoidance of a one-size-fits-all supervisory model is 
        far from elevating a class of financial institution into the 
        ``too-big-to-fail'' pantheon.

    In sum, I urge the Congress not to create a ``too-big-to-fail'' 
category of financial institutions, directly or indirectly, either 
through the regulatory mechanism or by rule. On the contrary, I urge 
the Congress to take steps to avoid the perpetuation of such a bias in 
our system.
3. It is essential to have a resolution mechanism that can resolve 
        entities, however large and interconnected.
    Essential Nature of the Problem. It cannot be overstressed just how 
important it is to develop a mechanism to safely resolve the largest 
and most interconnected financial institutions. If we do not have such 
a mechanism in place and functioning, we either condemn our largest 
institutions to become a species of public utility, less innovative and 
less competitive globally, or we have to create artificial measures to 
limit size, diversity, and perhaps product offerings. If we choose the 
first alternative and go the public utility route, we are in effect 
admitting that some institutions are ``too big to fail,'' and thus 
unbalancing the rest of our financial services sector. Moreover, 
adopting either alternative would change not only the fabric of our 
financial system, but the free-market nature of finance and the economy 
in the United States.
    Complexity of the Undertaking. An essential aspect to eliminating 
the perception and reality of institutions that are ``too big to fail'' 
is to ensure that we have a resolution mechanism that can handle the 
failure of very large and/or very connected institutions without taking 
the chance of creating a systemic event. However, it is worth 
emphasizing that creating such a resolution mechanism will require 
careful legislative and regulatory efforts. Resolving institutions is 
not easy.
    To step back for a moment, it is quite striking that the seizure of 
even a relatively small bank, (e.g., a bank with $60 million in assets) 
is a very substantial undertaking. With the precision of a SWAT team, 
dozens of bank examiners and resolutions experts descend on even a 
small institution that is to be resolved, and they work nearly around 
the clock for 48 hours, turning the bank inside out as they comb 
through books and records and catalogue everything from cash to 
customer files. Imagine magnifying that task to resolve a bank that is 
10 times, 100 times, or 1,000 times larger than my community bank 
example.
    A Resolution Mechanism Can Be Created To Resolve the Problem. The 
FDIC has capably discharged its duties as the receiver of even some 
very large banks, but significantly revised processes and procedures 
will have to be created to deal with the largest, most interconnected 
and geographically diverse institutions with broad ranges of product 
offerings. With that said, having worked both as a director of the FDIC 
and in the private sector as a lawyer with some bankruptcy experience, 
I am reasonably confident that we can create the necessary resolution 
mechanism.
    Several aspects to creating a resolution mechanism for the largest 
banks that deserve particular attention are enumerated below:

  a.  Costs Should Not Be Borne By Smaller Institutions. We have to be 
        careful that the costs of resolution of such institutions are 
        not borne by smaller or healthier institutions, particularly at 
        the time of failure when markets generally may be disrupted. 
        This means all large institutions that might avail themselves 
        of such a mechanism should be paying some fees into a fund that 
        should be available when resolution is needed.

  b.  Treasury Backstop. Furthermore, such a fund should be backstopped 
        by the Treasury as is the FDIC Deposit Insurance Fund (DIF). We 
        should not be calling on healthy companies to fill up the fund 
        quickly, particularly during periods of financial turmoil. An 
        unintended consequence of current law is that we have been 
        requiring healthy community banks to replenish the deposit 
        insurance fund during the banking crisis, making matters worse 
        by making the good institutions weaker and less able to lend. 
        We should change current law so that this is no longer the case 
        with respect to the DIF, and this certainly should not be the 
        case with a new fund set up to deal with larger bank and 
        nonbank failures.

  c.  Resolution Decisions. The ultimate decision to resolve at least 
        the largest financial institutions should be the province of a 
        systemic council, which I will discuss in greater detail 
        shortly. The decision should take into account both individual 
        institutional concerns and systemic concerns. Our current legal 
        requirements for resolving the troubled financial system is 
        flawed in that it is one-dimensional, causing the FDIC to make 
        the call on the basis of what would pose the ``least cost to 
        the DIF,'' not on the basis of the least cost to the economy, 
        or to the financial system. I emphasize that this is not a 
        criticism of the FDIC; that agency is doing what it has to do 
        under current law. My criticism is of the narrowness of the law 
        itself.

  d.  Resolution Mechanics. In terms of which agency should be in 
        charge of the mechanics of resolution itself, there are a 
        number of ways the Congress could come out on this question, 
        all of which have pluses and minuses. Giving the responsibility 
        to the FDIC makes sense in that the FDIC has been engaged 
        successfully in resolving banking organizations and so has 
        important resolutions expertise. One could also argue that the 
        primary regulator that knows the institution best should be in 
        charge of the resolution, calling upon the DIF for money and 
        back up. The primary regulators do in fact have some useful 
        resolutions and conservatorship experiences, though they have 
        not typically been active in the area, in part due to the lack 
        of a dedicated fund for such purposes. Or one could argue for a 
        special agency, like the RTC, perhaps under the control of the 
        new systemic risk council.

    I have not settled in my own mind which of these models works best, 
except to be certain that the institution in charge of resolutions has 
to be highly professional and that a special process must be in place 
to deal with the extraordinary issues presented by the failure of an 
extremely large and interconnected financial institution.
    In sum, I urge Congress to create a new function that can require 
the resolution of a large, complex financial institution. This new 
function can be handled as part of the responsibilities of the Systemic 
Risk Council discussed below. The mechanism that calls for resolution 
of a large troubled financial institution need not be the same 
institution that actually engages in the resolution activity itself. 
Any of the FDIC, the primary regulator and/or a new resolution 
mechanism could do the job of actually resolving a large troubled 
institution if properly organized for the purpose, though certainly 
much can be said for the FDIC's handling of this important mechanical 
function, given its expertise in the area generally. Even more 
important, it is absolutely key that we clarify existing law so that 
the decision--and the mechanics--to resolve a troubled institution is a 
question first of financial stability for the system and then a 
question of least-cost resolution.
4. A new systemic risk identification and mitigation mechanism must be 
        created by the Federal Government; A financial council is best 
        suited to be responsible for this important function.
    Nature of the Problem. The financial crisis we have been living 
through makes clear beyond a doubt that systemic risk is no 
abstraction. Starting in the summer of 2007, we experienced just how 
the rumblings of a breakdown in the U.S. subprime housing market could 
ripple out to Germany and Australia and beyond. Last year, we witnessed 
the devastating effects the demise of Lehman Brothers, a complex and 
interconnected financial company, could have on the financial system 
and the economy as a whole. The entire international financial system 
almost came to a standstill post Lehman Brothers failure.
    Notwithstanding the magnitude of the problem and the possible 
outcomes of a Lehman Brothers failure, our financial regulatory 
mechanism was caught relatively unaware. For more than a year preceding 
the Lehman Brothers catastrophe our regulatory mechanism was in denial, 
considering the problem to be a relatively isolated subprime housing 
problem.
    The same failure to recognize the signs of an impending crisis can 
be laid at the feet of the regulatory mechanism prior to the S&L 
crisis, the 1987 stock market meltdown, the banking crisis of the early 
1990s, the emerging market meltdown of 1998, and the technology crisis 
of 2000-2001. No agency of Government has functioned as an early 
warning mechanism, nor adequately mitigated systemic problems as they 
were emerging.
    Only after the systemic problem was relatively full blown have 
forceful steps been taken to quell the crisis. In some cases the delay 
in taking action and initial governmental mistakes in dealing with the 
crisis have cost the Nation dearly--as was true in the S&L crisis. The 
same can be said of the other crises of the preceding century where for 
example in the case of the Great Depression, steps taken by the 
Government after the problem arose--to withdraw liquidity from the 
market--actually made the problem markedly worse.
    Admittedly, identifying potential systemic problems is hard. It 
involves identifying financial ``bubbles,'' unsustainable periods of 
excess. However, though difficult, economists outside of Government 
have identified emerging bubbles, including the past one. Furthermore, 
there are steps that can be taken to mitigate such emerging problems, 
for example, increasing stock margin requirements or tightening lending 
standards or liquefying the markets early in the crisis.
    The Need To Create a New Governmental Mechanism. This Committee is 
wisely contemplating the creation of a Systemic Risk Council as a new 
mechanism to deal with questions of systemic risk. There is general 
agreement that some new mechanism is needed for identifying and 
mitigating systemic problems as none exists at the moment.
    Indeed, the current Treasury Department has also wisely highlighted 
the importance of considering systemic risk as one of the issues on 
which to focus as a central part of financial regulatory modernization. 
Former Treasury Secretary Paulson, too, who spearheaded Treasury's 
``blueprint,'' focused on this important issue. There is now a 
reasonable consensus that there are times when financial issues go 
beyond the regulation and supervision of individual financial 
institutions.
    Why a Council in Particular Makes the Most Sense. There are a 
number of reasons why no current agency of Government is suited to be 
in charge of the systemic risk issue, and why a council with its own 
staff is the best approach for dealing with this problem.

  1.  Systemic Risk: A Product of Governmental Action or Inaction. It 
        is essential to emphasize that historically, virtually all 
        systemic crises are at their root caused by Government action 
        or inaction. Though individual institutional weakness or 
        failure may be the product of these troubled times and may add 
        to the conflagration, the conditions and often even the 
        triggering mechanisms for a systemic crisis are in the 
        Government's control.

    i.  For example, the decision to withdraw liquidity from the 
        marketplace in the 1930s and the Smoot-Hawley tariffs were 
        important causes of the Great Depression;

    ii.  The decision to raise interest rates in the 1980s coupled with 
        a weak regulatory mechanism and expansion of S&L powers led to 
        the S&L failures of the 1980s;

    iii.  The decision to produce an extended period of low interest 
        rates, the unwillingness to rein in an over-levered consumer--
        indeed quite the contrary--and high liquidity coupled with a 
        de-emphasis of prudential regulation is at the root of the 
        current crisis.

  2.  No Current Regulatory Agency Is Well Suited for the Task. Our 
        existing regulators are not well suited, acting alone, to 
        identify and/or mitigate systemic problems. There are a variety 
        of reasons for this.

    a.  Substantial Existing Duties. First, each of our existing 
        institutions already has substantial responsibilities.

    b.  Systemic Events Cross Existing Jurisdictional Lines. Second, 
        systemic events often cross the jurisdictional lines of 
        responsibilities of individual regulators, involving markets, 
        sector concentrations, monetary policy considerations, housing 
        policies, etc.

    c.  Conflicts of Interest. Third, the responsibilities of 
        individual regulators can create built-in conflicts of 
        interest, biases that make it harder to identify and deal with 
        a systemic event.

    d.  Systemic Risk Not Fundamentally About Individual Private Sector 
        Institution Supervision. Fourth, as noted above, it bears 
        emphasis that the actions needed to deal with systemic issues 
        (identification of an emerging systemic crisis, or the 
        conditions for such a crisis, and then action to deal with the 
        impending crisis) are largely not about supervising individual 
        private-sector institutions.

    e.  Systemic Events May Involve Any One Agency's Policies. Systemic 
        crises may emanate from the polices of an individual financial 
        agency. That has been true in the past. It is hard to have 
        confidence that the same agency involved in making the policy 
        decisions that may bring on a systemic crises will not be 
        somewhat myopic when it comes to identifying the policy law or 
        how to deal with it.

    f.  Too Many Duties and Difficulties In Oversight. There is a 
        legitimate concern that adding a systemic risk function to the 
        already daunting functions of any of our existing financial 
        agencies will simply create a situation where the agency will 
        be unable to perform any one function as well as it would 
        otherwise. Furthermore, Congressional oversight is made 
        considerably more difficult where an agency has multiple 
        responsibilities.

    g.  Too Much Concentrated Power. Giving one agency systemic risk 
        authority coupled with other regulatory authorities moves away 
        from a situation of checks and balances to one of concentrated 
        financial power. This is particularly true where systemic risk 
        authority is incorporated in an agency with central banking 
        powers. Any entity this powerful goes precisely against the 
        wisdom of our founding fathers, who again and again opposed the 
        centralization of economic power represented by the 
        establishment of the First and Second Banks of the United 
        States, and instead repeatedly insisted upon a system of checks 
        and balances. They were wary, and I believe the current 
        Congress should likewise be wary, of any one institution that 
        does not have clear, simple functional responsibilities, or 
        that is so large and sprawling in its mission and authority 
        that the Congress cannot exercise adequate oversight.

  3.  Multiple Viewpoints With Focused Professional Staff. A Systemic 
        Risk Council of the type contemplated by Committee has the 
        virtue of combining the wisdom and differing viewpoints of all 
        the current financial agencies. Each of these agencies sees the 
        financial world from a different perspective. Each has its own 
        expertise. Combined they will have a more fulsome appreciation 
        of a larger more systemic problem.

    Of course, a council alone without a leader and staff will be less 
        effective. To be a major factor in identifying and mitigating a 
        systemic issue, the council will need a strong and thoughtful 
        leader appointed by the President and confirmed by the Senate. 
        That leader will need to have a staff of top economists and 
        other professionals, though the staff can be modest in size and 
        draw on the collective expertise of the staffs of the members 
        of the council.

    Accordingly, I urge Congress to adopt a system whereby the Federal 
Reserve along with its fellow financial regulators and supervisors 
should form a council, the board of directors, if you will, of a new 
systemic risk agency. The agency should have a Chairman and CEO who is 
chosen by the President and confirmed by the Senate. The Chairman 
should have a staff:

    The function of the systemic risk council's staff should be 
        to identify potential systemic events; take actions to avoid 
        such events; and/or to take actions to mitigate systemic events 
        in times of a crisis.

    Where the Chairman of the systemic council believes he or 
        she needs to take steps to prevent or mitigate a systemic 
        crisis, he or she may take such actions irrespective of the 
        views of the agencies that make up the council, provided a 
        majority of the council agrees.
5. Taking additional steps to enhance the professionalization of 
        America's financial services regulatory mechanism should be a 
        top priority.
    America is blessed with an extremely strong group of dedicated 
regulators at our current financial services regulatory agencies. 
However, we must do much more to provide professional opportunities for 
our fine supervisory people:

  a.  As I have said many times before, many colleges and universities 
        in America today offer every conceivable degree except a degree 
        in regulation, supervision, financial institution safety and 
        soundness--let alone the most basic components of the same. 
        Even individual courses in these disciplines are hard to come 
        by.

  b.  We should encourage chaired professors in these prudential 
        disciplines.

  c.  What I hope would be our new institutional regulatory agency 
        should have the economic wherewithal to provide not just 
        training but genuine, graduate school-level courses in these 
        important disciplines.

    In sum, we need to further professionalize our regulatory, 
examination and supervision services, including by way of enhancing 
university and agency professional programs of study.
6. Regulate all financial institutions, not just banks. All financial 
        institutions engaged in the same activities at the same size 
        levels should be similarly regulated.
    We cannot have a safe and sound financial services regulatory 
system that has to compete with un-regulated and under-regulated 
entities that are engaged in virtually identical activities:

  a.  It simply does not work to have a large portion of our financial 
        services system heavily regulated with specific capital charges 
        and limits on product innovation, while we allow the remainder 
        of the system to play by different rules. For America to have a 
        safe and sound financial system, it needs to have a level 
        regulatory playing field; otherwise the regulated sector will 
        have a cost base that is different from the unregulated sector, 
        which will drive the heavily regulated sector to go further out 
        on the risk curve to earn the hurdle rates of return needed to 
        attract much needed capital.

  b.  In this regard, I want to emphasize that good regulation does not 
        mean a lot of regulation. More is not better; bigger is not 
        better; better is better. Sound regulation does not mean 
        heaping burdens upon currently regulated or unregulated 
        financial players--quite the contrary. I have come to learn 
        after a lifetime of working with the regulatory services 
        agencies that some regulations work well, others do not work 
        and perhaps even more importantly many banks and other 
        organizations are made markedly less safe where the regulator 
        causes them to focus on the wrong item and/or piles on more and 
        more regulation. Regulators too often forget that a financial 
        services executive has only so many hours in a day. Targeting 
        that time on key safety and soundness matters is critical to 
        achieving a safer institution.
7. Protecting consumer interests and making sure that we extend 
        financial services fairly to all Americans must be a key 
        element of any regulatory reform. We cannot have a safe and 
        sound financial system without it.
    We cannot have a safe and sound financial regulatory system that 
does not protect the consumer, particularly the unsophisticated, nor 
can we have a safe and sound financial system that does not extend 
services fairly and appropriately to all Americans.
    The Administration has in this regard come out with a bold proposal 
to have an independent financial services consumer regulator. There is 
much to commend this proposal. However, this concept has been quite 
controversial not only among bankers but even among financial services 
regulators. Why? I think at the center of what gives serious heartburn 
to the detractors of this concept are three matters that deserve the 
attention of Congress:

  a.  First, critics are concerned about the burdens that such a 
        mechanism would create. These burdens are particularly 
        pronounced without a single prudential regulator like the one I 
        have proposed, because without such a change, we would again be 
        adding to our alphabet soup of regulators.

  b.  Second, I believe critics are justifiably concerned that the new 
        agency would at the end of the day be all about examining and 
        regulating banking organizations and bank-related organizations 
        but not the un- and under-regulated financial services 
        companies, many of which are heavily implicated as causes of 
        the current crisis.

  c.  Third, there is a concern that the new mechanism will not give 
        rise to national standards but rather, by only setting a 
        national standards floor, will give rise to 50 additional sets 
        of consumer rules, making the operation of a retail banking 
        organization a nightmare.

    For myself, I feel strongly that an independent consumer regulatory 
agency can only work if these three problems are solved. And I believe 
they can be solved in a way that improves upon the current situation 
for all stakeholders. My recommendations follow:

    Focus On Un- and Under-regulated Institutions. First, I 
        would focus a new independent consumer financial regulatory 
        agency primarily on the un- and under-regulated financial 
        services companies. These companies have historically caused 
        most of the problems for consumers. Many operate within well-
        known categories--check cashers, mortgage brokers, pay-day-
        lenders, loan sharks, pawn brokers--so they are not hard to 
        find. It is here that we need to expend the lion's share of 
        examination and supervisory efforts.

    Minimize Burden. Second, consistent with my comments on 
        prudential supervision, I would work to have maximum 
        effectiveness for the new agency with minimum burden. In this 
        regard, it is hard to judge such burden unless and until we can 
        see all the financial services regulatory modernization 
        measures. Chairman Dodd and Ranking Committee Member Shelby, 
        you along with many of your fellow Committee Members should be 
        commended for waiting to act on any piece of financial services 
        regulatory modernization until we can see the entire package--
        for precisely these reasons.

    National Standards for Nationally Chartered Entities. 
        Third, we need to establish uniform national standards for 
        nationally chartered financial organizations. We are one 
        Nation. One of our key competitive advantages as a Nation is 
        our large market. We take a big step toward ruining that market 
        for retail finance when we allow every State to set its own 
        standards with its own enforcement mechanism or entities that 
        have been nationally chartered and are nationally supervised. 
        Do we really want to be a step behind the European Union and 
        its common market? Do we really want to cut up our country so 
        that we are less competitive vis-a-vis other large national 
        marketplaces like China, Canada, and Australia? I hope not. I 
        do not think many of the detractors of the current independent 
        consumer agency proposal would continue to oppose the 
        legislation--irrespective of how high the standards are--if the 
        standards are uniform nationally and uniformly examined and 
        enforced.

    Utilization of Existing Supervisory Teams. It is worth 
        noting that one way to deal with the burden question that has 
        been suggested by Ellen Seidman, former Deputy to the National 
        Economic Council and former Director of the OTS, is to allow 
        the new agency to set rules and allow the banking agencies to 
        continue to be in charge of examination and enforcement. There 
        is a great deal to say for this approach. However, I am 
        reserving my own views until I see the entire package evolve, 
        absolute musts being for me the three items just mentioned: 
        strict burden reduction, true national standards, and a focus 
        on the unregulated and under-regulated financial services 
        entities.
Conclusion
    In conclusion, Mr. Chairman, I again want to commend you, your 
colleagues, and the Committee staff for the serious way in which you 
have attacked this national problem. The financial crisis has laid bare 
the underbelly of our economic system and made clear that system's 
serious vulnerabilities. We are at a crossroads. Either we act boldly 
along the lines I have suggested or generations of Americans will, I 
believe, pay a very steep price and our international leadership in 
financial services will be shattered.
    Thank you. I would be pleased to answer any questions you may have.
                                 ______
                                 
                 PREPARED STATEMENT OF MARTIN N. BAILY
       Senior Fellow, Economic Studies, The Brookings Institution
                           September 29, 2009
    Thank you Chairman Dodd, Ranking Member Shelby, and Members of the 
Committee for asking me to discuss with you the reform of Federal 
regulation of financial institutions. \1\
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     \1\ Martin Neil Baily is the Bernard L. Schwartz Senior Fellow in 
the Economic Studies Program at the Brookings Institutions, the cochair 
of the Pew Working Group on Financial Sector Reform and a member of the 
Squam Lake group of academics studying financial reform. He was 
Chairman of the Council of Economic Advisers under President Clinton. 
The opinions expressed are his own but he would like to thank Charles 
Taylor, Alice Rivlin, Doug Elliott, and many other colleagues for 
helpful comments.
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    I would like to share with the Committee my thoughts on 
consolidation of the Federal financial regulatory agencies and what it 
would take to make them successful in the future. However, this is part 
of a larger puzzle--the reorganization of Federal financial regulation 
generally and, in some respects, it is difficult to discuss the 
narrower topic without examining the broader context. I will therefore 
also say something about possible complementary changes in the roles of 
the Federal Reserve, the SEC and the proposed CFPA.
    A summary of my testimony today is as follows:

    The best framework to guide current reform efforts is an 
        objectives approach that divides regulation up into 
        microprudential, macroprudential, and conduct of business 
        regulation.

    The quality of regulation must be improved regardless of 
        where it is done. Regulatory and supervisory agencies must have 
        better qualified, better trained and better paid staff with 
        clear objectives to improve safety and soundness and encourage 
        innovation. Regulatory personnel must be accountable for their 
        actions.

    A single Federal microprudential regulator should be 
        created combining the regulatory and supervisory functions 
        currently carried out at the Fed, the OCC, the OTS, the SEC, 
        and the FDIC. This regulator should partner closely with State 
        regulators to ensure the safety and soundness of State 
        chartered financial institutions, sharing supervisory 
        authority.

    The U.S. needs effective conduct of business regulation. 
        The SEC is currently charged with protecting shareholders and 
        the integrity of markets and must improve its performance in 
        this area. In my judgment, the SEC should also create a new 
        division within the agency to protect consumers, that is to 
        say, it would add a CFPA division and become the consolidated 
        conduct of business regulator. Although my first choice is for 
        a single conduct of business regulator, a well-designed 
        standalone CFPA could also be effective.

    The Fed should be the systemic risk monitor with some 
        additional regulatory power to adjust lending standards. In 
        this it should work with a Financial Services Oversight 
        Council, as has been proposed by the Treasury.
The Objectives Approach to Regulation
    I support an objectives-based approach to regulation.
    The Blueprint for financial reform prepared by the Paulson Treasury 
proposed a system of objectives-based regulation, an approach that is 
the basis for successful regulation in Australia and other countries 
overseas. The White Paper prepared by the Geithner Treasury did not use 
the same terminology, but it is clear from the structure of the paper 
that their framework is an objectives-based one, as they lay out the 
different elements of regulatory reform that should be covered. 
However, they do not follow through the logic of this approach to 
suggest a major reorganization of regulatory responsibilities.
    There are three major objectives of regulation:

    First is the microprudential objective of making sure that 
        individual institutions are safe and sound. That requires the 
        traditional kind of regulation and supervision--albeit of 
        improved quality.

    Second is the macroprudential objective of making sure that 
        whole financial sector retains its balance and does not become 
        unstable. That means someone has to warn about the build up of 
        risk across several institutions and take regulatory actions to 
        restrain lending used to purchase assets whose prices are 
        creating a speculative bubble.

    Third is the conduct of business objective. That means 
        watching out for the interests of consumers and investors, 
        whether they are small shareholders in public companies or 
        households deciding whether to take out a mortgage or use a 
        credit card.

    An objectives-based approach to regulation assigns responsibilities 
for these three objectives to different agencies. The result is clear 
accountability, concentration of expertise, and no gaps in coverage of 
the financial services industry--even as its structure changes and new 
products, processes and institutional types emerge. No other way of 
organizing regulation meets these important criteria while avoiding an 
undue concentration of power that a single overarching financial 
services regulator would involve. \2\ The main focus of this testimony 
will be to make the case for a single microprudential regulator, 
something I believe would enhance the stability of the financial 
sector. Having a single microprudential regulator is not a new idea. In 
1993, the Clinton Administration and the Paulson Blueprint in 2008 
proposed the same thing.
---------------------------------------------------------------------------
     \2\ See, ``Pew Financial Reform Project Note #2: Choosing Agency 
Mandates'', by Charles Taylor.
---------------------------------------------------------------------------
    It is important to remember that how we organize regulation is not 
an end in itself. Our plan must meet the three objectives efficiently 
and effectively, while avoiding over-regulation. In addition for 
objectives-based regulation to work, it is essential to use the power 
of the market to enhance stability. Many of the problems behind the 
recent crisis--executive and trader compensation, excessive risk 
taking, obscure transaction terms, poor methodologies, and conflicts of 
interest--could have been caught by the market with clearer, more 
timely and more complete disclosures. It will never be possible to have 
enough smart regulators in place that can outwit private sector 
participants who really want to get around regulations. An essential 
part of improving regulation is to improve transparency, so the market 
can exert its discipline effectively.
The Independence of the Federal Reserve
    In applying this approach, it is vital for both the economy and the 
financial sector is that the Federal Reserve has independence as it 
makes monetary policy. Experience in the U.S. and around the world 
supports the view that an independent central bank results in better 
macroeconomic performance and restrains inflationary expectations. An 
independent Fed setting monetary policy is essential.
The Main Regulators and Lessons From the Crisis
    The main Federal microprudential regulators had mixed performance 
at best during the recent crisis.
    OTS did worst, losing its most important institutions--WaMu, 
IndyMac, and AIG--to sale and outright failure. Without any economies 
of scale in regulation, OTS suffered from a small staff in relation to 
their supervisory responsibilities. Its revenue was dominated by fees 
on a very small number of institutions, leading to regulatory capture. 
And, as many have observed, OTS lax standards attracted institutions to 
a thrift charter and it because the weakest link in the Federal 
financial depository regulatory chain. The lessons were: regulatory 
competition can create a de facto race to the bottom; and large 
institutions cannot be supervised and regulated effectively by small 
regulators--not only because of the complexity of the task but also 
because of capture.
    The Office of the Comptroller of the Currency (OCC) fared only 
somewhat better. Their responsibilities were far wider and their 
resources were far greater. Nevertheless, several of their larger 
institutions failed and had to be rescued or absorbed. While an element 
of the problem was that there were parts of these institutions where 
their writ did not reach--OCC-regulated banks bought billions of 
dollars of CDOs, putting many of them into off-balance-sheet entities--
it was not the only problem. Somehow, even this relative powerhouse 
failed to see the crisis coming. The lessons were: even the best of the 
Federal regulators may not have been up to the demanding task of 
overseeing highly complex financial institutions; and balkanized and 
incomplete coverage by microprudential regulators can be fatal.
    The FDIC is rightly given credit for having championed the leverage 
ratio as an important tool of policy. While the Fed and the OCC became 
increasingly enamored of Basel II over the past 10 years, the FDIC 
suffered repeated criticism for their stick-in-the-mud insistence on 
the leverage ratio. On that issue, they have been vindicated not only 
here in the U.S., but internationally. But they did not do so well in 
prompt corrective actions during this crisis. Their insurance fund 
dropped from $45bn to $10bn in 12 months. Several of the firms that 
failed were well capitalized just days beforehand. The lesson is that 
liquidity and maturity transformation can matter as much as leverage in 
a crisis. Prompt corrective action focused on capital ratios alone is 
not enough.
    While some State regulators have a fine record, nonbank financial 
institutions, largely overseen at the State level, were a major source 
of trouble in the recent financial crisis. Often working with brokers, 
these institutions originated many of the subprime, prime, and jumbo 
mortgages that have subsequently defaulted. They provided the initial 
funding for mortgages, but then quickly sold them to other entities to 
be packaged and securitized into the CDOs that were sliced and diced 
and resold with high credit ratings of dubious quality. They made money 
by pushing mortgages through the system and did not carry risk when 
these mortgages defaulted. Many State regulators failed to control bad 
lending practices. The main lessons: skin in the game is needed to keep 
the ``handlers'' of securitizations honest; and any reform of financial 
regulation has to somehow strengthen State regulation as well as 
Federal.
    Perhaps the most difficult regulator to assess in the current 
crisis is the Federal Reserve.
    More than any other institution, it has prevented the financial 
system from falling off a cliff through often brilliant and 
unprecedented interventions during the worst days of the crisis. I have 
expressed publicly my admiration for the job that Ben Bernanke has done 
in managing this crisis with Secretary Geithner and others. Taxpayers 
are understandably angry because of the funds that have been spent or 
put at risk in order to preserve the financial sector, but the 
alternative of a more serious collapse would have been much worse. The 
historical experience of financial crises here in the United States and 
around the world is that a banking collapse causes terrible hardship to 
the economy, even worse than the current recession. Bernanke and 
Geithner have helped avoid that disaster scenario.
    However, the Fed did nothing at all for 14 years to prevent the 
deterioration in mortgage lending practices, even though Congress had 
given it the authority to do so in 1994 under HOEPA. Several of the 
bank holding companies under Fed supervision faced severe problems in 
the crisis--its microprudential regulation was ineffective. And, while 
the Fed has repeatedly claimed that systemic risk management was their 
responsibility, they failed to anticipate, or even prepare for, the 
crisis in any meaningful way.
    In short, in its role as a regulator of bank holding companies, the 
record of the Fed is not good. Bank regulation has been something of a 
poor relation at the Fed compared to the making of monetary policy. The 
Fed as an institution has more stature and standing than any other 
Federal financial institution, but this stature comes from its control 
over monetary policy, not on its role in bank supervision and 
regulation. In addition, the Fed's powers were limited. It could not 
gain access to key information from many large financial institutions 
and had no power to regulate them. Lehman and Bear Stearns are two 
examples.
    While, the Fed has increased its knowledge and understanding of the 
large banks as a result of managing the crisis and conducting the 
stress tests, the lessons are: having an institution with a secondary 
mandate for consumer protection (under HOEPA) does not work well; and 
the Fed's focus on monetary policy also makes it difficult to direct 
enough institutional focus on supervision.
    Finally, there is the Securities and Exchange Commission which did 
an abysmal job in this crisis. It told the public that Bear Stearns was 
in fine shape shortly before the company failed; in fact it failed to 
supervise effectively any of the bulge bracket firms, Merrill Lynch, 
Bear Stearns, Goldman Sachs, Morgan Stanley, and Lehman). It did 
nothing to restrain the credit agencies from hyping the ratings of 
CDOs. And it did not stop Madoff and others from defrauding investors. 
However, the leadership has changed at the SEC and I believe it has 
learned important lessons from the crisis: its strong suit is not 
microprudential regulation of institutions; it must focus on investor 
protection and the integrity of the markets--not only the traditional 
ones like the stock and bond markets, but also the securitization 
market--including the development and implementation of policies to 
revamp securitization credit ratings.
    One vital issue to recognize in regulating the large financial 
institutions is that they are run as single businesses. They decide 
what their business strategies will be and how to execute them most 
effectively. The specific legal forms they choose for their different 
divisions is determined by what they think will work best to achieve 
their strategic goals, given the tax, regulatory and legal environment 
that policymakers have set up. Under the current regulatory system, the 
Fed supervises and regulates the bank holding company while, for 
example, the OCC supervises the U.S. banks that are the subsidiaries of 
the holding company. Most of the large financial institutions are in 
several lines of business and, at present, are regulated by more than 
one agency. Inevitably, this encourages them to shift activities to the 
subsidiary and hence the regulator that is most tolerant of the 
activity they want to pursue. Balkanized regulation is unlikely to stop 
the next crisis.
    This short review is not inclusive. There are credit unions that 
have a separate regulator and there are important issues around the 
GSE's and their regulation and around derivatives and their regulation 
that I will not tackle in this testimony. This review has been critical 
of the regulatory agencies but I want to note that there are many 
people to blame for the financial crisis, including bankers who took 
excessive risks and failed to do due diligence on the assets they 
purchased. Economists generally did not predict that such a severe 
crisis was possible. Very few people saw the possibility of a 20 
percent or more decline in the price of housing and almost nobody saw 
the depth of problems that have resulted from the sharp declines in 
house prices.
What Structure Best Meets the Objectives of Financial Regulation?
Regulatory Performance Must Be Improved Regardless of Where It Is Done
    There must be improved performance in the supervision and 
regulation of financial institutions regardless of who is doing it. 
There were rooms full of regulators sitting in all of the large 
regulated financial institutions prior to the crisis and they failed to 
stop the crisis. This means there should be more accountability for 
regulators, so that they are censured or removed if they do not perform 
the role they were hired to do. It means they should be better paid. It 
seems paradoxical to reward a group that did not do so well 
historically, but if we want better regulators then they must receive 
salaries that make their jobs attractive to high quality people, those 
who can understand complex institutions and products and who may have 
the option of earning high incomes in the private sector. Adequate 
training must be available. Better quality regulation is a ``must-
have'' of financial reform and must be part of the legislation now 
being considered. A lot of improvement can be made even under existing 
legislation if regulators have the incentives and abilities to do their 
jobs.
    Some people argue that regulation has been the cause of the problem 
and that if the Government were removed from the equation then the 
financial sector would regulate itself, with weak companies failing and 
the strong companies surviving. Overall, I am a strong supporter of 
letting markets work and letting companies fail if they cannot be 
efficient or innovative. This includes financial institutions that 
should be allowed to fail if they do make bad decisions and fail to 
meet the market test. The financial sector has unique features that 
make it different from most other industries, however. Failure in one 
institution can spill over to others and problems in the financial 
sector can rock the whole economy, as we have seen in this crisis. 
Regardless of one's perspective on this issue, however, it is clearly a 
mistake to create worst of both worlds. If the Government provides a 
safety net for consumer deposits and props up financial institutions in 
a crisis, then there must be effective high quality regulation that 
will protect the interests of taxpayers.
The Case for a Consolidated Microprudential Regulator for the Financial 
        Sector
    A single prudential regulator would become a powerful institution 
with stature in the policy community that could hire talented staff and 
attract strong and able leadership. It would be formed by drawing 
together the best people from the existing supervisors and regulators 
in the OCC, the OTS, the SEC, the FDIC, and the Federal Reserve, it 
would hire financial experts in areas where more expertise was needed, 
and it would be the primary supervisor of the institutions that make up 
the financial sector of the United States. The head of the organization 
would be chosen by the President with the consent of the Senate and 
would serve for a term of several years. It would be worth considering 
a structure like that of the Federal Reserve, with a board that served 
staggered 16 year terms. Thus constituted, the financial regulator 
would have the standing and capability to stand up to the heads of 
leading financial institutions and to be an independent arbiter. It 
would be a partner with and advisor to the Administration, Congress and 
the Federal Reserve.
    The financial sector does not stand still. It evolves and innovates 
and new institutions and products are born. A single prudential 
regulator with the necessary staff and skills would be best positioned 
to evolve along with the industry and adapt regulation to a changing 
world. Having a single prudential regulator would make it much easier 
to avoid gaps in regulation and discourage the kind of regulatory 
evasion that contributed to the crisis. It would also reduce the 
regulatory burden on financial institutions because it would avoid much 
of the duplication that now exists.
    A single prudential regulator would supervise and regulate large 
institutions and small and be able to maintain a level playing field 
for competition. It would be able to examine all of the activities of 
the large global banks and make sure they were not accumulating 
excessive risks through a combination of activities in different parts 
of their business.
    There is a great deal to be said for competition in our economy. 
Ultimately, competition in the private sector drives innovation and 
growth and provides choices to consumers. It is the lifeblood of our 
economy. It is not clear, however, that competition among regulators a 
good thing. The serious danger in regulatory competition is that it 
allows a race to the bottom as financial institutions seek out the most 
lenient regulator that will let them do the risky things they want to 
try, betting with other people's money. One possible advantage of 
regulatory competition is that it could make it easier for companies to 
innovate whereas a single regulator might become excessively 
conservative and discourage new products even if these would bring 
substantial benefits. However, given the experience of the recent 
crisis, the dangers created by multiple regulators, including a race to 
the bottom, are greater and outweigh the possible advantages of 
competition among regulators.
    An effective single prudential regulator acting as a cop on the 
beat could actually increase the level of effective competition among 
private companies in the financial sector, thus making the private 
market work better. In addition, it would be very important that the 
mandate of the single prudential regulator include the promotion of 
innovation and economic growth. The U.S. financial sector has been one 
of the strongest in the world and has been one of our major exporters. 
Prior to the crisis there was great concern that the New York financial 
markets were losing their global competitive position--See, for example 
the Bloomberg-Schumer report. The goal of sustaining a dynamic and 
competitive sector remains vital.
    Another advantage of creating a single Federal prudential regulator 
is that it would enhance the independence of the Federal Reserve in 
making monetary policy. It gets the Fed out of the regulatory business 
and lets it concentrate on its main tasks.
The Role of the FDIC
    With a single microprudential regulator, the FDIC would lose the 
supervisory and regulatory authority it has now. Staff from the FDIC 
that have performed well in this crisis would move to the new 
prudential regulator, so there would not be a loss of knowledge or 
expertise. The role of the FDIC as manager and supervisor of the 
deposit insurance fund would continue. In this position, it would also 
be able to sound warnings about depository institutions in 
difficulties, acting as a backup for the new unified prudential 
regulator. Another possibility is that the FDIC would become the 
principle agency dealing with the resolution of failing institutions. 
\3\
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     \3\ I have testified to this Committee before on the dangers of 
``too big to fail'' or ``too interconnected to fail.'' An important 
aspect of regulatory reform is to make sure badly run financial 
companies are allowed to fail in a way that does not imperil the whole 
system, either through a resolution mechanism or through a special 
bankruptcy court. The FDIC would play an important role with either 
system.
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The SEC as the Conduct of Business Regulator
    Under the single prudential regulator described above, the SEC 
would lose its authority to supervise nonbank financial institutions, 
which would reside instead with the prudential regulator. The SEC would 
continue to have a very important role as a protector of the interests 
of shareholders, a bulwark against insider trading, market 
manipulation, misselling and other practices that can undermine our 
capital markets. There is a case for giving the SEC additional 
authority to provide consumers protection against financial products 
that are deceptive or fraudulent.
    The Treasury White Paper proposed establishing a new standalone 
agency, the CFPA, to provide consumer protection and it is 
understandable that such a proposal is made given what has happened. 
There were a lot of bad lending practices that contributed to the 
financial crisis. As noted earlier, many brokers and banks originated 
mortgages that had little chance of being repaid and that pushed 
families onto the street, having lost their savings. There was also 
misbehavior by borrowers, some of whom did not accurately report their 
income or debts or manipulated their credit scores. I agree with the 
Administration and many in Congress--notably Chairman Dodd--on the 
importance of protecting families against a repetition of the bad 
behavior that proliferated in recent years.
    My first choice would be to place the responsibility for consumer 
protection in a new division within the SEC rather than creating a 
separate agency. The proliferation of regulators was a contributory 
factor in the crisis, so that adding a new agency is something that 
should be done reluctantly. While the SEC did badly in the crisis, 
there has been an important change in leadership and the new head of 
the agency is clearly someone of strength and talent who has pledged 
reform in the operations of the agency. Congress should ask the SEC to 
form a new CFPA division within its ranks charged specifically with 
consumer protection. \4\
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     \4\ The Federal Reserve did not do a good job in protecting 
consumers in the period leading up to this crisis, nor did it stop the 
erosion of mortgage lending standards that contributed to build up of 
toxic assets in the financial system. Since the crisis, however, the 
consumer protection division within the FED has been strengthened and 
is now an effective force with strong leadership. The personnel from 
the consumer protection division of the FED, together with the best 
personnel in this function in other agencies, could be moved into the 
new CFPA division.
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    Placing the tasks of the CFPA into the SEC would create a single 
strong conduct of business regulator with divisions specifically tasked 
to protect both consumers and small and minority shareholders. It would 
also make it easier to gain acceptance for greater consumer protection 
from the financial industry. The CFPA has become a lightning rod for 
opposition to regulatory reform. Given that the financial sector is 
largely responsible for the crisis, it is surprising that this sector 
is now lobbying so hard against greater consumer protection. Greater 
protection for consumers is needed and that would also provide greater 
protection for taxpayers. However, having the CFPA functions as a 
division within the SEC would accomplish that goal while calming 
industry fears.
    Having the CFPA functions within the SEC is my first choice, but if 
Congress decides against this approach, I could support a standalone 
agency. The Treasury White Paper does a good deal to allay the fears 
that the new agency would stifle innovation, including: the overall 
focus on unfair, deceptive, and dangerous practices, rather than risk, 
per se; the instruction to weigh economic costs and benefits; the 
instruction to place a significant value on access to financial 
products by traditionally underserved consumers; the prohibition 
against establishing usury limits and; the option to consider previous 
practice in regard to financial products. The Treasury recognizes the 
dangers of having an agency that would overreach and its proposed 
structure would avoid that possibility. \5\
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     \5\ See, additional discussion of these issues by Douglas Elliott 
of Brookings and also by the current author posted on the Brookings Web 
site. The financial reform project of the Pew Charitable trusts has 
also posted material on the topic.
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    One final issue with the CFPA is preemption. The Treasury proposal 
indicates that State regulators would have the power to enact consumer 
protection legislation that was stronger than that in the Federal 
statute. I understand the case for States' rights in this arena, but 
the prospect of a myriad of different State rules is daunting and has 
the potential to reduce the efficiency of the massive U.S. marketplace. 
There has been enormous progress towards a single market in financial 
products, leveling the playing field for businesses and consumers, so 
that the terms of loans or other financial activities are the same in 
all States. Whether or not Federal consumer protection rules preempt 
State rules is not a major issue for safety and soundness, but having 
single set of consumer rule uniform in all States would improve 
economic efficiency. As a result, I support the view that Federal rules 
should preempt State rules in this area.
Regulating State Chartered Financial Institutions
    Starting with a clean sheet of paper, I would prefer to see all 
banks and relevant nonbank financial institutions have Federal charters 
and be supervised by the unified prudential regulator. However, that is 
not the situation we are in and I recognize the importance of States' 
rights and the desire to have local institutions that can help local 
businesses by using the power of personal knowledge and relationships. 
It is a fact of life that there will continue to be State chartered 
banks subject to State supervision.
    In the short run, it is unlikely that we will see again State 
chartered nondepository institutions that are originating and selling 
bad mortgages. The markets have been burned and will remember for a 
while that such institutions may not be selling quality products. Over 
the years, however, memories will fade and regulatory reform enacted 
today should avoid problems in the future as far as possible. I urge 
Congress to require State regulators to partner with the Federal 
prudential regulator in order to harmonize safety and soundness 
standards and to exchange information for State chartered banks and 
nonbanks. The Federal prudential regulator should set out minimum 
standards that it would like to see in State run financial 
institutions. And State regulators should be required to exchange data 
with the Federal regulator and work in cooperation with them. This is 
already how things work for most banks and it is important that we do 
not see in the future a situation where State charters are exploited by 
nonbank financial institutions to undercut the safety of the financial 
system.
The Federal Reserve as Systemic Risk Monitor or Regulator
    The Treasury White Paper has proposed that there be a council, an 
extension of the President's Working Group on financial stability to 
coordinate information and assess systemic risk. The Working Group has 
played a valuable role in the past and I support its extension to 
include the leaders of all institutions with power to regulate the 
financial sector. As others have said, however, committee meetings do 
not solve crises.
    The proposal outlined earlier in this testimony is for a single 
microprudential regulator, which would deprive the Fed of all its 
microprudential functions. However, I propose that monitoring and 
managing systemic stability and responding to increased exposure to 
systemic risks formally be added to the Fed's responsibilities. The 
strong performance of the Fed in managing this crisis strongly suggests 
that this institution should be the primary systemic risk monitor/
regulator. Moreover, this role is a natural extension of monetary 
policy, which can be thought of as the monitoring of, and response to, 
macroeconomic developments. It fits with the dominant culture of 
economists and the Fed's strong tradition of independence, which are 
both needed for systemic risk management to be effective. It would 
slightly cut into the role you have proposed for the Financial Services 
Oversight Council, but not much.
    For monitoring the economy and for making monetary policy the Fed 
needs, among other things, quick access to a broad base of financial 
information. Currently, the regulatory reporting is primitive. More 
complete, relevant and real time data should be available to all 
Federal financial regulators. A coordinated information strategy for 
the Federal financial regulatory agencies ought to be one of the first 
tasks of the FSOC. The Fed as systemic regulator would need to work 
closely with the prudential regulator so that it knows what is going on 
inside the big institutions, and the small ones. It would also need to 
work closely with the Treasury and the FSOC, exchanging information 
with all members that could help it see dangerous trends as they 
emerge.
    To respond to specific systemic risks, the Fed needs another 
instrument in addition to its control over short term interest rates 
and I suggest that Congress should grant the Fed the power to adjust 
minimum capital, leverage, collateral and margin requirements generally 
in response to changing systemic risks, in addition to the specific 
power it has had to adjust margin requirements in stock trading since 
the Great Depression. The microprudential regulator would set basic 
minimum standards. The Fed would adjust a ``multiplier'' up or down as 
systemic circumstances required. This additional power should be used 
rarely and in small increments; recall how the Volcker-Carter credit 
restrictions stopped the U.S. economy on a dime in 1980.
    No one can guarantee that a systemic regulator will be able to 
foresee the next bubble or crisis, but it is definitely worth the 
effort to spot trouble forming. In particular, the Fed may be able to 
spot a concentration of purchases of risky assets made with borrowed 
funds. A systemic regulator could have seen that many banks had lent 
large sums to LTCM to speculate in Russian bonds or other risky assets. 
It should have been able to spot the build up of risky CDOs in SIVs 
that were affiliated with the banks. It could potentially see if large 
hedge funds or private equity companies were using borrowed funds and 
concentrating on a particularly risk class of assets. Analysts who were 
studying the real estate market prior saw signs of trouble well before 
the crisis started.
Conclusions
    A single strong agency would meet the objective of microprudential 
regulation of all financial institutions that were subject to 
regulation and supervision. It would work with State regulators, 
especially to make sure the abuses that contributed to the crisis could 
not be repeated. It would work closely with the conduct of business 
regulator(s) (the SEC and the CFPA) and the Federal Reserve to ensure 
that consumer protection is adequate, that monetary policymakers are 
well informed and that all these institutions and the Treasury would 
work together effectively to deal with a new crisis should it occur in 
the future.
    The Federal Reserve has shown its mettle in managing the crisis and 
should be given the role of principle systemic regulator or monitor. It 
would work closely with the members of the risk council in performing 
this task. It should have the power to adjust borrowing rules prudently 
if it sees a bubble developing driven by excessive leverage.
    The SEC is the natural institution to become the conduct of 
business regulator with a mandate to protect small and minority 
shareholders and, with a CFPA division, also to protect consumers in 
financial markets. A single prudential regulator plus a single conduct 
of business regulator would constitute the so-called ``twin peaks'' 
approach to regulation that many experts around the world see as the 
best regulatory structure. However, a well-designed standalone CFPA 
could also be an effective protector of consumers and taxpayers.
Appendix: Lessons From the U.K. and Australia
    Opponents of regulatory consolidation in the United States 
frequently cite the experience of the United Kingdom, which has a 
consolidated regulator, the Financial Services Authority (FSA) but did 
not escape the crisis, indeed it has suffered perhaps even worse than 
the United States. Given London's status as a global financial center 
it was to be expected that the U.K. would face problems in the global 
crisis, but it is surprising that the extensive regulatory reforms 
undertaken in the late 1990s did not better insulate the country from 
the effects of the financial crisis.
    In 1997 the U.K. overhauled its financial regulatory system, 
combining a myriad of independent regulatory authorities (including the 
regulatory functions of the Bank of England, the Securities Investment 
Board, and the Securities Futures Board, among nine total) into a 
single entity. Then Chancellor of the Exchequer Gordon Brown argued 
that the distinctions between banks, securities firms and insurance 
companies had broken down, and that in this new era of more fluid and 
interchangeable institutional definitions, the old regulatory divisions 
no longer made sense. The FSA's statutory objectives are to maintain 
market confidence, to promote public awareness on financial matters, to 
protect consumers, and to reduce financial crime. To achieve those 
ends, the FSA employs broad investigatory, enforcement, and 
prosecutorial powers.
    Although the external structure of regulation in the U.K. may 
appear simple enough, there is a great deal of internal complexity. 
There are two main branches within the FSA; one branch which deals with 
retail markets and another branch, which focuses on wholesale and 
institutional markets. Within each branch, there are further divisions 
based on specific financial activities and institutional design, 
including insurance, banking and mortgages, asset management, and 
credit unions. There also exist some internal groups which look at 
specific financial activities in each of the retail and wholesale 
sectors. Therefore, in practice the FSA did not create an effective 
single prudential regulator. Instead it preserved some of its older 
agency divisions, albeit under a single umbrella. Critics of the FSA 
have pointed to the haste with which the FSA was formed and the failure 
of the new integrated regulator to fully overcome the old institutional 
divisions of its former approach to regulation.
    The FSA has admitted on its own to significant failings over 
Northern Rock. An internal FSA report cited inadequate resources 
devoted to overseeing the institution, including high personnel 
turnover and limited direct contact with the institution (no one had 
visited the bank for 3 years), and a failure to push management at the 
bank to modify an eventually disastrous business model. \6\ The U.K. 
Government was determined to develop London as the key financial center 
in Europe and that London could compete effectively with New York. As 
part of this strategy, they instituted ``light touch'' regulation, in 
which financial institutions were given the goals or principles that 
they should follow but were given considerable leeway to determine how 
the goals should be met. While there is some merit in this approach, it 
created significant danger and it meant in practice that U.K. financial 
institutions took on excessive risks. Some U.K. banks developed a 
reputation around the world for lending money to companies that local 
banks would not touch and the regulators were not stopping them from 
taking these bad risks.
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     \6\ Hughes, 2008.
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    Another problem is that there was totally inadequate communication 
between the FSA and the Bank of England. The Bank of England was intent 
on maintaining its independence and focused on its mission of fighting 
inflation. When the crisis struck, the Bank was unwilling to step in 
quickly to support troubled institutions and markets because it had not 
been kept up to date about the condition of the banks and had not been 
tasked with the job of maintaining system stability.
    In summary, the U.K. experience does not provide an appropriate 
counter example for the regulatory model proposed in this testimony. 
They did not create an effective, strong single prudential regulator. 
They did not make the Bank of England responsible for systemic 
stability, nor did they ensure that the Bank of England was informed 
about the condition of the U.K. banks.
    Australia does not have a major financial center serving the global 
market and so it cannot provide an ideal example for the United States 
to copy. Nevertheless, the Australian regulatory reforms seem to have 
been well designed and well-executed and there are some lessons to be 
learned.
    Australia determined that the ``twin peaks'' model was the right 
one and they created the Australian Prudential Regulatory Authority 
(APRA), which is responsible for prudential regulation while the 
Australian Securities and Investment Commission (ASIC) oversees 
conduct-of-business regulation. A cross-agency commission seeks to 
resolve conflicts of overlap and facilitate communication between the 
two agencies.
    The Australian economy weathered the financial crisis better than 
many other developed countries, and its experience owes much of its 
better-than-average performance during the financial crisis to sound 
policy choices and the effectiveness of its financial regulation. There 
was not a housing bubble and there was not the same erosion in lending 
standards as had occurred in the U.S. This was in part due to stricter 
regulation of mortgage lending. Australia's prudential regulator had 
raised capital requirements for banks investing in riskier mortgage 
products. \7\ Consumer protection laws and foreclosure laws also 
discouraged borrowers from taking out mortgages that they could not 
afford.
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     \7\ Ellis, 2009.
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    Until 1998 Australian financial regulation resided with the 
country's Central Bank and took an institutional approach. Following a 
review of the country's overall financial system, the twin peaks 
approach was put into place. As in the U.K., APRA's regulation is a 
largely a principles-based approach, relying heavily on dialogue 
between the regulators and the regulated institutions, but with a 
considerably heavier touch by the regulators to guard against excessive 
risk taking.
    The ASIC oversees securities market and financial services 
providers. ASIC has the power to impose criminal or civil sanctions 
against financial firms or individuals. As a corporate regulator, ASIC 
oversees company directors and officers, capital raising, takeovers, 
financial reporting, etc. It also provides licensing and monitoring for 
financial services firms. In addition, ASIC has been tasked to protect 
consumers against misleading or deceptive conduct related to financial 
products and services.
    The Australian approach is cited as a model for other countries, 
for example in the Paulson Treasury's blueprint, in part because it 
allows flexibility and innovation, while maintaining protections. The 
regulatory structure is not the only reason for the fact that their 
economy avoided the worst of the financial crisis, but it seems to have 
helped. One aspect of the Australian regulatory approach that could 
serve as a model is the process by which it arrived at reform. Where 
the road to reform in the U.K. was hasty and lacked adequate 
consideration, the Australian reform process began with the Wallis 
Inquiry in 1996 to review how financial system reform could be 
structured in Australia. The inquiry looked specifically at how prior 
attempts at deregulation had affected the Australian financial system, 
what forces were at work changing the system further, and what would 
provide the most efficient, effective and competitive regulatory 
structure for the country going forward.
    In summary, Australia provides a good positive example where a 
single prudential regulator has worked well.
                                 ______
                                 
                PREPARED STATEMENT OF RICHARD S. CARNELL
         Associate Professor, Fordham University School of Law
                           September 29, 2009
    Mr. Chairman, Senator Shelby, Members of the Committee: You hold 
these hearings in response to an extraordinary financial debacle, 
costly and far-reaching: a debacle that has caused worldwide pain and 
will saddle our children with an oversized public debt. ``And yet,'' to 
echo President Franklin D. Roosevelt's inaugural address, ``our 
distress comes from no failure of substance. We are stricken by no 
plague of locusts. . . . Plenty is at our doorstep.'' Our financial 
system got into extraordinary trouble--trouble not seen since the Great 
Depression--during a time of record profits and great prosperity.
    This disaster had many causes, including irrational exuberance, 
poorly understood financial innovation, loose fiscal and monetary 
policy, market flaws, regulatory gaps, and the complacency that comes 
with a long economic boom. But our focus here is on banking, where the 
debacle was above all a regulatory failure. Banking is one of our most 
heavily regulated industries. Bank regulators had ample powers to 
constrain and correct unsound banking practices. Had regulators 
adequately used those powers, they could have made banking a bulwark 
for our financial system instead of a source of weakness. In banking, 
as in the system as a whole, we have witnessed the greatest regulatory 
failure in history. Our fragmented bank regulatory structure 
contributed to the debacle by impairing regulators' ability and 
incentive to take timely preventive action. Reform of that structure is 
long overdue.
    In my testimony today, I will:

  1.  Note how regulatory fragmentation has grave defects, arose by 
        happenstance, and persists not on its merits but through 
        special-interest politics and bureaucratic obduracy;

  2.  Recommend that Congress unify banking supervision in a new 
        independent agency; and

  3.  Reinforce the case for reform by explaining how regulatory 
        fragmentation helps give regulators an unhealthy set of 
        incentives--incentives that hinder efforts to protect bank 
        soundness, the Federal deposit insurance fund, and the 
        taxpayers.
I. Fragmentation Impedes Effective Supervision
Fragmentation Is Dysfunctional
    Our fragmented bank regulatory structure is needlessly complex, 
needlessly expensive, and imposes needless compliance costs on banks. 
It ``requires too many banking organizations to deal with too many 
regulators, each of which has overlapping, and too often maddeningly 
different, regulations and interpretations,'' according to Federal 
Reserve Governor John LaWare. It engenders infighting and impedes 
prudent regulatory action. FDIC Chairman William Seidman deplored the 
stubbornness too often evident in interagency negotiations: ``There is 
no power on earth that can make them agree--not the President, not the 
Pope, not anybody. The only power that can make them agree is the 
Congress of the United States by changing the structure so that the 
present setup does not continue.'' The current structure promotes 
unsound laxity by setting up interagency competition for bank 
clientele. It also blunts regulators' accountability with a tangled web 
of overlapping jurisdictions and responsibilities. Comptroller Eugene 
Ludwig remarked that ``it is never entirely clear which agency is 
responsible for problems created by a faulty, or overly burdensome, or 
late regulation. That means that the Congress, the public, and 
depository institutions themselves can never be certain which agency to 
contact to address problems created by a particular regulation.''
    Senator William Proxmire, longtime Chairman of this Committee, 
called this structure ``the most bizarre and tangled financial 
regulatory system in the world.'' Treasury Secretary Lloyd Bentsen 
branded it ``a spider's web of overlapping jurisdictions that 
represents a drag on our economy, a headache for our financial services 
industry, and a source of friction within our Government.'' Chairman 
Seidman derided it as ``complex, inefficient, outmoded, and archaic.'' 
The Federal Reserve Board declared it ``a crazy quilt of conflicting 
powers and jurisdictions, of overlapping authorities, and gaps in 
authority'' (and that was in 1938, when the system was simpler than 
now). Federal Reserve Vice Chairman J.L. Robertson went further:

        The nub of the problem . . . is the simple fact that we are 
        looking for, talking about, and relying upon a system where no 
        system exists. . . . Our present arrangement is a happenstance 
        and not a system. In origin, function, and effect, it is an 
        amalgam of coincidence and inadvertence.

    Opponents of reform portray a unified supervisory agency as ominous 
and unnatural. Yet although the Federal Government regulates a wide 
array of financial institutions, no other type of institution has 
competing Federal regulators. Not mutual funds, exchange-traded funds, 
or other regulated investment companies. Not securities broker-dealers. 
Not investment advisers. Not futures dealers. Not Government-sponsored 
enterprises. Not credit unions. Not pension funds. Not any other 
financial institution. A single Federal regulator is the norm; 
competition among Federal regulators is an aberration of banking.



    Nor do we see competition among Federal regulators when we look 
beyond financial services--and for good reason. Senator Proxmire 
observed:

        Imagine for a moment that we had seven separate and distinct 
        Federal agencies for regulating airline safety. Imagine further 
        the public outcry that would arise following a series of 
        spectacular air crashes while the seven regulators bickered 
        among themselves on who was to blame and what was the best way 
        to prevent future crashes.

        There is no doubt in my mind that the public would demand and 
        get a single regulator. There is a growing consensus among 
        experts that our divided regulatory system is a major part of 
        the problem. There are many reasons for consolidating financial 
        regulations, but most of them boil down to getting better 
        performance.
Fragmentation Is the Product of Happenstance
    Two forces long shaped American banking policy: distrust of banks, 
particularly large banks; and crises that necessitated a stronger 
banking system. Our fragmented regulatory structure reflects the 
interplay between these forces. As FDIC Chairman Irvine H. Sprague 
noted, this structure ``had to be created piecemeal, and each piece had 
to be wrested from an economic crisis serious enough to muster the 
support for enactment.''
    Distrust of banking ran deep from the beginning of the Republic. 
John Adams, sober and pro-business, declared that ``banks have done 
more injury to the religion, morality, tranquility, prosperity, and 
even wealth of the Nation than they have done or ever will do good.'' 
Thomas Jefferson asserted that states ``may exclude [bankers] from our 
territory, as we do persons afflicted with disease.'' Andrew Jackson 
won reelection pledging to destroy the Nation's central bank, which he 
likened to a malicious monster. This powerful, longstanding distrust of 
banking shaped U.S. law in ways that, until recent decades, kept U.S. 
banks smaller and weaker (relative to the size of our economy) than 
their counterparts in other developed countries.
    Yet banking proved too useful to ignore or suppress. To cope with 
financial emergencies, Congress acted to strengthen the banking system. 
It created:

    National banks to finance the Civil War and the OCC to 
        supervise national banks;

    The Federal Reserve in response to the Panic of 1907;

    The FDIC, its thrift-institution counterpart, and the 
        Federal thrift charter to help stabilize the financial system 
        during the Great Depression; and

    The Office of Thrift Supervision in response to the thrift 
        debacle of the 1980s.

These and other ad hoc actions gave us a hodgepodge of bank regulatory 
agencies unparalleled in the world. Each agency, charter type, and 
regulatory subcategory developed a political constituency resistant to 
reform.
    The Bank Holding Company Act, another product of happenstance, 
exacerbated this complexity. It ultimately gave most banking 
organizations of any size a second Federal regulator: the Federal 
Reserve Board. As enacted in 1956, the Act sought to prevent ``undue 
concentration of economic power'' by limiting banks' use of holding 
companies to enter additional businesses and expand across State lines. 
The Act reflected a confluence of three disparate forces: populist 
suspicion of bigness in banking; special-interest politics; and the 
Federal Reserve Board's desire to bolster its jurisdiction. 
Representative Wright Patman, populist chairman of the House Banking 
Committee, sought to prevent increased concentration in banking and the 
broader economy. Small banks sought to keep large banks from expanding 
into new products and territory. A variety of other firms sought to 
keep banks out of their businesses. The Fed gained both expanded 
jurisdiction and a respite from Chairman Patman's attempts to curtail 
its independence in monetary policy. \1\ The Act originally applied 
only to companies owning two or more banks. But in 1970 Congress 
extended the Act to companies owning a single bank.
---------------------------------------------------------------------------
     \1\ Mark J. Roe, ``Strong Managers, Weak Owners: The Political 
Roots of American Corporate Finance'', 99-100 (1994).
---------------------------------------------------------------------------
Special-Interest Politics Perpetuate Fragmentation
    Regulatory fragmentation leaves individual agencies smaller, 
weaker, and more vulnerable to pressure than a unified agency would be. 
It can also undercut their objectivity. Fragmentation played a pivotal 
role in the thrift debacle. Specialized thrift regulators balked at 
taking strong, timely action against insolvent thrifts. Regulators 
identified with the industry and feared that stern action would sharply 
shrink the industry and jeopardize their agencies' reason for being. In 
seeking to help thrifts survive, the regulators multiplied the ultimate 
losses to the deposit insurance fund and the taxpayers. For example, 
they granted sick thrifts new lending and investment powers for which 
the thrifts lacked the requisite competence (e.g., real estate 
development and commercial real estate lending).
    By contrast, bank regulators who also regulated thrifts took 
firmer, more appropriate action (e.g., limiting troubled institutions' 
growth and closing deeply insolvent institutions). These policies bore 
fruit in lower deposit insurance losses. State-chartered thrifts 
regulated by State banking commissioners were less likely to fail--and 
caused smaller insurance losses--than thrifts with a specialized, 
thrift-only regulator. Likewise, thrifts regulated by the FDIC fared 
far better than those regulated by the thrift-only Federal Home Loan 
Bank Board.
II. Unifying Federal Bank Supervision
    Fragmentation problems have a straightforward, common-sense 
solution: unifying Federal bank regulation. Treasury Secretary Lloyd 
Bentsen offered that solution here in this room 15 years ago. As 
Assistant Secretary of the Treasury for Financial Institutions, I 
worked with him in preparing that proposal. He made a cogent case then, 
and I'll draw on it in my testimony now.
    Secretary Bentsen proposed that we unify the supervision of banks, 
thrifts, and their parent companies in a new independent agency, the 
Federal Banking Commission. The agency would have a five-member board, 
with one member representing the Treasury, one member representing the 
Federal Reserve, and three independent members appointed by the 
President and confirmed by the Senate. The President would designate 
and the Senate confirm one of the independent members to head the 
agency.
    The commission would assume all the existing bank regulatory 
responsibilities of the Comptroller of the Currency, Federal Reserve 
Board, FDIC, and Office of Thrift Supervision. The Federal Reserve 
would retain all its other responsibilities, including monetary policy, 
the discount window, and the payment system. The FDIC would retain all 
its powers and responsibilities as deposit insurer, including its power 
to conduct special examinations, terminate insurance, and take back-up 
enforcement action. The three agencies' primary responsibilities would 
correspond to the agencies' core functions: bank supervision, central 
banking, and deposit insurance.
    This structure would promote clarity, efficiency, accountability, 
and timely action. It would also help the new agency maintain its 
independence from special-interest pressure. The agency would be larger 
and more prominent than its regulatory predecessors and would supervise 
a broader range of banking organizations. It would thus be less 
beholden to a particular industry clientele--and more able to carry out 
appropriate preventive and corrective action. Moreover, a unified 
agency could do a better job of supervising integrated banking 
organizations--corporate families in which banks extensively interact 
with their bank and nonbank affiliates. The agency would look at the 
whole organization, not just some parts. Secretary Bentsen put the 
point this way:

        Under today's bank regulatory system, any one regulator may see 
        only a limited piece of a dynamic, integrated banking 
        organization, when a larger perspective is crucial both for 
        effective supervision of the particular organization and for an 
        understanding of broader industry conditions and trends.

Having the same agency oversee banks and their affiliates both 
simplifies compliance and makes supervision more effective. We have no 
need for a separate holding company regulator.
    Under the Bentsen proposal, the Fed and FDIC would have full access 
to supervisory information about depository institutions and their 
affiliates. Their examiners could participate regularly in examinations 
conducted by the commission and maintain their expertise in sizing up 
banks. As members of a Federal Banking Commission-led team, Fed and 
FDIC examiners could scrutinize the full spectrum of FDIC-insured 
depository institutions, including national banks. The two agencies 
would have all the information, access, and experience needed to carry 
out their responsibilities.
    The Treasury consulted closely with the FDIC in developing its 1994 
reform proposal. The FDIC supported regulatory consolidation in 
testimony before this Committee on March 2, 1994. It stressed that in 
the context of consolidation it had five basic needs. First, to remain 
independent. Second, to retain authority to set insurance premiums and 
determine its own budget. Third, to have ``timely access'' to 
information needed to ``understand and stay abreast of the changing 
nature of the risks facing the banking industry . . . and to conduct 
corrective resolution and liquidation activities.'' Fourth, to retain 
power to grant and terminate insurance, assure prompt corrective 
action, and take back-up enforcement action. Fifth, to retain its 
authority to resolve failed and failing banks.
    A regulatory unification proposal can readily meet all five of 
those needs. Indeed, Secretary Bentsen's proposal dealt with most of 
them in a manner satisfactory to the FDIC. The Treasury and FDIC did 
disagree about FDIC membership on the Federal Banking Commission. The 
FDIC regarded membership as an important assurance of obtaining timely 
information. The Treasury proposal did not provide for an FDIC seat, 
partly out of concern that it would entail expanding the commission to 
seven members. Now as then, I believe that the agency's board should 
include an FDIC representative.
    The Federal Reserve and FDIC complain that they cannot properly do 
their jobs unless they remain the primary Federal regulator of some 
fraction of the banking industry. These complaints ignore the sort of 
safeguards in Secretary Bentsen's proposal. They also exaggerate the 
significance of the two agencies' current supervisory responsibilities. 
FDIC-supervised banks hold only 17 percent of all FDIC-insured 
institutions' aggregate assets; Fed-supervised banks, only 13 percent. 
Nor does the Fed's bank holding jurisdiction fundamentally alter the 
picture: the Fed as holding company regulator neither examines nor 
supervises other FDIC-insured institutions. The Fed and FDIC, in 
carrying out their core responsibilities, already rely primarily on 
supervisory information provided by others.
    Thus it strains credulity to suggest that the FDIC cannot properly 
carry out its insurance and receivership functions unless it remains 
the primary Federal regulator of State nonmember banks. These banks, 
currently numbering 5,040, average $460 million in total assets. How 
many community banks must the FDIC supervise to remain abreast of 
industry trends and remember how to resolve a community bank? Likewise, 
the Fed cannot plausibly maintain that its ability to conduct monetary 
policy, operate the discount window, and gauge systemic risk 
appreciably depends on remaining the primary Federal regulator of 860 
State member banks (only 10 percent of FDIC-insured institutions), 
particularly when those banks average less than $2 billion in total 
assets. Moreover, according to the most recent Federal Reserve Flow of 
Funds accounts, the entire commercial banking industry (including U.S.-
chartered commercial banks, foreign banks' U.S. offices, and bank 
holding companies) holds only some 18 percent of our Nation's credit-
market assets. In sum, the two agencies' objections to reform ring 
false. They are akin to saying, ``I can't do my job right without being 
the supreme Federal regulator for some portion of the banking industry, 
small though that portion may be. Nothing else will do.''
    Nor do regulatory checks and balances depend on perpetuating our 
multiregulator jumble. ``Regulatory power is not restrained by creating 
additional agencies to perform duplicate functions,'' Secretary Bentsen 
rightly declared. A unified banking supervisor would face more 
meaningful constraints from ``congressional oversight, the courts, the 
press, and market pressures.'' Its decision making would also, under my 
recommendations, include the insights, expertise, and constant 
participation of the Federal Reserve Board and FDIC.
III. Regulatory Fragmentation Promotes Unsound Laxity
    Most debate about banking regulation pays little heed to bank 
regulators' incentives. That's a serious mistake, all the more so given 
the recent debacle. As noted at the outset, regulators had ample powers 
to keep banks safe but failed to do so. This failure partly involved 
imperfect foresight (an ailment common to us all). But it also 
reflected an unhealthy set of incentives--incentives that tend to 
promote unsound laxity. These incentives discouraged regulators from 
taking adequate steps to protect bank soundness, the Federal deposit 
insurance fund, and the taxpayers. Economists refer to such incentives 
as ``perverse'' because they work against the very goals of banking 
regulation. These incentives represent the regulatory counterpart of 
moral hazard. Just as moral hazard encourages financial institutions to 
take excessive risks, these incentives discourage regulators from 
taking adequate precautions. To improve regulation, we need to give 
regulators a better set of incentives--incentives more compatible with 
protecting the FDIC and the taxpayers.
    Several key factors create perverse incentives for bank regulators. 
First, we have difficulty telling good regulation from bad--until it's 
too late. Second, lax regulation is more popular than stringent 
regulation--until it's too late. Third, regulators' reputations suffer 
less from what goes wrong on their watch than from what comes to light 
on their watch. This is the upshot:

        Bank Soundness Regulation Has No Political Constituency--Until 
        It's Too Late.

    To make the incentive problem more concrete, put yourself in the 
position of a regulator who, during a long economic boom and a possible 
real estate bubble, sees a need to raise capital standards. The 
increase will have short-term, readily identifiable consequences. To 
comply with the new standards, banks may need to constrain their 
lending and reduce their dividends. Prospective borrowers will 
complain. Banks' return on equity will decline because banks will need 
more equity per dollar of deposits. Hence bankers will complain. You'll 
feel immediate political pain. Yet the benefits of higher capital 
standards, although very real, will occur over the long run and be less 
obvious than the costs. Raising capital levels will help protect the 
taxpayers, but the taxpayers won't know it. Moreover, in pressing 
weaker banks to shape up and in limiting the flow of credit to real 
estate, you may get blamed for causing problems that already existed. 
From the standpoint of your own self-interest, you're better off not 
raising capital standards. You can leave office popular. By the time 
banks get into trouble, you'll have a new job and your successor will 
have to shoulder the problem.
    Similar incentives encourage too-big-to-fail treatment. Bailouts 
confer immediate, readily identifiable benefits. By contrast, the costs 
of intervention (such as increased moral hazard and potential for 
future instability) are long-term, diffuse, and less obvious. But you 
can leave those problems for another day and another regulator. You 
risk criticism whether or not you intervene. But on balance you run a 
greater risk of destroying your reputation if you let market discipline 
take its course. Unwarranted intervention may singe your career; a 
seemingly culpable failure to intervene will incinerate it.
    Bank regulators need better incentives far more than they need new 
regulatory powers. Creating a unified regulator will make for a 
healthier set of incentives.
Conclusion
    Now is the right time to fix the bank regulatory structure: now, 
while we're still keenly aware of the financial debacle; now, while 
special-interest pressure and bureaucratic turf struggles are less 
respectable than usual. Reform should promote efficiency, sharpen 
accountability, and help regulators withstand special-interest 
pressure.
    Speaking from this table in 1994, Secretary Bentsen underscored the 
risk of relying on ``a dilapidated regulatory system that is ill-
designed to prevent future banking crises and ill-equipped to cope with 
crises when they occur.'' He observed, in words eerily applicable to 
the present, that our country had ``just emerged from its worst 
financial crisis since the Great Depression,'' a crisis that our 
cumbersome bank regulatory system ``did not adequately anticipate or 
help resolve.'' He also issued this warning, which we would yet do well 
to heed: ``If we fail to fix [the system] now, the next financial 
crisis we face will again reveal its flaws. And who suffers then? Our 
banking industry, our economy, and, potentially, the taxpayers. You 
have the chance to help prevent that result.''
                PREPARED STATEMENT OF RICHARD J. HILLMAN
  Managing Director, Financial Markets and Community Investment Team, 
                    Government Accountability Office
                           September 29, 2009



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