[Congressional Record (Bound Edition), Volume 156 (2010), Part 3]
[Senate]
[Pages 3182-3187]
[From the U.S. Government Publishing Office, www.gpo.gov]




                           WALL STREET REFORM

  Mr. KAUFMAN. Madam President, financial regulatory reform is perhaps 
the most important legislation the Congress will address for many years 
to come. If we do not get it right, the consequences of another 
financial meltdown could be devastating.
  In the Senate, as we continue to move closer to consideration of a 
landmark bill, however, we are still far short of addressing some of 
the fundamental problems--particularly that of too big to fail--that 
caused the last crisis and already have planted the seeds for the next 
one. This is happening after months of careful deliberation and 
negotiations and just a year and a half after the virtual meltdown of 
our entire financial system.
  Following the Great Depression, the Congress built a legal and 
regulatory edifice that endured for decades. One of its cornerstones 
was the Glass-Steagall Act, which established a firewall between 
commercial and investment banking activities. Another was the federally 
guaranteed insurance fund to back up bank deposits. There were other 
rules imposed on investors and designed to tamp down on rampant 
speculation--Federal rules such as margin requirements and the uptick 
rule for short selling.
  That edifice worked well to ensure financial stability for decades. 
But in the past thirty years, the financial industry, like so many 
others, went through a process of deregulation. Bit by bit, many of the 
protections and standards put in place by the New Deal were 
methodically removed. And while the seminal moment came in 1999 with 
the repeal of Glass-Steagall, that formal rollback was primarily the 
confirmation of a lengthy process already underway.
  Indeed, after 1999, the process only accelerated. Financial 
conglomerates that combined commercial and investment banking 
consolidated, becoming more leveraged and interconnected through ever 
more complex transactions and structures, all of which made our 
financial system more vulnerable to collapse. A shadow banking industry 
grew to larger proportions than even the banking industry itself, 
virtually unshackled by any regulation. By lifting basic restraints on 
financial markets and institutions, and more importantly, failing to 
put in place new rules as complex innovations arose and became 
widespread, this deregulatory philosophy unleashed the forces that 
would cause our financial crisis.
  I start by asking a simple question: Given that deregulation caused 
the crisis, why don't we go back to the statutory and regulatory 
frameworks of the past that were proven successes in ensuring financial 
stability? This is basically a conservative question and I am a 
conservative on this issue. Why don't we go back to what has worked in 
the past?
  And what response do I hear when I raise this rather obvious 
question? That we have moved beyond the old frameworks, that the eggs 
are too scrambled, that the financial industry has become too 
sophisticated and modernized and that it was not this or that piece of 
deregulation that caused the crisis in the first place.
  Mind you, this is a financial crisis that necessitated a $2.5 
trillion bailout. And that amount includes neither the many trillions 
of dollars more that were committed as guarantees for toxic debt nor 
the de facto bailout that banks received through the Federal Reserve's 
easing of monetary policy. The crisis triggered a Great Recession that 
has thrown millions out of work, caused millions to lose their homes, 
and caused everyone to suffer in an American economy that has been 
knocked off its stride for more than 2 years.
  Given the high costs of our policy and regulatory failures, as well 
as the reckless behavior on Wall Street, why should those of us who 
propose going back to the proven statutory and regulatory ideas of the 
past bear the burden of proof? The burden of proof should be upon those 
who would only tinker at the edges of our current system of financial 
regulation. After a crisis of

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this magnitude, it amazes me that some of our reform proposals 
effectively maintain the status quo in so many critical areas, whether 
it is allowing multitrillion-dollar financial conglomerates that house 
traditional banking and speculative activities to continue to exist and 
pose threats to our financial system, permitting banks to continue to 
determine their own capital standards, or allowing a significant 
portion of the derivatives market to remain opaque and lightly 
regulated.
  To address these problems, Congress needs to draw hard lines that 
provide fundamental systemic reforms, the very kind of protections we 
had under Glass-Steagall. We need to rebuild the wall between the 
government-guaranteed part of the financial system and those financial 
entities that remain free to take on greater risk. We need limits on 
the size of systemically significant nonbank players. And we need to 
effectively regulate the derivatives market that caused so much 
widespread financial ruin. It is my sincere hope that we don't enact 
compromise measures that give only the illusion of change and a false 
sense of accomplishment. If we do, then we will only have set in place 
the prelude to the next financial crisis.
  First, however, let us examine the origins--both obscure and well-
known--of the Great Recession of 2008. As I have already noted, the 
regulators began tearing down the walls between commercial banking and 
investment banking long before the repeal of Glass-Steagall. Through a 
series of decisions in the 1980s and 1990s, the Federal Reserve 
liberalized prudential limitations placed upon commercial banks, 
allowing them to engage in securities underwriting and trading 
activities, which had traditionally been the particular province of 
investment banks. One fateful decision in 1987 to relax Glass-Steagall 
restrictions passed over the objections of then Federal Reserve 
Chairman Paul Volcker, the man who is today leading the charge to 
restrict government-backed banks from engaging in proprietary trading 
and other speculative activities.
  With the steady erosion of these protections by the Federal Reserve, 
the repeal of Glass-Steagall had become a fait accompli even before the 
passage of the Gramm Leach Bliley Act in 1999. In effect, by passing 
GLBA, Congress was acknowledging the reality in the marketplace that 
commercial banks were already engaging in investment banking. As the 
business of finance moved from bank loans to bonds and other forms of 
capital provided by investors, commercial banks pushed the Federal 
Reserve to relax Glass-Steagall standards to allow them to underwrite 
bonds and make markets in new products like derivatives. Even before 
GLBA was passed, J.P. Morgan, Citigroup, Bank of America and their 
predecessor organizations had all become leaders in those businesses.
  If the changes in the financial marketplace that led to the repeal of 
Glass-Steagall took place over many years, the market's transformation 
after 1999 was swift and profound.
  First, there was frenzied merger activity in the banking sector, as 
financial supermarkets that had bank and nonbank franchises under the 
umbrella of a single holding company bought out smaller rivals to gain 
an ever-increasing national and international footprint. While the 
Riegle-Neal Banking Act of 1994, which established a 10 percent cap 
nationally on any particular bank's share of federally insured 
deposits, should have been a barrier for at least some of these 
mergers, regulatory forbearance permitted them to go through anyway. In 
fact, then Citicorp's proposed merger Travelers Insurance was actually 
a major rationale behind the Glass-Steagall Act. Most of the largest 
banks are products of serial mergers. For example, J.P. Morgan Chase is 
a product of J.P. Morgan, Chase Bank, Chemical Bank, Manufacturers 
Hanover, Banc One, Bear Stearns, and Washington Mutual. Meanwhile, Bank 
of America is an amalgam of that predecessor bank, Nation's Bank, 
Barnett Banks, Continental Illinois, MBNA, Fleet Bank, and finally 
Merrill Lynch.
  Second, the business of finance was changing. Disintermediation, the 
process by which investors directly fund businesses and individuals 
through securities markets, was already in full bloom by the time of 
the repeal of Glass-Steagall. This was demonstrated by the dramatic 
growth in money market fund and mutual fund assets and by the fact that 
corporate bonds actually exceeded nonmortgage bank loans by the middle 
of the 1990s.
  The subsequent boom in structured finance took this process to ever 
greater heights. Securitization, whereby pools of illiquid loans and 
other assets are structured, converted and marketed into asset-backed 
securities, ABS, is in principle a valuable process that facilitates 
the flow of credit and the dispersion of risk beyond the banking 
system. Regulatory neglect, however, permitted a good model to mutate 
and grow into a sad farce.
  On one end of the securitization supply chain, regulators allowed 
underwriting standards to erode precipitously without strengthening 
mortgage origination regulations or sounding the alarm bells on harmful 
nonbank actors--not even those within bank holding companies over which 
the regulators had jurisdiction. On the other, securities backed by 
risky loans were transformed into securities deemed ``hi-grade'' by 
credit rating agencies, only after a dizzying array of steps where 
securities were packaged and repackaged into many layers of senior 
tranches, which had high claims to interest and principal payments, and 
subordinate tranches.
  The nonbanking actors--investment banks, hedge funds, money market 
funds, off-balance-sheet investment funds--that powered structured 
finance came to be known as the shadow banking market. Of course, the 
shadow banking market could only have grown to surpass by trillions of 
dollars the actual banking market with the consent of regulators.
  In fact, one of the primary purposes behind the securitization market 
was to arbitrage bank capital standards. Banks that could show 
regulators that they could offload risks through asset securitizations 
or through guarantees on their assets in the form of derivatives called 
credit default swaps received more favorable regulatory capital 
treatment, allowing them to build their balance sheets to more and more 
stratospheric levels.
  With the completion of the Basel II Capital Accord, determinations on 
capital adequacy became dependent on the judgments of rating agencies 
and, increasingly, the banks' own internal models. While this was a 
recipe for disaster, it reflected in part the extent to which the size 
and complexity of this new era of quantitative finance exceeded the 
regulators' own comprehension.
  When Basel II was effectively applied to investment banks like Lehman 
Brothers and Goldman Sachs, which had far more precarious and 
potentially explosive business models that utilized overnight funding 
to finance illiquid inventories of assets, the results were even worse. 
The SEC, which had no track record to speak of with respect to ensuring 
the safety and soundness of financial institutions, allowed these 
investment banks to leverage a small base of capital over 40 times into 
asset holdings that, in some cases, exceeded $1 trillion.
  Third, little more than a year after repealing Glass-Steagall, 
Congress passed legislation--the Commodity Futures Modernization Act of 
2000--to allow over-the-counter derivatives to essentially remain 
unregulated. Following the collapse of the hedge fund Long Term Capital 
Management in 1998, then Commodities Futures Trading Commission 
Chairwoman Brooksley Born began to warn of problems in this market. 
Unfortunately, her calls for stronger regulation of the derivatives 
market clashed with the uncompromising free-market philosophies of 
Federal Reserve Chairman Alan Greenspan, then Treasury Secretary Robert 
Rubin and later Treasury Secretary Larry Summers. To head off any 
attempt by the CFTC or another agency from regulating this market, they 
successfully convinced Congress to pass the CFMA.
  The explosive growth of the OTC derivatives market following the 
passage

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of the CFMA was stunning--the size of the OTC derivatives market grew 
from just over $95 trillion at the end of 2000 to over $600 trillion in 
2009. This growth had profound implications for the overall risk 
profile of the financial system. While derivatives can be used as a 
valuable tool to mitigate or hedge risk, they can also be used as an 
inexpensive way to take on leverage and risk. As I noted before, 
certain OTC derivatives called credit default swaps were crucial in 
allowing banks to evade their regulatory capital requirements. In other 
contexts, CDS contracts have been used to speculate on the credit 
worthiness of a particular company or asset.
  But they pose other problems as well. Since derivatives represent 
contingent liabilities or assets, the risks associated with them are 
imperfectly accounted for on company balance sheets. And they have 
concentrated risk in the banking sector, since even before the repeal 
of Glass-Steagall, large commercial banks like J.P. Morgan were major 
derivatives dealers. Finally, the proliferation of derivatives has 
significantly increased the interdependence of financial actors while 
also overwhelming their back-office infrastructure. Hence, while the 
growth of derivatives greatly increased counterparty credit risks 
between financial institutions--the risk, that is, that the other party 
will default at some point during the life of the derivative contract--
those entities had little ability to quantify those risks, let alone 
manage them.
  Therefore, on the eve of what was arguably the biggest economic 
crisis since the Great Depression, which was caused in large part by 
the confluence of all the forces and trends that I have just described, 
the financial industry was larger, more concentrated, more complex, 
more leveraged and more interconnected than ever before. Once the 
subprime crisis hit, it spread like a contagion, causing a collapse in 
confidence throughout virtually the entire financial industry. And 
without clear walls between those institutions the government insures 
and those that are free to take on excessive leverage and risk, the 
American taxpayer was called upon to step forward into the breach.
  Unfortunately, the government's response to the financial meltdown 
has only made the industry bigger, more concentrated and more complex. 
As the entire financial system was imploding following the bankruptcy 
filing by Lehman Brothers, the Treasury and the Federal Reserve hastily 
arranged mergers between commercial banks, which had a stable source of 
funding in insured deposits, and investment banks, whose business model 
depended on market confidence to roll over short-term debt.
  Before the Lehman bankruptcy, Bear Stearns had been merged into J.P. 
Morgan. After the Lehman collapse, one of the biggest mergers to occur 
was between Bank of America and Merrill Lynch. And Ken Lewis, the CEO 
of Bank of America at the time, alleges that it was consummated only 
following pressure he received from Treasury Secretary Hank Paulson and 
Federal Reserve Chairman Ben Bernanke.
  As merger plans for the remaining two investment banks, Goldman Sachs 
and Morgan Stanley, faltered, another plan was hatched. Both Goldman 
Sachs and Morgan Stanley--neither of which had anything even close to 
traditional banking franchises--were both given special dispensations 
from the Federal Reserve to become bank holding companies. This 
provided them with permanent borrowing privileges at the Federal 
Reserve's discount window--without having to dispose of risky assets. 
In a sense, it was an official confirmation that they were covered by 
the government safety net because they were literally ``too big to 
fail.''
  Following the crisis, the U.S. mega banks left standing have even 
more dominant positions. Take the multitrillion-dollar market for OTC 
derivatives. The five largest banks control 95 percent of that market. 
Let me repeat that. The five largest banks control 95 percent of the 
over-the-counter derivatives market. With such strong pricing power, 
these firms could afford to expand dramatically their margins. The 
Federal Reserve estimated that those five banks made $35 billion from 
trading in the first half of 2009 alone. Of course, they used these 
outsized profits from trading activities in derivatives and other 
securities not only to replenish their capital, but also to pay 
billions of dollars in bonuses.
  Large and complex institutions like Citigroup dominate our financial 
industry and our economy. MIT professor Simon Johnson and James Kwak, a 
researcher at Yale Law School, estimate that the six largest U.S. banks 
now have total assets in excess of 63 percent of our overall GDP. Only 
15 years ago, the six largest US banks had assets equal to 17 percent 
of GDP. This is an extraordinary increase. We haven't seen such 
concentration of financial power since the days of Morgan, Rockefeller 
and Carnegie.
  As I stated at the outset, I am extremely concerned that our reform 
efforts to date do little, if anything, to address this most serious of 
problems. By expanding the safety net--as we did in response to the 
last crisis--to cover ever larger and more complex institutions heavily 
engaged in speculative activities, I fear that we may be sowing the 
seeds for an even bigger crisis in only a few years or a decade.
  Unfortunately, the current reform proposals focus more on 
reorganizing and consolidating our regulatory infrastructure, which 
does nothing to address the most basic issue in the banking industry: 
that we still have gigantic banks capable of causing the very financial 
shocks that they themselves cannot withstand.
  Rather than pass the buck to a reshuffled regulatory deck, which will 
still be forced to oversee banks that former FDIC Chairman Bill Isaac 
describes as ``too big to manage, and too big to regulate,'' we must 
draw hard statutory lines between banks and investment houses.
  We must eliminate the problem of ``too big to fail'' by reinstituting 
the spirit of Glass-Steagall, a modern version that separates 
commercial from investment banking activities and imposes strict size 
and leverage limits on financial institutions.
  We must also establish clear and enforceable rules of the road for 
our securities market in the interest of making them less fragmented, 
opaque and prone to collapse. The over-the-counter derivatives market 
must be tightly regulated, as originally proposed by Brooksley Born--
and rejected by Congress--in the late 1990s.
  Finally, I believe the myriad conflicts of interest on Wall Street 
must be addressed through greater protection and empowerment of 
individual investors. Our antifraud provisions, as represented for 
example by rule 10(b)5, under the 1934 Securities Act, need to be 
strengthened.
  One key reform that has been proposed to address the ``too big to 
fail'' problem is resolution authority. The existing mechanism whereby 
the FDIC resolves failing depository institutions has, by and large, 
worked well. After the experiences of Bear Stearns and Lehman Brothers 
in 2008, it is clear that a similar process should be applied to entire 
bank holding companies and large nonbank institutions.
  While no doubt necessary, this is no panacea. No matter how well 
Congress crafts a resolution mechanism, there can never be an orderly 
wind-down, particularly during periods of serious stress, of a $2-
trillion institution like Citigroup that had hundreds of billions of 
off-balance-sheet assets, relies heavily on wholesale funding, and has 
more than a toehold in over 100 countries.
  There is no cross-border resolution authority now, nor will there be 
for the foreseeable future. In the days and weeks following the 
collapse of Lehman Brothers, there was an intense and disruptive 
dispute between regulators in the U.S. and U.K. regarding how to handle 
customer claims and liabilities more generally. Yet experts in the 
private sector and governments agree--national interests make any 
viable international agreement on how financial failures are resolved 
difficult to achieve. A resolution authority based on U.S. law will do 
precisely nothing to address this issue.
  While some believe market discipline would be reimposed by refining 
the

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bankruptcy process, Lehman Brothers demonstrates that the very concept 
of market discipline is illusory with institutions like investment 
banks, which used funds that they borrowed in the repo market to 
finance their own inventories of securities, as well as their own book 
of repurchase agreements, which they provided to hedge funds through 
their prime brokerage business.
  Investment banks, the fulcrum of these institutional arrangements, 
found themselves in a classic squeeze. On one side, their hedge fund 
clients and counterparties withdrew funds and securities in their prime 
brokerage accounts, drew down credit lines and closed out derivative 
positions, all of which caused a massive cash drain on the bank. On the 
other side, the repo lenders, concerned about the value of their 
collateral as well as the effect of the cash drain on the banks' credit 
worthiness, refused to roll over their loans without the posting of 
substantial additional collateral. These circumstances quickly prompted 
a vicious cycle of deleveraging that brought our financial system to 
the brink. With such large, complex and combustible institutions like 
these, there can be no orderly process of winding them down. The rush 
to the exits happens much too quickly.
  That is why we need to directly address the size, the structure and 
the concentration of our financial system.
  The Volcker rule, which would prohibit commercial banks from owning 
or sponsoring ``hedge funds, private equity funds, and purely 
proprietary trading in securities, derivatives or commodity markets,'' 
is a great start, and I applaud Chairman Volcker for proposing that 
purely speculative activities should be moved out of banks. That is why 
I joined yesterday with Senators Jeff Merkeley and Carl Levin to 
introduce a strong version of the Volcker rule. But I think we must go 
further still. Massive institutions that combine traditional commercial 
banking and investment banking are rife with conflicts and are too 
large and complex to be effectively managed.
  We can address these problems by reimposing the kind of protections 
we had under Glass-Steagall. To those who say ``repealing Glass-
Steagall did not cause the crisis, that it began at Bear Stearns, 
Lehman Brothers and AIG,'' I say that the large commercial banks were 
engaged in exactly the same behavior as Bear Stearns, Lehman and AIG--
and would have collapsed had the federal government not stepped in and 
taken extraordinary measures. That is the reason why commerical banks 
did not go under, because we were protecting them because they were too 
big to fail. We let Bear, Lehman and AIG--go under because they were 
not. This seems like a circular argument on why we should not do more 
about commercial banks in this country that are so incredibly large and 
we would be stuck with the same situation we were in during the 
meltdown. Moreover, in response to the last crisis, we increased the 
safety net that covers these behemoth institutions. The result: they 
will continue to grow unchecked, using insured deposits for speculative 
activities without running any real risk of failure on account of their 
size.
  We need to reinstate Glass-Steagall in an updated form to prevent or 
at least severely moderate the next crisis.
  By statutorily splitting apart massive financial institutions that 
house both banking and securities operations, we will both cut these 
firms down to more reasonable and manageable sizes and rightfully limit 
the safety net only to traditional banks. President of the Federal 
Reserve Bank of Dallas Richard Fisher recently stated:

       I think the disagreeable but sound thing to do regarding 
     institutions that are [``too big to fail''] is to dismantle 
     them over time into institutions that can be prudently 
     managed and regulated across borders. And this should be done 
     before the next financial crisis, because it surely cannot be 
     done in the middle of a crisis.

  A growing number of people are calling for this change. They include 
former FDIC Chairman Bill Isaac, former Citigroup chairman John Reed, 
famed investor George Soros, Nobel Prize winning economist Joseph 
Stiglitz, president of the Federal Reserve Bank of Kansas City, Thomas 
Hoenig, and Bank of England Governor, Mervyn King, among others. A 
chastened Alan Greenspan also adds to that chorus, noting:

       If they're too big to fail, they're too big. In 1911 we 
     broke up Standard Oil--so what happened? The individual parts 
     became more valuable than the whole. Maybe that's what we 
     need to do.

  Alan Greenspan, in my opinion, has never been more right.
  But even this extraordinary step of splitting these institutions 
apart is not sufficient. Cleaving investment banking from traditional 
commercial banking will still leave us with massive investment banks, 
some with balance sheets that exceed $1 trillion in assets.
  For that reason, Glass-Steagall would need to be supplemented with 
strict size and leverage constraints. The size limit should focus on 
constraining the amount of nondeposit liabilities at large investment 
banks, which rely heavily on short-term financing, such as repos and 
commercial paper.
  The growth of those funding markets in the run-up to the crisis was 
staggering. One report by researchers at the Bank of International 
Settlements estimated that the size of the overall repo market in the 
United States, Euro region and the United Kingdom totaled approximately 
$11 trillion at the end of 2007. Incredibly, the size was more than $5 
trillion more than the total value of domestic bank deposits at that 
time, which was less than $7 trillion.
  The overreliance on such wholesale financing made the entire 
financial system vulnerable to a classic bank run, the type that we had 
before we instituted a system of deposit insurance and strong bank 
supervision. Remarkably, while there is a prudential cap on the amount 
of deposits a bank can have--even though deposits are already federally 
insured--there is no limit of any kind on liabilities like repos that 
need to be rolled over every day. With a sensible limit on these 
liabilities at each financial institution--for example, as a percentage 
of GDP--we can ensure that never again will the so-called shadow 
banking system eclipse the real banking system.
  In addition, institutions that rely upon market confidence every day 
to finance their balance sheet and market prices to determine the worth 
of their assets should not be leveraged to stratospheric levels. To 
ensure that regulatory forbearance does not permit another Lehman 
Brothers, we should institute a simple statutory leverage requirement, 
that is, a limit on how much firms can borrow relative to how much 
their shareholders have on the line. As I have said in a previous 
speech, a statutory leverage requirement that is based upon banks' core 
capital--i.e., their common stock plus retained earnings--could 
supplement regulators' more highly calibrated risk-based assessments, 
providing a sorely needed gut check that ensures that regulators don't 
miss the forest for the trees when assessing the capital adequacy of a 
financial institution.
  This would push firms back towards the levels of effective capital 
they had in the pre-bailout days--like in the post World War II period 
when our financial system generally functioned well. To be sure, this 
would move our core banks from being predominantly debt financed to 
substantially based on equity. But other parts of our financial system 
already operate well on this basis--with venture capital being the most 
notable example. The return on equity relative to debt would need to 
rise to accommodate this change, but--as long as we preserve a credible 
monetary policy--this is consistent with low interest rates in real 
terms.
  I would also stress that a leverage limit without breaking up the 
biggest banks will have little effect. Because of their implicit 
guarantee, ``too big to fail'' banks enjoy a major funding advantage--
and leverage caps by themselves do not address that. Our biggest banks 
and financial institutions have to become significantly smaller if we 
are to make any progress at all.
  Turning now to derivatives reform, I have already noted how large 
dealer banks completely dominate the OTC marketplace for derivatives, 
an opaque

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market where these banks exert enormous pricing power. For over two 
decades, this market has existed with virtually no regulation 
whatsoever.
  Amazingly, it is a market where the dealers themselves actually set 
the rules for the amount of collateral and margin that needs to be 
posted by different counterparties on trades. Dealers never post 
collateral, while the rules they set for their counterparties are both 
lax and procyclical, meaning that margin requirements tend to increase 
during periods of market turmoil when liquidity is at a premium. The 
complete lack of oversight of these markets has almost brought our 
financial system to its knees twice in 10 years, first with the failure 
of LTCM in 1998, and then with the failure of Lehman Brothers in 2008. 
We have known about these problems for over a decade--yet we have so 
far done nothing to make this market better regulated.
  That is why I applaud CFTC Chairman Gary Gensler's efforts in pushing 
for centralized clearing and regulated electronic execution of 
standardized OTC derivatives contracts as well as more robust 
collateral and margin requirements. Clearinghouses have strong policies 
and procedures in place for managing both counterparty credit and 
operational risks. Chairman Gensler underscores that this would get 
directly at the problem of ``too big to fail'' by stating: ``Central 
clearing would greatly reduce both the size of dealers as well as the 
interconnectedness between Wall Street banks, their customers and the 
economy.'' Moreover, increased clearing and regulated electronic 
trading will make the market more transparent, which will ultimately 
give investors better pricing.
  A strong clearing requirement, however, should not be swallowed by 
large exemptions that circumvent the rules. While I am sympathetic to 
concerns about increased costs raised by nonfinancial corporations that 
use interest rate and currency swaps for hedging purposes, any 
exemption of this sort should be narrowly crafted. For example, it 
might be limited to transactions where non-financial corporations use 
OTC derivatives in a way that qualifies for GAAP hedge accounting 
treatment. In any case, we should recognize more explicitly that when 
such derivatives contracts are provided by too big to fail banks, the 
end users are in effect splitting the hidden taxpayer subsidy with the 
big banks. And remember that this subsidy is not only hidden--it is 
also dangerous, because it is central to the incentives to become 
bigger and to take more risk once any financial firm is large.
  Given that one of the key objectives behind increased clearing is to 
reduce counterparty credit risk, it also seems reasonable that 
derivatives legislation place meaningful constraints on the ownership 
of clearinghouses by large dealer banks.
  Finally, we need to address the fundamental conflicts of interest on 
Wall Street. While separating commercial banking from investment 
banking is a critical step, there are still inherent conflicts within 
the modern investment banking model.
  Let's take the example of auction rate securities. Brokers at UBS and 
other firms marketed these products, which were issued by 
municipalities and not-for-profit entities, as ``safe, liquid cash 
alternatives'' to retail investors even though they were really long-
term debt instruments whose interest rates would reset periodically 
based upon the results of Dutch auctions. In other words, these 
unsuspecting investors would be unable to sell their securities if new 
buyers didn't enter the market, which is exactly what happened. As 
credit concerns by insurers who guaranteed these securities drained 
liquidity from the market, bankers continued to sell these securities 
to retail clients as safe, liquid investments. There was a blatant 
conflict of interest where the banks served as broker to their retail 
customers while also underwriting the securities and conducting the 
auctions.
  There is an open issue of why such transactions did not constitute 
securities fraud, for example under rule 10(b)5--which prohibits the 
nondisclosure of material information. Civil actions are still in 
progress and perhaps we will learn more from the outcomes of particular 
cases. But no matter how these specific cases are resolved, we should 
move to strengthen the legal framework that enables both private 
parties and the SEC--both civil and criminal sides--to bring successful 
enforcement actions.
  Individuals at Enron, Merrill Lynch, and Arthur Anderson were called 
to account for their participation in fraudulent activities--and at 
least one executive from Merrill went to prison for signing off on a 
deal that would help manipulate Enron's earnings. But it is quite 
possible that no one will be held to account, either in terms of 
criminal or civil penalties, due to the deception and misrepresentation 
manifest in our most recent credit cycle. We must work hard to remove 
all the loopholes that helped create this unfair and unreasonable set 
of outcomes.
  We can begin by strengthening investor protection. Currently, brokers 
are not subject to a fiduciary standard as financial advisors are, but 
only subject to a ``suitability'' requirement when selling securities 
products to investors. Hence, brokers don't have to be guided by their 
customers' best interest when recommending investment product 
offerings--they might instead be focused on increasing their 
compensation by pushing proprietary financial products. I am not saying 
they are doing that, but we have to be aware and deal with clear 
conflicts of interest. By harmonizing the standards that brokers and 
financial advisors face and by better disclosing broker compensation, 
retail investors will be able to make better, more informed investment 
decisions. Even Lloyd Blankfein, the CEO of Goldman Sachs, has stated 
that he ``support[s] the extension of a fiduciary standard to broker/
dealer registered representatives who provide advice to retail 
investors. The fiduciary standard puts the interests of the client 
first. The advice-giving functions of brokers who work with investors 
have become similar to that of investment advisers.''
  It has also become known that some firms underwrite securities--
promoting them to investors--and then short these same securities 
within a week and without disclosing this fact, which any reasonable 
investor would regard as adverse material information. In the 
structured finance arena, investment banks sold pieces of 
collateralized debt obligations--which were packages of different 
asset-backed securities divided into different risk classes--to their 
clients and then took--proceeded to take short positions in those 
securities by purchasing credit default swaps. Some banks went further 
by shorting mortgage indexes tied to securities they were selling to 
clients and by shorting their counterparties in the CDS market. This is 
how a firm such as Goldman Sachs could claim that they were effectively 
hedged to an AIG collapse.
  Unfortunately, the use of products like CDS in this way allows the 
banks to become empty creditors who stand to make more money if people 
and companies default on their debts than if they actually paid them. 
These and other problematic practices that place financial firms' 
interests against those of their clients need to be restricted. They 
also completely violate the spirit of our seminal legislation from the 
1930s, which insisted--for the first time--that the sellers and 
underwriters of securities disclose all material information. This is 
nothing less than a return to the unregulated days of the 1920s; to be 
sure, those days were heady and exciting, but only for a while--such 
practices always end in a major crash, with the losses 
disproportionately incurred by small and unsuspecting investors.
  Investors should also have greater recourse through our judicial 
system. For example, auditors, accountants, bankers and other 
professionals that are complicit in corporate fraud should be held 
accountable. That is why I worked on a bill with Senators Specter and 
Reed to allow for private civil actions against individuals who 
knowingly or recklessly aid or abet a violation of securities laws.
  Admittedly, this is not an exhaustive list of financial reforms. I 
also believe we need to reconstitute our system of

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consumer financial protection, which was a major failure before our 
last crisis. We must have an independent Consumer Financial Protection 
Agency, CFPA, that has strong and autonomous rulemaking authority and 
the ability to enforce those rules at nonbanking entities like payday 
lenders and mortgage finance companies. Most importantly, the head of 
this agency must not be subject to the authority of any regulator 
responsible for the ``safety and soundness'' of the financial 
institutions.
  This is basic. If you are involved, like most of our banking 
regulatory agencies, in the Treasury, their primary responsibility is 
the safety and soundness of those financial institutions. We need an 
organization such as the CFPA, which looks out totally for the interest 
of consumers and consumers alone.
  Unfortunately, like the public option in healthcare, the CFPA issue 
has become something of a ``shiny object''--though certainly an 
important one--that has distracted the focus of debate away from the 
core issues of ``too big to fail.''
  Beginning with the solutions for ``too big to fail,'' each of these 
challenges represents a crucial step along the way towards fixing a 
regulatory system that has permitted both large and small failures. 
Each is an important piece to the puzzle.
  I know there are those who will disagree with some, and perhaps all 
of these proposals. They sincerely advocate a path of incrementalism, 
of achieving small reforms over time. They say that problems as complex 
as these need to be solved by the regulators, not by Congress. After 
all, they are the ones with the expertise.
  I respectfully disagree.
  Giving more authority to the regulators is not a complete solution. 
While I support having a systemic risk council and a consolidated bank 
regulator, these are necessary but not sufficient reforms--the 
President's Working Group on Financial Markets has actually played a 
role in the past similar to that of the proposed council, but to no 
discernible effect. I do not see how these proposals alone will address 
the key issue of ``too big to fail.''
  In the brief history I outlined earlier, the regulators sat idly by 
as our financial institutions bulked up on short-term debt to finance 
large inventories of collateralized debt obligations backed by subprime 
loans and leveraged loans that financed speculative buyouts in the 
corporate sector.
  They could have sounded the alarm bells and restricted this behavior, 
but they did not. They could have raised capital requirements, but 
instead farmed out this function to credit rating agencies and the 
banks themselves. They could have imposed consumer-related protections 
sooner and to a greater degree, but they did not. The sad reality is 
that regulators had substantial powers, but chose to abdicate their 
responsibilities.
  What is more, regulators are almost completely dependent on the 
information, analysis and evidence as presented to them by those with 
whom they are charged with regulating. Last year, former Federal 
Reserve Chairman Alan Greenspan, once the paragon of laissez-faire 
capitalism, stated that ``it is clear that the levels of complexity to 
which market practitioners, at the height of their euphoria, carried 
risk management techniques and risk-product design were too much for 
even the most sophisticated market players to handle properly and 
prudently.'' I submit that if these institutions that employ such 
techniques are too complex to manage, then they are surely too complex 
to regulate.
  That is why I believe that reorganizing the regulators and giving 
them additional powers and responsibilities isn't the answer. We cannot 
simply hope that chastened regulators or newly appointed ones will do a 
better job in the future, even if they try their hardest. Putting our 
hopes in a resolution authority is an illusion. It is like the 
harbormaster in Southampton adding more lifeboats to the Titanic, 
rather than urging the ship to steer clear of the icebergs. We need to 
break up these institutions before they fail, not stand by with a plan 
waiting to catch them when they do fail.
  Without drawing hard lines that reduce size and complexity, large 
financial institutions will continue to speculate confidently, knowing 
that they will eventually be funded by the taxpayer if necessary. As 
long as we have ``too big to fail'' institutions, we will continue to 
go through what Professor Johnson and Peter Boone of the London School 
of Economics has termed ``doomsday'' cycles of booms, busts and 
bailouts, a so-called ``doom loop'' as Andrew Haldane, who is 
responsible for financial stability at the Bank of England, describes 
it.
  The notion that the most recent crisis was a ``once in a century'' 
event is a fiction. Former Treasury Secretary Paulson, National 
Economic Council Chairman Larry Summers, and J.P. Morgan CEO Jamie 
Dimon all concede that financial crises occur every 5 years or so.
  Without clear and enforceable rules that address the unintended 
consequences of unchecked financial innovation and which adequately 
protect investors, our markets will remain subverted.
  These solutions are among the cornerstones of fundamental and 
structural financial reform. With them we can build a regulatory system 
that will endure for generations instead of one that will be laid bare 
by an even bigger crisis in perhaps just a few years or a decade's 
time. We built a lasting regulatory edifice in the midst of the Great 
Depression, and it lasted for nearly half a century. I only hope we 
have both the fortitude and the foresight to do so again.

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