[Senate Hearing 111-42]
[From the U.S. Government Publishing Office]
MODERNIZING THE U.S. FINANCIAL REGULATORY SYSTEM
S. Hrg. 111-42
MODERNIZING THE U.S. FINANCIAL
REGULATORY SYSTEM
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
THE GOVERNMENT ACCOUNTABILITY OFFICE'S FRAMEWORK FOR ASSESSING
PROPOSALS TO MODERNIZE THE U.S. FINANCIAL REGULATORY SYSTEM AND THE
GROUP OF 30's RECENT REPORT ON CREATING A FRAMEWORK FOR FINANCIAL
STABILITY
----------
FEBRUARY 4, 2009
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Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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50-564 PDF
______
2009
S. Hrg. 111-42
MODERNIZING THE U.S. FINANCIAL
REGULATORY SYSTEM
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
THE GOVERNMENT ACCOUNTABILITY OFFICE'S FRAMEWORK FOR ASSESSING
PROPOSALS TO MODERNIZE THE U.S. FINANCIAL REGULATORY SYSTEM AND THE
GROUP OF 30's RECENT REPORT ON CREATING A FRAMEWORK FOR FINANCIAL
STABILITY
__________
FEBRUARY 4, 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
?
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
SHERROD BROWN, Ohio JIM DeMINT, South Carolina
JON TESTER, Montana DAVID VITTER, Louisiana
HERB KOHL, Wisconsin MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Colin McGinnis, Acting Staff Director
William D. Duhnke, Republican Staff Director and Chief Counsel
Dean V. Shahinian, Counsel
Jonathan Miller, Committee Professional Staff
Deborah Katz, OCC Detailee
Julie Chon, Senior International Adviser
Lisa Frumin, Legislative Assistant
Drew Colbert, Legislative Assistant
Didem Nisanci, Legislative Assistant
Robert Lee, GAO Detailee
David Stoopler, Legislative Assistant
Emma Palmer, Legislative Assistant
Matthew Pippin, Legislative Assistant
Jonathan Davidson, Legislative Assistant
Tamara Fucile, Legislative Assistant
Mary Perko, Legislative Assistant
Mark Oesterle, Republican Deputy Staff Director
Andrew Olmem, Republican Counsel
Mark Calabria, Senior Professional Staff Member
Mike Nielsen, Legislative Assistant
Gregg Richard, Legislative Assistant
Sarah Novascone, Legislative Assistant
Dawn Ratliff, Chief Clerk
Devin Hartlet, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
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C O N T E N T S
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WEDNESDAY, FEBRUARY 4, 2009
Page
Opening statement of Senator Dodd................................ 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 4
Senator Schumer
Prepared Statement....................................... 48
WITNESSES
Paul A. Volcker, Chairman, Steering Committee of the Group of 30. 7
Prepared statement........................................... 49
Response to written questions of Senator Johnson............. 262
Gene L. Dodaro, Acting Comptroller General, U.S. Government
Accountability Office; accompanied by Orice M. Williams and
Richard J. Hillman............................................. 35
Prepared statement........................................... 126
Response to written questions of Senator Johnson............. 263
Additional Material Supplied for the Record
GAO Report to Congressional Requesters; Corporate Shareholder
Meetings: Issues Relating to Firms That Advise Institutional
Investors on Proxy Voting...................................... 267
GAO Report to the Ranking Minority Member, Committee on Health,
Education, Labor, and Pensions, U.S. Senate; ``Pension Plans:
Additional Transparency and Other Actions Needed in Connection
With Proxy Voting''............................................ 295
Testimony of Yvonne D. Jones, GAO, before the Subcommittee on
Oversight of Government Management, the Federal Workforce, and
the District of Columbia, Committee on Homeland Security and
Governmental Affairs, U.S. Senate; ``Financial Literacy and
Education Commission: Further Progress Needed To Ensure an
Effective National Strategy''.................................. 340
Letter submitted by Derek B. Stewart, GAO, to the Subcommittee on
Oversight of Government Management, the Federal Workforce, and
the District of Columbia, Committee on Governmental Affairs;
``Military Personnel: Bankruptcy Filings Among Active Duty
Service Members''.............................................. 360
Testimony of Valerie C. Melvin, GAO, before the Subcommittee on
Oversight and Investigations, Committee on Financial Services,
House of Representatives; ``Military Personnel: DOD Has Taken
Steps To Address Servicemember's Financial Needs, but
Additional Effort Is Warranted''............................... 369
(iii)
MODERNIZING THE U.S. FINANCIAL REGULATORY SYSTEM
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WEDNESDAY, FEBRUARY 4, 2009
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 3:05 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Christopher J. Dodd (Chairman
of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN DODD
Chairman Dodd. The Committee will come to order.
Let me thank all of my colleagues, and I think you all
understood we intended, obviously, at some time earlier to have
this hearing a little earlier. But as I think all of you may
know, we had an interesting session on our side of the aisle,
gathering today to listen to some of our new economic team
under President Obama, as well as the President himself and
others, talk about many of the issues that are confronting the
country, not the least of which was the issue of the subject
matter of this hearing, the modernization of the U.S. financial
regulatory system. I am particularly honored and delighted to
have Paul Volcker here with us, who has been a friend for many
years, someone I have admired immensely for his contribution to
our country.
How we will proceed is, because we are getting underway
much later than normal for the conducting of Senate hearings,
with the indulgence of my colleagues, I will make some opening
comments myself, turn to Senator Shelby, and then we will go
right to you, if we could, Chairman Volcker. Then I will invite
my colleagues and tell them that any opening comments that they
do not make for themselves, we will include them in the record
as if given. And since there are not many of us here, we can
move along pretty quickly, I hope, as well. So, with that
understanding, we will get underway and, again, I thank all of
you for joining us here today.
Today, we continue the Senate Banking Committee's
examination of how to modernize our outdated financial
regulatory system. We undertake this examination in the midst
of a deepening recession and the worst financial crisis since
the Great Depression in the 20th century. We must chart a
course forward to restore confidence in our Nation's financial
system upon which our economy relies.
Our mission is to craft a framework for 21st century
financial regulation, informed by the lessons we have learned
from the current crisis and designed to prevent the excesses
that have wreaked havoc with homeowners and consumers, felled
financial giants, and plunged our economy into a recession.
This will not be easy, as we all know. We must act
deliberately and thoughtfully to get it right. We may have to
act in phases given the current crisis. But inaction is not an
option at all, and time is not neutral. We must move forcefully
and aggressively to protect consumers, investors, and others
within a revamped regulatory system.
Last Congress, this Banking Committee built a solid
foundation upon which we will base our work today, and I want
to once again thank Dick Shelby, former Chairman of this
Committee, and my colleagues, both Democrats and Republicans,
who played a very, very constructive role in the conduct of
this Committee that allowed us to proceed as we did.
Subcommittees and Committees held 30 hearings to identify
the causes and consequences of this crisis, from predatory
lending and foreclosures, to the collapse of Bear Stearns, the
role of the credit rating agencies, the risks of derivatives,
the regulation of investment banks and the insurance industry,
and the role and condition of banks and thrifts.
The lessons we have learned thus far have been rather
clear, and let me share some of them with you.
Lesson number one: consumer protection matters. The current
crisis started with brokers and lenders making subprime and
exotic loans to borrowers unable to meet their terms. As a
former bank regulator recently remarked to me, ``Quite simply,
consumers were cheated.'' Some lenders were so quick to make a
buck and so certain they could pass the risk on to the next
guy, they ignored all standards of prudent underwriting. The
consumer was the canary in the coal mine, but no one seemed to
notice.
Lesson number two: regulation is fundamental. Many of the
predatory lenders were not regulated. No one was charged with
minding the store. But soon the actions of these unregulated
companies infected regulated institutions. Banks and their
affiliates purchased loans made by mortgage brokers or the
securities or derivatives backed by these loans, relying on
credit ratings that turned out to be wildly optimistic. So we
find that far from being the enemy of well-functioning markets,
reasonable regulation is fundamental to sound and efficient
markets, and necessary to restore the shaken confidence in our
system at home and around the globe.
Lesson number three: regulators must be focused,
aggressive, and energetic cops on the beat. Although banks and
thrifts made fewer subprime and exotic loans than their
unregulated competitors, they did so with impunity. Their
regulators were so focused on banks' profitability, they failed
to recognize that loans so clearly unsafe for consumers were
also a threat to the banks' bottom line. If any single
regulator recognized the abusiveness of these loans, no one was
willing to stand up and say so. And with the Fed choosing not
to use its authority to ban abusive home mortgages, which some
of us have been calling for, for years, the regulators were
asleep at the switch.
Lesson number four: risks must be understood in order to be
managed. Complex instruments, collateralized debt obligations,
credit default swaps designed to manage the risks of the fault
loans that backed them turned out to magnify that risk. The
proliferation of these products spread the risk of subprime and
Alt-A loans like an aggressive cancer through the financial
system. Institutions and regulators alike failed to appreciate
the hidden threat of these opaque instruments, and the current
system of regulators acting in discrete silos did not equip any
single regulator with the tools to identify or address
enterprise or systemwide risks. On top of that, CEOs had little
incentive to ferret out risks to the long-term health of their
companies because too often they were compensated for short-
term profits.
I believe these lessons should form the foundation of our
effort to shape a new, modernized, and, above all, transparent
structure that recognizes consumer protection and the health of
our financial system are inextricably linked. And so in our
hearing today and those to come--and there will be many--I will
be looking for answers to these questions. What structure best
protects the consumer? What additional regulations are needed
to protect consumers from abusive practices? We will explore
whether to enhance the consumer protection mission of the
prudential regulators or create a regulator whose sole job is
protecting the American consumer.
How do we identify and supervise the institutions and
products on which the health of our financial system depends?
Financial products must be more transparent for consumers and
institutional investors alike. But heightened supervision must
not stifle innovation of financial actors and markets.
Third, how do we ensure that financial institution
regulators are independent and effective? We cannot afford a
system where regulators withhold bold and necessary action for
fear that institutions will switch charters to avoid stricter
supervision. We should consider whether a single prudential
regulator is preferable to the alphabet soup of regulators that
we have today.
Fourth, how should we regulate companies that pose a risk
to our system as a whole? Here we must consider whether to
empower a single agency to be the systemic risk regulator. If
that agency is the Federal Reserve Board, we must be mindful of
ensuring the independence and integrity of the Fed's monetary
policy function. Some have expressed a concern--which I share,
by the way--about overextending the Fed when they have not
properly managed their existing authority, particularly in the
area of protecting consumers.
Fifth, how should we ensure that corporate governance
fosters more responsible risk taking by employees? We will seek
to ensure that executives' incentives are better aligned with
the long-term health of their companies, not simply short-term
profits.
Of course, my colleagues and our witnesses today may
suggest other areas. I do not mean to suggest this is the
beginning and end-all of the questions that need to be asked,
and I welcome today's witnesses' as well as our colleagues'
contributions to this discussion and the questions that ought
to be addressed.
I look forward to moving forward collaboratively in this
historic endeavor to create an enduring regulatory framework
that builds on the lessons of the past, restores confidence in
our financial system, and recognizes that our markets and our
economy will only be as strong as those who regulate them and
the laws by which they abide. That is the responsibility of
this Committee. It is the Republican of this Congress. It is
the responsibility of the administration.
I will recognize Senator Shelby for an opening comment and
ask my colleagues if they might withhold statements, at least
at the outset, so we can get to our witnesses.
With that, I turn to Senator Shelby.
STATEMENT OF SENATOR SHELBY
Senator Shelby. Thank you, Mr. Chairman.
Today, the Committee will hear from one of this Nation's
most respected economists and veteran policymakers. Dr. Volcker
is no stranger to this Committee. Senator Dodd and I remember
many years ago when he would come here as Chairman of the
Federal Reserve Board. During the financial crisis in the late
1970s, it was Paul Volcker who helped put our economic house
back in order, and, Dr. Volcker, I welcome you back to the
Committee again.
While I am very interested in the views of our witnesses on
regulatory modernization, I think the hearing could be a little
bit premature. Let me explain.
As I have said many times and will continue to say, I
believe that before we discuss how to modernize our regulatory
structure, or even before we consider how to address the
current financial crisis, we need to first understand its
underlying causes. If we do not have a comprehensive
understanding of what went wrong, we will not be able to
determine with any degree of certainty whether our regulatory
structure was sufficient and failed or was insufficient and
must change.
I understand that next week Chairman Dodd plans to hold a
hearing on the origins of the financial crisis, for which I
commend him. I welcome that hearing, but I believe that one
hearing, or even a handful of hearings, falls well short of
what these exceptional times will demand. Instead, this
Committee should, I believe, and must conduct a full and
thorough investigation of the market practices, regulatory
actions, and economic conditions that led to this crisis.
The Committee should hear testimony from all relevant
parties and produce a written report of its findings. This work
is crucial, I believe, if we are to develop policies that will
help end this crisis and prevent it from occurring again.
While I understand many people have their own views of what
happened, this Committee has yet to make that determination in
a comprehensive and organized manner. As a result, nearly a
year and a half later, we still have not documented what
started the crisis and why it became so severe. The uncertainty
about its origins has not only exacerbated our economic
downturn by undermining confidence in our entire financial
system, but it has left us without a clear understanding of
what needs to be done. We need to remedy that. Thus far, the
efforts of the Treasury Department and the Congress have been
ad hoc at best.
When this all began, I strongly opposed the TARP bailout
legislation because I believed Congress jumped right to a
legislative solution without first identifying the problem it
was trying to solve. Since we never developed a consensus about
what caused this crisis, neither Congress nor the Treasury
Department can devise a targeted solution. And as a result,
TARP has drifted rudderless since it was passed 4 months ago,
wasting taxpayer dollars while the crisis rages on without an
end in sight.
It is well past time that we investigate the origins of the
financial crisis so that we can begin to lay the groundwork for
a bipartisan, effective, and durable solution. In the absence
of such effort, there is now talk of creating a commission to
examine the origin of the financial crisis and to make
recommendations for further action. At this time, I would
oppose the creation of such a commission because a thorough
investigation is something that this Committee can do and must
do. The American people rightly expect their elects
representatives, the Senators here, not unaccountable
commissions to do the work necessary to solve the problems
facing the country.
This Committee is uniquely positioned to conduct a
transparent investigation that could build the necessary
political consensus around the appropriate legislative remedy
that we must seek. This particular Committee has a long history
of conducting such investigations. The best precedent, I
believe, for this type of investigation that our current
economic situation demands is the year-long investigation of
stock market abuses the Committee conducted during the Great
Depression. The so-called Pecora hearings produced a detailed
report exposing a wide range of abuses on Wall Street. The
Committee heard testimony from hundreds of witnesses, producing
nearly 12,000 pages of transcripts from over 100 hearings. The
investigative staff was made up of dozens of individuals and
included attorneys, accountants, and statisticians. They
conducted scores of interviews and sworn depositions. The
Committee subpoenaed corporate records and heard testimony from
the heads of Wall Street and industry, including 3 days of
testimony, I have been told, from Mr. Morgan himself. The
Committee's investigative record comprises 171 boxes in the
National Archives.
The record that the Pecora hearings established ultimately
laid the groundwork for the passage of the Securities Act and
the creation of the Securities and Exchange Commission.
Recently, renowned economic historian Ron Chernow wrote an
editorial in the New York Times calling for Congress to
initiate an investigation in the tradition of the Pecora
hearings. He stated the importance of such an investigation to
resolving the current crisis by pointing out, and I will quote
him:
If history is any guide, legislators can perform a signal
service by moving beyond the myriad details of the rescue plans
to provide a coherent account of the origins of the current
crisis. The moment calls for nothing less than a sweeping
inquest into the twin housing and stock market crashes to
create both the intellectual context and the political
constituency for change.
I believe that he is correct.
The hearings this Committee has held to date on the credit
crisis have been helpful, but I think they have lacked the
focus and purpose displayed during the Pecora hearings, partly
due to the Committee's lack of resources up to this time. To
remedy this problem, Senator Dodd and I have already submitted
an initial request for additional funding and office space for
the Committee. We were recently informed that the Committee is
going to receive additional funding, although not what is
necessary, I believe, to conduct a thorough and fair
investigation.
I am hoping that our colleagues on the Rules Committee
would agree that this type of effort here in the Banking
Committee right now is not only necessary but deserving of
their support. I believe the investigation should start by
calling before the Committee all of the regulators from the
past decade or more who were appointed to make sure this crisis
did not happen, but it did.
The Committee has heard from regulators on their views on
how to solve the crisis, but it has yet to hear from present
and former regulators on what caused the crisis and whether
steps could have been taken to prevent it. The Committee, I
believe, should supplement this testimony with an exhaustive
review of the records of the regulators from that period. Once
again, there will be a time to discuss what needs to be done,
but before we entrust any new or existing regulator with
additional responsibilities or authorities, I believe we need
to know if and how our present regulatory structure failed us.
After we complete a thorough review of the role of the
regulators, we should then call the CEOs of the largest banks,
insurance companies, brokerage firms, home builders, realtors,
and other financial services companies of the past 10 years to
testify. This, of course, would be preceded by an extensive
staff effort to examine the activities of each institution or
industry.
Since the crisis began, the Committee has not yet heard
from Wall Street CEOs on their role in creating the toxic
assets that have spread through our financial system like a
cancer. Nor have they publicly explained why their risk
management systems failed or why they operated with such
dangerous levels of leverage. Because many of these firms have
either failed, received public money, or sought some type of
Federal assistance, I believe they owe it to the American
people to explain how this crisis started and what role they
played in it.
Last year, I called for a hearing to examine the role of
underwriters in spawning the crisis. The Committee announced
that it would hold a hearing to examine underwriting practices,
but it was postponed and is yet to be scheduled. That hearing
could now be part of this effort.
Mr. Chairman, I am willing to work with you, as I have, and
I believe this Committee is uniquely positioned, as you do, to
perform this important service at this time for the American
people. I pledge my full support should you choose to undertake
your own version of the Pecora hearings, as long as they are
comprehensive.
Chairman Dodd. Well, I thank you, Senator, very, very much.
I would just note for the record that there have already been
some proposals, including one from Senator Isakson and Senator
Conrad, for sort of a 9/11 Commission--some of my colleagues
may be aware of this already--to be done outside of this
Committee to go back and examine that, and that has, obviously,
some appeal as well. Certainly we want to examine what
happened, but also we need to go forward.
With that, I thank you very much, Chairman Volcker, for
being with us, and for those are unfamiliar with our first
witness, Chairman Volcker is the Chair of the President's
Economic Recovery Advisory Board, Chairman of the Board of
Trustees of the Group of 30, and former Chairman of the Board
of Governors of the Federal Reserve System. Chairman Volcker
worked in the Federal Government for almost 30 years, including
positions at the Federal Reserve Bank of New York, the Treasury
Department, and Chase Manhattan--he has a wealth of experience.
We thank you for coming and welcome you to the Committee.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, STEERING COMMITTEE OF
THE GROUP OF 30
Mr. Volcker. Thank you, Mr. Chairman, Mr. Shelby, Members
of the Committee. I am delighted to be here. I want to make
clear that I am appearing as Chairman of the Steering Committee
of the Group of 30 and not as Chairman of the President's
Economic Recovery Advisory Board this morning.
Chairman Dodd. It is so noted. We will make that
distinction here.
Mr. Volcker. People accuse me of liking the title
``Chairman,'' but I want to make sure Chairman of what.
[Laughter.]
Mr. Volcker. The Group of 30 is a group of people drawn
from the private and public sectors with experience in finance,
and I emphasize that it is international, and this report was
directed not just toward the United States, although it is
perhaps most relevant to the United States. But it is directed
toward authorities in any country that has extensive financial
operations around the world.
It does not discuss all the origins of the crisis. It does
touch upon it, but that is not my purpose in appearing before
you this morning. What is evident is, whatever the cause is--
and we could go into that. What is evident is that we do meet
at a time, as you have emphasized, of acute distress in
financial markets. Strongly adverse effects on the economy more
broadly are apparent. There is a clear need, I think, for early
and effective governmental programs. They cannot wait a year
for attacking the immediate problems to support economic
activity and to ease the flow of credit. But I think it is also
evident that more fundamental changes are needed in the
financial system, and they will take some time to work out.
But to the extent that we have some sense of the direction
of those reform efforts, I think it will help the more
immediate problem. The important thing is that we do not and
should not want to contemplate a repetition of this experience,
and that is what this report is aimed at, and I am sure will be
your concerns over time.
I understand that President Obama and his people are going
to be placing before you some more immediate measures. They are
not the subject of our report. But when we look further ahead,
I do think the more we have a sense of the longer-term future,
the better place you will be for appraising the immediate
actions to make sure they are consistent with what we would
like to see in the longer run.
The basic thrust of the G-30 report is to distinguish among
the basic functions of any financial system. First, there is a
need for strong and stable institutions that serve the needs of
individuals, of businesses, of governments, and others for a
safe and sound repository of funds, providing a reliable source
of credit, and maintaining a robust financial infrastructure
able to withstand and diffuse shocks and volatility that are
inevitable in the future. I think of that as the service-
oriented part of the financial system. It deals primarily with
customer relationships. It is characterized mainly by
commercial banks that have long been supported and protected by
deposit insurance, by access to the Federal Reserve credit, and
by other elements of the so-called Federal safety net.
Now, what has become apparent during this period of crisis
is increasing concentration in banking and the importance of
official support for what is known as systemically important
institutions when they become at risk of failure. What is
apparent is that a sudden breakdown or discontinuity in the
functioning of those institutions risks widespread
repercussions on markets, on closely interconnected financial
institutions, and at the end of the day, on the broader
economy.
The design of any financial system raises large questions
about the appropriate criteria for, and the ways and means of,
providing official support for these systemically important
institutions.
In common ground with virtually all official and private
analysts, the G-30 Report calls for ``particularly close
regulation and supervision, meeting high and common
international standards'' for such institutions deemed
systemically critical. It also explicitly calls for
restrictions on ``proprietary activities that present
particularly high risks and serious conflicts of interest''
deemed inconsistent with the primary responsibilities, I would
say the primary fiduciary responsibilities, of those
institutions to its customers. Of relevance in the light of
recent efforts of some commercial enterprises to recast
financial affiliates as bank holding companies, the report
strongly urges continuing past U.S. practice of prohibiting
ownership or control of Government-insured, deposit-taking
institutions by non-financial firms.
Second, the report implicitly assumes that while regulated
banking institutions will be dominant providers of financial
services, a variety of capital market institutions will remain
active. Organized markets and private pools of capital will be
engaging in trading, transformation of credit instruments, and
developing derivatives and hedging strategies. They will take
place in other innovative activities, potentially adding to
market efficiency and flexibility.
Now, these institutions do not directly serve the general
public; individually, they are less likely to be of systemic
significance. Nonetheless, experience strongly points to the
need for greater transparency. Specifically beyond some minimum
size, registration of hedge and equity funds should be
required, and if substantial use of borrowed funds takes place,
an appropriate regulator should be able to require periodic
reporting and appropriate disclosure.
Furthermore, in those exceptional cases when size,
leverage, or other characteristics pose potential systemic
concerns, the regulator should be able to establish appropriate
standards for capital, liquidity, and risk management.
Now, the report does not deal with important and sensitive
questions of the appropriate administrative arrangements for
the regulatory and supervisory functions, which agency will
supervise which institutions. These are in any case likely to
be influenced by particular national traditions and concerns.
What is emphasized is that the quality and effectiveness of
prudential regulation and supervision must be improved.
Insulation from political and private special interests is a
key, along with adequate and highly competent staffing. That
implies adequate funding.
The precise role and extent of the central bank with
respect to regulation and supervision is not defined in the
report. It is likely to vary country by country. There is,
however, a strong consensus that central banks should accept a
continuing role in promoting and maintaining financial
stability, not just in times of crisis, but in anticipating and
dealing with points of vulnerability and risk.
The report also deals with many more specific issues
cutting across all institutions and financial markets. These
include institutional and regulatory standards for governance
and risk management, an appropriate accounting framework
(including common international standards), reform of credit
rating agencies, and appropriate disclosure and transparency
standards for derivatives and securitized credits.
Specifically, the report calls for ending the hybrid private/
public nature of the two very large Government-sponsored
mortgage enterprises in the United States. Under the pressure
of financial crisis, they have not been able to serve either
their public purposes or their private stockholders
successfully. To the extent that the Government wishes to
provide support for the residential mortgage market, it should
do so by means of clearly designated Government agencies.
Finally, I want to emphasize that success in the reform
effort, in the context of global markets and global
institutions, will require consistency in approach among
countries participating significantly in international markets.
There are established fora for working toward such
coordination. I also trust that the forthcoming G-20 meeting,
bringing together leaders of so many relevant nations, can
provide impetus for thoughtful and lasting reform.
Thank you, Mr. Chairman. I am delighted to have any
comments or questions.
Chairman Dodd. Well, thank you very much, Mr. Chairman as
well. And what I am going to do is ask the clerk here to put
the clock on at 8 minutes, and we will try to adhere to that so
we can get around to everybody, since we have not had opening
statements be made. And I will begin, then turn to Senator
Shelby.
Let me, if I can, begin with a couple of--sort of a broad
question, if I can. The GAO report states--and I am quoting it
here. It says, ``Mechanisms should be included for identifying,
monitoring, and managing risks to the financial system,
regardless of the source of the risk.''
What was the source of the risk in the current crisis, in
your view?
Mr. Volcker. Well, that is a complicated question that goes
to some of Senator Shelby's concerns about what caused the
crisis. If I were analyzing this crisis in a substantial way,
you have to go back to the imbalances in the economy, not just
in financial markets. But as you know, the United States has
been consuming more than it has been producing for some years,
and its savings have practically disappeared, and that was made
possible by, among other things, a very fluid flow of savings
from abroad, low interest rates--very easy market conditions,
low interest rates, which in turn incited the great world of
financial engineering to develop all kinds of complex
instruments to afford a financing for businesses, and
particularly in this case for individuals, homebuyers, that
went on to exceed basically their capacity to pay. And it was
all held up by rising house prices for a while, as you know,
and everybody felt better when the house prices were rising,
but that could not happen forever. And when house prices
stopped rising, the basic fragility in that system was exposed.
So you had an underlying economic problem, but on top of
that, you had a very fragile, as it turned, highly engineered
financial system that collapsed under the pressure. I think of
it as we built up kind of a Potemkin Village with very fancy
structures, but they were not very solid.
Chairman Dodd. Let me draw upon your experience as the
Chairman of the Federal Reserve System, and you correct me if
my facts are wrong about this thing. But as I understand it,
there are about 1,800 economists that work for the various
Federal Reserve banks across the country.
Mr. Volcker. How many?
Chairman Dodd. I am told about 1,800. I do not know if that
is true or not, but someone mentioned that number to me. But a
very high number, whether it is 1,800 or not, but a significant
number of people who do research all the time in the various
banks. Can someone explain to me why there was not someone
sounding the alarms out of the Federal Reserve System as people
who monitor and watch what is happening economically that would
have sent a signal to us back in the days of, I think, in 2005
or 2006 even, that this was a problem emerging in a glaring
way? Why didn't we hear?
Mr. Volcker. Well, I have to say I do not think economists
are very good at this kind of analysis. In a macro world, I am
sorry to say that, but I am not sure there has been much
improvement over the years. But I think if there are 1,800
economists, I am sure some of them were concerned and did in
their own way raise some questions.
But, you know, when things are going well--this is the bane
of regulation. When things are going well, nobody wants to hear
about regulation and restraints.
Senator Shelby. Absolutely right.
Mr. Volcker. And so it is very hard to have your voice
heard. When things are going poorly, everybody wants to
regulate everything. And somehow we have to find a balance
between too little and too much.
This was an extreme case, but it is not unusual for
imbalances to go along for a while without anybody really
wanting to stand up and take strong action.
Chairman Dodd. Well, I would love to at some point further
pursue the discussion about the Federal Reserve System and how
it is working.
Let me ask you, if I can as well, about the consumer
protection issue. Your report describes the need to establish
standards for capital liquidity and risk management for
financial institutions. But do you also believe that strong
consumer protections play an integral part in financial
stability? I am sure you do, by the way. And if so, what
regulatory structure would best protect consumers? A separate
consumer protection agency, as has been suggested by some?
Elizabeth Warren, who will be before us tomorrow, has made a
recommendation along those lines. Distinct consumer protection
missions of the prudential regulator? Which of those two
options do you find----
Mr. Volcker. Well, let me say, first of all, our report
does not deal with that question.
Chairman Dodd. You do not. I realize that.
Mr. Volcker. Quite deliberately. But there is--obviously,
this administrative question you raise is relevant. We were
dealing with what we think of as safety and soundness of the
system. We were not dealing with protection of consumers,
protection of investors, business practices--which are related
but a different function. And one of the questions--which we
did not deal with, but I think the Congress has to deal with it
and the administration has to deal with it--do you adopt a
separate agency and a separate administrative structure for
what I will call ``business practices,'' including consumer
protection, separate from the prudential regulator--which is a
development which is true in some countries now, and it is
along the lines that Secretary Paulson proposed in his thinking
about the long run.
I think that is a serious issue. I do not want to express
an opinion now, but I have certain sympathy for exploring it,
at least, personally.
Chairman Dodd. Well, I would welcome that as you give it
more thought.
Last, let me address the issue of systemic risk regulation
again. And I realize I am not specifically referring to the
report in some cases. I am drawing upon your knowledge and
expertise in these areas.
The G-30 report describes one of the lessons from the
current crisis as follows, and let me quote it. It says:
Unanticipated and unsustainably large losses in proprietary
trading, heavy exposure to structured credit products and
credit default swaps, and sponsorship of hedge funds have
placed at risk the viability of the entire enterprise and its
ability to meet its responsibilities to its clients,
counterparties, and investors.
Three questions: Should we allow financial institutions to
become large and systemically significant? Should there be a
single systemic risk regulator or should that substantial be
shared among different agencies? Should the systemic risk
responsibility be given to the Federal Reserve, in your view?
And are you concerned that it would also be a burden on the
Federal Reserve with numerous divergent tasks which you and I
have discussed? And I will not elaborate here. You know the
point I am trying to make. And, third, are you concerned that
extensive involvement by the Fed in so many aspects of day-to-
day operations of the economy and the financial system might
jeopardize its independence?
Mr. Volcker. Again, these are questions we did not deal
with in the report. We dealt with the structural question that
we felt these basic, systemically important institutions and
banking institutions that are protected by the Government and
are dealing in a fiduciary way with customers should not engage
in the kind of activities that you read from the report, these
highly risky proprietary activities, because it undermines
potentially their basic function.
When it gets to who regulates it, it is just simply not in
the report. But I tell you, the kind of considerations that you
raise for the Federal Reserve, or without the Federal Reserve,
I think are very relevant to that decision. You will have a
different Federal Reserve if the Federal Reserve is going to do
the main regulation or all the regulation from the prudential
standpoint. And you have to consider whether that is a wise
thing to do given their primary--what is considered now their
primary responsibilities for monetary policy.
They obviously have important regulatory functions now, and
maybe those functions have not been pursued with sufficient
avidity all the time. But if you are going to give them the
whole responsibility, for which there are arguments, I do think
you have to consider whether that is consistent with the degree
of independence that they have and focus on monetary policy.
Chairman Dodd. I hope I am not over-reading you there. I
hear that tone suggesting that that kind of a super-regulatory
function would, I think, put into question the very issues that
are raised by it. A systemic risk regulator might have less of
a problem, in your view.
Mr. Volcker. That is true. Then you have to consider how
the systemic risk regulator matches up with the other
prudential regulators. There are very interesting questions
here.
The G-30 issued a report, a rather detailed report, a year
or so ago or 9 months ago, on different regulatory practices
around the world, which raised the questions that you are
raising, and almost all countries are struggling with these
questions now.
Chairman Dodd. I thank you.
Senator Shelby.
Senator Shelby. I want to pick up, Chairman Volcker, on
some of the area that Senator Dodd is getting into. I think it
is very important.
Do you have any concerns, Dr. Volcker, that if the Fed
assumes too many responsibilities, its ability to conduct
monetary policy could be undermined?
Mr. Volcker. Yes.
Senator Shelby. And what are your views on the separation
of monetary policy from banking policy along the lines of the
reforms that were enacted in the United Kingdom in the late
1990s that gave banking regulation to the FSA and monetary
policy to the Bank of England?
Mr. Volcker. Well, that is an interesting experience. That
was rather widely acclaimed, and other countries attempted to
or did follow that pattern. But then when they had a crisis,
they found out it did not work so well.
Senator Shelby. It did not work.
Mr. Volcker. And whether that was some idiosyncratic
reasons in the U.K. or whether it is a more general reason, I
do not know. But the underlying problem----
Senator Shelby. Why didn't it work, if you could----
Mr. Volcker. Well, I----
Senator Shelby. I know it did not work.
Mr. Volcker. It seemed to be a lack of coordination between
three agencies involved--the U.K. Treasury, the Bank of
England, and the FSA, the regulatory agency--even though they
had overlapping personnel to some extent. But it seems clear
that coordination was not close enough.
But I would make one point in connection with your
observation. Supervision regulation has implications for the
performance of the financial system and the economy, and it can
work in support of monetary policy or it can work contrary to
monetary policy. And that is one reason for giving the Federal
Reserve responsibility for both.
Senator Shelby. Dr. Volcker, as you keep up with all this,
and as a former Chairman of the Federal Reserve, you know the
Fed has had a dramatic expansion of its liquidity facilities
over the past year, and it has raised concerns that the Fed has
moved out of the realm of monetary policy and into the realm of
fiscal policy.
The Group of 30 Report, as I understand it, recommends that
central bank liquidity support operations should not involve
lending against or outright purchases of high-risk assets.
Instead, your report, as I understand it, recommends that those
forms of support should be handled by directly accountable
Government entities.
In your view, what role should be given to the President or
the Treasury Secretary in approving Government bailouts or
other support for institutions that will likely involve
taxpayer dollars?
Mr. Volcker. Well, in cases where they do involve risk and
the use of taxpayers' dollars, we are pretty clear that the
administration, particularly the Treasury, ought to be involved
in that decision, and the Federal Reserve should not undertake
those kinds of actions, if they do it at all, without the
concurrence of the administration.
Senator Shelby. Is this in the line under our
constitutional system that it would be inappropriate for
unelected central bankers to determine whether a company or
industry receives a taxpayer-funded bailout? Shouldn't those
decisions be made by the President and the Congress, who are
accountable to the people? Is that----
Mr. Volcker. Well, Congress can provide a framework for
making those decisions, but I think they do involve political
questions that the President and the administration should be
involved in. I think just to clarify, my own understanding from
outside is when the Federal Reserve has done this recently,
they have worked closely with the Treasury. They have not gone
off on their own and undertaken these measures.
Senator Shelby. It seems like a new role for the Fed than
when you were Chairman.
Mr. Volcker. Yes, it is a non-traditional role.
Senator Shelby. Non-traditional role. You are very----
Mr. Volcker. The report takes a traditional view of the
functions of the Federal Reserve.
Senator Shelby. Dr. Volcker, recently Stanford economist
and, somebody you know, a former Under Secretary of the
Treasury, John Taylor, argued that excessively loose monetary
policy during the first part of this decade caused the
financial crisis.
Mr. Volcker. Well, I do not think I am going to get into
that question this afternoon. I do think that conditions in
financial markets which were related to the large balance of
payments deficit, large current account deficit, and the free
flow of money from abroad laid the groundwork for many of the
excesses in the market.
Senator Shelby. Now, this is in your report, as I
understand it. One of the key recommendations of the G-30
Report is creating a failure resolution regime that imposes
discipline--that is, actual losses--not only on managers and
shareholders but also on sophisticated creditors.
I believe one of the primary failings of the recent
bailouts of the GSEs, AIG, and Bear Stearns was the intent of
protecting any creditors from losses.
Dr. Volcker, in terms of who qualifies as a ``sophisticated
creditor,'' do you believe that both financial institutions
such as investment banks and foreign central banks would count
as sophisticated creditors? Or should?
Mr. Volcker. Well, they individually are sophisticated,
yes. Whether they need to be protected in some particular
occasions is another question.
Senator Shelby. Given that the large creditors of the GSEs,
AIG, and Bear had no legal claim to being bailed out--which
they did not--what specific mechanisms would you suggest that
we think up here to put in place to assure that such
sophisticated creditors take losses in the future, which helps
bring discipline to the market?
Mr. Volcker. The premise of your question included the
GSEs?
Senator Shelby. Yes.
Mr. Volcker. Well, the GSEs, I think, if I may say so, with
the connivance of the Congress, were considered to be something
special and they would be protected. And there was a general
understanding, rightly or wrongly, while officially they did
not have the full legal requirement of a guarantee, through the
years----
Senator Shelby. But they had the implicit guarantee, didn't
they?
Mr. Volcker. Pardon me?
Senator Shelby. The implicit guarantee.
Mr. Volcker. Yes, they had an implicit guarantee and that
was----
Senator Shelby. Was that because they were hybrid----
Mr. Volcker.----I think, generally understood.
Senator Shelby.----you know, stock owned and Government
sponsored?
Mr. Volcker. We are very clear on one recommendation in
this report. We should not have that kind of hybrid institution
anymore.
Senator Shelby. I totally agree with you.
Mr. Volcker. You know, you cannot change it overnight, but
I think as we design a new financial system, we ought to avoid
that kind of compromise that is going to get you in trouble.
That does not mean that Congress or the Government cannot
support the mortgage market if they want to.
Senator Shelby. Right.
Mr. Volcker. But they ought to do it directly.
Senator Shelby. Yes, sir. Thank you.
Thank you, Chairman Dodd.
Chairman Dodd. Thank you very much.
Senator Warner.
Senator Warner. Thank you, Mr. Chairman.
Dr. Volcker, I have got three questions, and I think they
follow up on both the Chairman's and Senator Shelby's approach.
It seems from the report a clear understanding that there needs
to be some level of regulation of some of these institutions
that fell between the cracks. Yet it seems that even though
major money center banks that clearly were regulated followed
the market to start putting out these same kind of complex new
instruments, your term of ``over the top financial
engineering.''
I guess on a going-forward basis, as we move forward to
some new structure, even with regulation and transparency, is
that going to be enough or should there be some point of an
evaluation, almost a societal value evaluation, of some of
these instruments, whether the extra ability to price that risk
down to the last decimal point is worth all of the side risks
that we have seen taking place by some of these instruments?
Mr. Volcker. Well, we do a lot of talking about the
importance of risk management and so forth, but, in essence,
the conclusion that we have is that some of these innovations
and some of these very risky activities are almost inevitably
going to get ahead of the regulators, and these basic
institutions--the big commercial banks, in particular--are of
systemic importance, therefore should not get involved in those
activities. They are too risky, and I think it is clearly
demonstrable they involve conflicts of interest that add to the
uncertainty and risk.
Senator Warner. So you would see some system whereby there
might be bright-line prohibitions----
Mr. Volcker. Yes, I see--we suggest some bright-line
prohibitions for hedge funds and equity funds, and you asked me
about proprietary trading--you did ask me about proprietary
trading. I think these big financial institutions probably have
to have some capacity, do need some capacity for trading. But
if they have very aggressive trading in very large amounts,
where it is not quite such a bright line, you probably need
special attention, and we suggest special attention via special
capital requirements if they are going to engage in those
activities.
Senator Warner. And as you said, sometimes these
instruments get ahead of the regulators, and how do you----
Mr. Volcker. No question about that.
Senator Warner. You do not want to stifle innovation, but
it seems to me that some of these instruments recently were
more about fee generation than they were about appropriately
pricing risk?
Mr. Volcker. Well, I think that is true, but there is
plenty of room for innovation outside of the basic banking
system, and that is a distinction we make. All kinds of
sophisticated capital market techniques, a derivative explosion
which may have gone too far, but the whole idea of
securitization could be developed outside the banking system.
To the extent it is inside the banking system, we say, well,
the bank should hold onto what they securitize. That is a
traditional function. But outside, they can engage in all kinds
of trading and----
Senator Warner. But wouldn't you say some of these outside
functions now need to have some kind of regulatory----
Mr. Volcker. Yes, well, I guess we are trying to say we
want to go relatively lightly, if they are relatively small
institutions without systemic significance. But if they get big
enough--and some of the hedge funds have, and we had the
experience of Long Term Capital Management in the past where,
rightly or wrongly, people thought it had systemic
implications. Then you have to think about leverage
requirements and capital requirements and liquidity
requirements.
I myself think that would just be a handful of those
institutions, and most of them--we do call for reporting and
registration, but I do not think they would take heavy
regulation.
Senator Warner. Well, let me follow up on Chairman Dodd's
question as well, one of the points he raised. A lot of your
focus is on systemic risk. We have heard the comment a lot in
the popular press, you know, certainly these institutions are
``too big to fail.'' On a going-forward basis to try to
alleviate that systemic risk, should there be some examination
of sizing of some of these institutions?
Mr. Volcker. Yes, well, we make a fleeting reference to
that actually in the report. There is now more concentration
than you ever had in the United States. The degree of
concentration is not as great as many foreign countries have,
but it is very large from our history. And I think that is a
question you want to ponder. It has got political, obviously,
as well as economic circumstances, whether there is such a
thing as not only ``too big to fail,'' ``too big to exist.''
Senator Warner. Right.
Mr. Volcker. And it has got--we certainly have seen how
difficult it is to manage these institutions given the variety
of functions they have been performing. Now, we suggest that
their functions be simplified. That would be easier to manage.
But, still, there is in present law, as you know, a limit on
deposit-taking. I think it is 10 percent. You cannot go beyond
10 percent. Back when I was Chairman, we once suggested 5
percent, which some people thought was too big. Now it is 10
percent.
You know, it raises a question at some point. When is
enough enough?
Senator Warner. Right.
Mr. Volcker. And I think you ought to look at it.
Senator Warner. One last question. Over the last decade, as
somebody who spent some time in the financial markets, there
has always been the argument, oftentimes from our friends in
the U.K., you know, to come over to their markets. Wall Street
was complaining that if there was additional regulation, we
would see a flight of all these firms abroad, development of
new money centers all around the world with not as stringent a
regulatory structure.
In light of this complete worldwide collapse, do you think
there will be an ability to come up with some strong
international standards? Or are we going to be able to patch
this over and still have a few 2-years later, 5-years later, a
rush to the bottom as firms try to go around the world to find
the least regulatory----
Mr. Volcker. I think we have had a real wake-up call, here
and elsewhere, in Europe, Japan, China. And this wake-up call I
hope is strong enough so that we will emerge from this with
consistency and the basic regulatory and supervisory framework.
If it does not, I would still do what we think is appropriate
here and let them go if they want to be in----
Senator Warner. Even if we have a regulated system, you
could make the argument that might be the safer system.
Mr. Volcker. Yes, and I think in the long run--suppose we
now had a strong regulatory system, and it was Europe and Japan
and elsewhere that was in worse shape. All the money would be
flowing into us because it was the strongest system.
Now, unfortunately, that is not the case right now. But it
should be the case. What should be the case is we have a high
degree of uniformity. And I do not think that is impossible.
You already have that pretty much in the capital area. Now,
that is just one area. You have got a lot of other areas--the
hedge fund regulation, rating agency regulation, accounting is
one place where I am sure--I have a special background here,
but I think we should have uniform accounting around the world.
Senator Warner. If I just follow where you are headed, you
would actually say a strong regulatory system with appropriate
oversight in this country would not be counterproductive to the
continued growth of capital markets in the United States. It
might still be a long-term benefit to our country.
Mr. Volcker. Yes. That does not mean you want unproductive
regulation. Good regulation we ought to have, regardless of
what the rest of the world does.
Senator Warner. All right. Thank you, sir.
Chairman Dodd. Thank you very much, Senator. I asked
someone once, ``Why do you think it is that the world comes
here?''--talking about, obviously, not the present day, but a
little time ago. ``Why does the world come here and bring its
wealth?'' The answer I was given, two reasons: one, we are very
good at making money, and as importantly or more importantly,
it was a safe place to be. You might make a bad bet, but you
were not going to lose your money because the system was
corrupt or did not work. And I think that is the point that
Senator Warner is making, and I think if you have a strong,
sensible, balanced regulatory system, the world could also
follow us. They may not join us, but they will move in that
direction.
Mr. Volcker. I have hopes that, given what has happened,
you will get some uniformity. You know, the argument always was
we will lose all this business to London. Well, London has got
the problem at least as much as we have, and I think that is
generally recognized at this point.
Chairman Dodd. Senator Johanns.
Senator Johanns. Thank you, Mr. Chairman.
In reference to your last comment, I will offer an
observation, and that is that the financial crisis is bad
enough; where I do think there is a good chance of uniformity,
just as you suggest, I think over time it is hard to sustain
that. Why? Just simply because one country is going to look at
this and, you know, when things stabilize--and hopefully they
will stabilize--that country is going to say, you know, we
could get more banking business here if we tweaked this a
little bit and tweaked that a little bit. So you almost need to
think about what mechanism you have in place to deal with that
economic phenomenon. Countries want business, and they are
going to do things. Sometimes over time we see it is bad
judgment, but I would just offer that observation.
A couple more observations, and then I would like to ask
you a question. It seems to me--and this is so complicated. It
is hard to say there are a couple of reasons for what is going
on, but it seems to me that there are two really, really
important things that really have led in a substantial way to
this financial crisis.
Number one is whatever mechanism was in place to evaluate
risk accurately just failed. Highly compensated, enormously
bright people being advised by the best in the business simply
lost their way when it came to evaluating risk.
The second thing was that, for whatever reason, as
regulatory agencies or departments tried to get a handle on
this, it was very difficult for them or they dropped the ball,
or whatever, in terms of themselves blowing the whistle on
unreasonable risk being taken.
Those two things strike me as really fundamental to what we
are dealing with here. If you agree with that statement, I
would really be interested, Dr. Volcker, in your educating us
on how your recommendations would deal with that, number one,
the failure to accurately evaluate risk and, number two, the
failure, for whatever reason, to blow the whistle on that risk.
Mr. Volcker. Well, we have got a lot of rhetoric in this
report about the importance of risk management and trying to
deal with the problem you have and the failures of risk
management in our leading financial institutions--partly, and
importantly, because the complexity became so great that we
lost sight of how to measure the risk.
Now, I have got a point of view on this, but the markets
were taken over by financial engineers. They were
mathematicians. They were not market people. They somehow
thought that financial markets would follow the laws of physics
or some natural law and everybody had a nice, normal
distribution curve. And they kept being surprised by outlying
events. Well, they seemed outlying if you thought of the world
of a normal distribution curve, but that is not the world of
finance that I know. Financial markets are affected today by
what happened yesterday, and what is happening right now
affects thinking and affects what happens tomorrow. So you get
people going to extremes in both directions. And these
financial engineers kind of thought that they had the answer to
how to measure risk and take care of it.
Things were very complex. When you mixed together these
enormous compensation practices, the enormous gains possible,
with obscure financial engineering, you had a recipe for
extremes, I think, that kind of came back to haunt us.
Senator Johanns. If I might just----
Mr. Volcker. That will be addressed by what is happening,
but so much of the best talent in the United States is going
off into financial markets. I wish more of it would go building
bridges instead of financial markets.
Senator Johanns. If I might just offer another observation,
and your thoughts on compensation, I think, really warrant this
Committee kind of digging deep on that issue. But there is
another piece to it, too. There was a point in time where
someone was compensated based upon the quality of the loan that
they wrote. You know, when I bought my first house, you didn't
get that loan unless you had a reasonable chance of continued
employment, you had 20 percent down in the bank, et cetera.
However, the compensation structure turned to how many loans
you could write and bundle and then sell, and like I said,
nobody was figuring out how to evaluate the risk, or if they
did, they threw all the rules out the window.
Mr. Volcker. Well, I think that is a good example. In the
old days, you had a customer. You evaluated his ability to pay,
the value of the house, and so forth. But then they came along
and said, well, look. If we put 80,000 of these loans together,
our statistical analysis says 85 percent of them will be OK and
the result was you put poorer and poorer loans in the package.
It turned out that 85 percent were no longer good, and that is
where we are.
Senator Johanns. And the frustrating thing about that, and
I will wrap this up, for the average citizen out there is that
15 percent now has been labeled toxic assets and somehow the
taxpayer feels like they are being imposed upon to own that
risk today and they are saying, ``why me?''
Mr. Volcker. I don't know how you want me to respond to
that----
Senator Johanns. You don't have to respond, Doctor. You
are----
Mr. Volcker. There comes a time when you have to support
these institutions in the interest of the greater good and the
stability of the markets. But one of the difficulties in this
whole business is very much commented on today, is how you
price those assets when the taxpayer takes them over.
It is possible you could think of a scenario where if the
taxpayer has to take them over and the markets are stabilized,
the taxpayer may actually make money. But you certainly don't
want to go into it with the taxpayer unnecessarily losing a lot
of money. But it is a very--this is all complex enough so it is
very hard to unscramble all this stuff.
Senator Johanns. Thank you very much.
Chairman Dodd. Thank you, Senator. Very good questions.
Senator Reed?
Senator Reed. Thank you, Mr. Chairman, and thank you,
Chairman Volcker, for not only your testimony, but for your
service on this G-30 Commission as well as so many other
commissions.
We have been confronted with a long to-do list by the G-30
report, but our capacity is limited. I wonder, could you focus
on what you consider to be the top two or three systemic risks
that should be dealt with immediately? A sense of priority, I
think, would help--I will speak for myself--would help.
Mr. Volcker. Well, when you say immediately----
Senator Reed. Well, immediately in the----
Mr. Volcker. First of all, we are going to have--I am not
sure this is what you meant in asking the question--it is going
to cost more money to deal with this financial crisis. There
shouldn't be any mistake in your mind about that, that this has
deteriorated to the point where it is going to take Government
support in the interest of overall economic stability and
recovery, and it is going to be lots more billions of dollars.
I don't know how many. But that is necessarily a priority,
which I hope and believe the administration will face you with
shortly.
Now, looking ahead, I think we rather put the priority in
what I put in my statement as our first point, that you have
got to take these big protected institutions, particularly the
large ones, but all the banks are going to be protected to some
extent, and you have got to develop apparatus for protecting,
but you have also got to limit what they can do, and you want
to do that as intelligently as you can, because you want them
to compete. You want them to be innovative in providing
services. But you don't want them taking a kind of risk that is
inconsistent with the fact that at the end of the day,
Government support is in the background. Now it is in the
foreground. But ordinarily, it is in the background. And I
think that is the, I think, the most fundamental thing.
But there are so many things that need attention that it is
hard for me to rank them in priority. The accounting problem is
a real one. And apart from the fact of the desirability of
uniformity, and there has been a lot of progress in that area.
That is one area I think we are going to get uniformity, and we
should get uniformity. But then uniformity is one thing, but
uniformity according to what standard? And there, there is a
problem with all this mark to market business and fair value
accounting. When should that be applied? When should it not be
applied? If it is not mark to market, what else do you do?
My own feeling is that is something that has to be thought
about by the regulators themselves and they ought to have a
voice in the accounting for the basics, banking anyway,
banking, insurance companies. But intellectually, that is a
very tough problem.
Senator Reed. Let me ask this related question. We are
debating a significant recovery package at the moment. That, I
would think, would complement any efforts we make to further
aid the financial institutions, because without this recovery
package, then the potential hole has got to be much bigger. Is
that your view, also?
Mr. Volcker. That is right. No, you have got kind of a
three-legged stool. You have got the stimulus package to help
provide direct support to the economy. You have got to have the
financial package to unleash the flow of credit. And then
related to both those things, I think you have got the
individual mortgage problem, which nobody has figured out how
to deal with very effectively, but it is an important part of
the problem. So you have got to advance on all those fronts.
Senator Reed. Let me----
Mr. Volcker. Let me just point out----
Senator Reed. Yes, sir?
Mr. Volcker.----the obvious. If you didn't have the
stimulus package, let us say, the worse the economy gets, the
more problems you are going to have in the banking system. That
is obvious.
Senator Reed. And the bigger the hole that has to be
filled.
Mr. Volcker. The hole gets bigger.
Senator Reed. In the G-30 report, the reported noted that
credit rating agencies are not held legally accountable for
their ratings. Do you believe that has to change?
Mr. Volcker. I believe this is an area that has to be
reviewed. We made a few suggestions in the report, including
the one that you mentioned. I don't feel that that is the last
word, frankly, what we say in this report. The whole
compensation structure is important and we allude to it, but we
don't say what the answer is. I am not prepared now to say I
think I know the answer to that, but it is not an unimportant
question, obviously.
Senator Reed. Let me ask you a final sort of set of
questions. The Chairman raised the issue of 1,800 economists at
the Federal Reserve. Did anyone sort of notice the implications
of the housing bubble building up and other problems? The
Ranking Member has talked about sort of looking into the
regulatory practices of the Federal Reserve, particularly
regulating these large institutions.
My assumption is that on a daily basis, the Federal Reserve
would have hundreds, perhaps, of examiners within these
institutions. Why wasn't anyone aware of some of these off-
balance sheet devices, liquidity puts? Was it an area of
concern? Was this an issue they were aware or, or were they
completely blindsided? I think it goes to the point of trying
to discover who knew what when so we have an idea of how we can
restructure the----
Mr. Volcker. I do not know the answer to your question. A
perfectly reasonable question. I was not there. I can't answer
the question.
Senator Reed. That is a perfectly reasonable response.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you.
Senator Bennett?
Senator Bennett. Thank you, Mr. Chairman.
Dr. Volcker, welcome. We have had three simultaneous
bubbles. They haven't burst simultaneously, but they were going
on simultaneously. We have had the housing bubble. We had the
oil bubble. And then we had a credit bubble. The oil bubble,
everyone who pumps gas is delighted that it has burst. Everyone
who produces gas and oil is probably a little sorry that it has
burst. But all of the dire consequences that we heard predicted
with respect to the oil bubble are now no longer on the front
page and we no longer talk about the oil shock and its impact
on the economy and the rest of us because the price----
Mr. Volcker. What about the opposite? The price isn't high
enough to stimulate the----
Senator Bennett. That is right. It has gone from $145 a
barrel to $35 a barrel and then bounced around. But that is a
bubble that burst and a collapse that happened very rapidly and
the American motorist is delighted.
The housing bubble has burst and we don't know where the
bottom is. It is uneven across the country, and that is why I
am a little suspect of the Case-Shiller number, because that
takes the worst parts. There are some places in the country
where housing prices have actually risen, but the mortgage
problem remains very much a difficulty because nobody knows
what the securities are worth. They don't know how much toxic
paper they have, and so on.
Let us talk about the credit bubble. It is different from
the classic bubbles of the housing bubble and the oil bubble,
but we still don't have a firm handle on what is happening with
respect to credit. We don't have any kind of normalcy. There
was a time when credit was enormously available. Now, it is
almost not available at all, except again, like the housing
thing, there are some parts of the country where it is
available, or there are some markets where it is available and
others where it is not.
Look into your crystal ball and tell me, or tell us what it
is going to take for the credit bubble to resolve itself and
how long you think that might be.
Mr. Volcker. Well, I won't profess to know the answer to
that question with any reliability. It is going to take some
time. We are not at the end of this business. And I think the
immediate challenge is to provide some basis for greater
confidence in the banking system and in lending. You know, it
is kind of a spiraling process. The worse the economy gets, the
less confidence there is, and the less confidence there is, the
more difficult creditors and the worse the economy gets.
So we have got to break into that cycle, and I think that
is why I emphasized earlier the importance of dealing with the
banking situation. It is going to cost some money. And if we do
that effectively, then I think we could begin seeing the end of
this. But it is, I don't know how many months, but it is not
going to be overnight.
Senator Bennett. It is not going to be soon----
Mr. Volcker. We have had a great shock to confidence and
trust in markets and these markets depend upon confidence and
trust and it is going to take a while to restore that.
Senator Bennett. It is not going to be soon and it is not
going to be cheap.
Mr. Volcker. And it is not going to be cheap.
Senator Bennett. Now, since you have put your finger, I
think, on the real core of all of this, which is confidence,
you talk about a three-legged stool, a stimulus package,
something, for want of a better summary term, I will call more
TARP to deal with the financial institutions, and then
resolving the mortgage crisis. I am perfectly willing to go
down all three roads, but what happens if we pass a stimulus
package that is not stimulative? Doesn't that produce a greater
hit to the confidence circumstance than if we did nothing?
That is what I think the debate is all about. I don't
subscribe to those who say, well, we want the economy to fail
because then Obama will fail and then the Republicans will come
back. This is one Republican who rejects that, absolutely, and
for the good of the country.
But it is one thing to say, let us pass a stimulus package.
It is another to be sure it is going to be stimulative. It is
one thing to say, well, let us shore up the financial
institutions. Then it is another thing to be sure that the way
we do that is going to be helpful, and so on. Can you give us
your advice as an economist as to what you think is the most
stimulative?
Mr. Volcker. Well, I want a stimulus package that
stimulates.
Senator Bennett. Well, we all stipulate to that.
Mr. Volcker. To the extent--you know the dilemma here--to
the extent you can take action that not only stimulates but is
in accordance with some longer-term needs of the economy,
obviously you are sympathetic toward that. I am sympathetic
toward that, and that, among other things, leads you to
infrastructure.
Senator Bennett. Right.
Mr. Volcker. The problem is, that takes time. So what do
you do in the immediate future? There are things that are very
compelling in the short run in terms of helping people that are
out of work in terms of unemployment compensation and other
things where there is the pressure of immediate money in their
hands. But when you take those two different kind of extremes,
both useful, put it together in as good a package as you can
and get it passed, would be my advice. I am not an expert on
all the particulars of this program. I haven't looked at it.
But I am aware of the debate. But I hope that gets resolved in
a constructive way as quick as you can.
Senator Bennett. I have talked to some bankers who say,
well, the injection of capital that has come as a result of
TARP is not only welcome, but essential, but we still do not
have sufficient capital to make any loans. We have sufficient
capital to sustain our present balance sheet, which we didn't
have before. But we are unable to attract any private capital
and we are unlikely to get any more public capital. Do you have
any prescription for us as to what we should be doing there
with respect to----
Mr. Volcker. Well, I don't know what the administration is
going to propose, but I suspect there is going to need to be
some public capital----
Senator Bennett. And then----
Mr. Volcker.----maybe quite a lot of it.
Senator Bennett. Then the question arises, in what form?
The first TARP, for which I voted, contrary to my friend,
Senator Shelby, was sold to us on the basis that it was going
to acquire the toxic assets and clean up the balance sheets of
the bank, and then it changed toward a program of buying
preferred stock or making some other kinds of loans, warrants,
and so on. Along with Senator Dodd, I agreed we ought to give
the Secretary of the Treasury full authority to do whatever he
thought was best, but the track record, at least coming from
somebody's analysis, has been a little bit spotty as to whether
that is----
Mr. Volcker. Well, I think it is fair to say, if you look
back over the last 6 months or so, that they were kind of
repeatedly firefighting, on some crucial weekends in
particular, and it may have been successful or unsuccessful in
particular cases, I think mostly successful in putting out a
particular fire, but it didn't come across as being very
consistent and very credible in terms of what comes next and I
think we have suffered from that. And what we need now is, I
think, a kind of comprehensive program that recognizes the
breadth of the problem--it is not just one or two
institutions--and provides a framework for dealing with this in
a consistent way. I think that is essential to get confidence
back in this situation. I hope that is what is going to happen
in the next couple of weeks.
Senator Bennett. Thank you very much.
Chairman Dodd. Thank you, Senator Bennett.
Just a quick question before I turn to Senator Schumer. In
your view, Doctor, looking back, did we do the right thing in
early October in supporting that TARP program or not?
Mr. Volcker. You know, it is very hard to sit on the
outside and say what should have been done in particular
circumstances. All I know is something had to be done. Whether
it was perfect foresight or whatever, we could have done it
differently, you mentioned the TARP program, which was designed
in the first instance--I had actually written something about
it before it happened and suggested that we get rid of some--
buy up some of these so-called toxic assets, and that was the
original intention and then they switched, maybe for good
reason. But the whole thing wasn't as persuasive as it might
have been.
Now understand, as time goes past, these loans are getting
worse. They are not getting better because the economy is
worse, so that makes it more difficult.
Chairman Dodd. So the answer----
Mr. Volcker. Well, the answer, as I say, I think you need,
apart from the stimulus program, you need a program that looks
big enough, powerful enough, across the board enough, not that
it necessarily has to be applied, but you have something there
that can be applied in terms of further deterioration of the
market or individual institutions. You hope that by the mere
fact of being there, confidence might begin to be restored. The
better looking the program, the less you have to use it.
Chairman Dodd. So I think I hear you saying, yes, you agree
that it should have been done. How it was executed is another
matter. Is that a fair characterization?
Mr. Volcker. I think--yes, I think so.
Chairman Dodd. Senator Schumer?
Senator Schumer. Thank you, Mr. Chairman, and thank you,
Mr. Chairman. It is good to see you. I have been on Banking
Committees for 28 years and I think you have been testifying
before them for about 28 years.
Mr. Volcker. Just about.
Senator Schumer. So it is good to see you. I have an
opening statement, Mr. Chairman. I am going to forego reading
it. It outlines my general views on regulatory reform,
including a much more unitary--well, controlling systematic
risk, ensuring stability--I have always thought all holding
companies should be regulated by one regulator, maybe the Fed,
maybe not, but one regulator, and I know you have been asked
about that--unifying our regulatory structure--we have too many
regulators, too many holes between the cracks, too many
conflicting organizations. Third, regulating the currently
unregulated part of the markets, both instruments and entities,
hedge funds and others. We need to do that. Fourth, to
recognize that we are in a global financial world, global
solutions, and increase transparency. Those have been my five
principles. I wrote an op-ed about this about a year ago and I
have been sticking with them. It hasn't changed. So I ask
unanimous consent that that be put in the record.
Senator Schumer. I would like to focus on the international
part first, because to me, the biggest challenge we face when
we set up a new system of regulation is not what we do here. I
think there is sort of a consensus. I mean, I have heard
Chairman Dodd has said, Chairman Frank, the administration,
they are very similar to the five things that I have outlined
here. But how in this international financial world, with a
national system of regulation, don't you always flee--doesn't
money always flee to the lowest common denominator? And if we
regulate swaps here or regulate hedge funds here, they just
migrate to a place where they are not regulated because the
individual operators, regulation is a common good.
Mr. Volcker. Well, I expressed some optimism on this point
earlier, before you came in----
Senator Schumer. Good. Well, I welcome hearing again,
because there isn't much----
Mr. Volcker. I have optimism only because this crisis is so
serious. We here in this country, in the U.K., in Japan,
potentially in China, have never seen anything like this, and
so this kind of focuses the mind. I think the leaders in Europe
and the United States, Canada, Latin America, they are all
interested in this subject.
You have a forum in the G-30. I don't think it is an ideal
forum for this purpose, frankly, for getting into the detail,
but it is a good forum for making sure that somebody else does
it. And we do have some international bodies that are making
progress.
In many of the areas that you would be concerned with, take
hedge funds, the Europeans are more concerned about regulating
hedge funds than we are.
Senator Schumer. You know, I am not so worried--I mean,
although the details, look how long it took to get some
agreement on Basel and the capital accords.
Mr. Volcker. Right.
Senator Schumer. Everyone had general agreement and it took
five or 10 years to get this done.
Mr. Volcker. Now wait a minute, I was largely, or
importantly responsible for the first so-called Basel
Agreement. It only took 2 years.
Senator Schumer. Right, but Basel II took much longer.
Mr. Volcker. The revision took much longer because we did
such a good job the first time.
[Laughter.]
Senator Schumer. But, you know, in this new global world,
Hong Kong could decide that they don't want the Western
consensus. They will go for the short-term hit of having----
Mr. Volcker. I----
Senator Schumer. You know, it is just difficult.
Mr. Volcker. Look, one area where this is front and center
is in accounting----
Senator Schumer. Yes.
Mr. Volcker. and I have a special interest in this because
I used to be the Chairman of the International Accounting
Standards Committee.
Senator Schumer. Right.
Mr. Volcker. And there, the suspicion in the United States
has been our U.S. GAAP is better than anything else and that we
have international accounting standards and we ought to adopt
U.S. GAAP. Well, I think that has been proven to be a bit of an
illusion. U.S. GAAP is not God, either----
Senator Schumer. Right.
Mr. Volcker. and there are lots of problems, and I see no
reason--I do not believe that the international standards are
in any sense weaker than GAAP. They are more principle-based--
--
Senator Schumer. Yes.
Mr. Volcker.----but in terms of the substance, they are no
weaker, and there has been a lot of progress.
Now, there are political pressures on the international
standard setters and we ought to be alert to that and those
pressures, frankly, are--well, they are in the United States,
too, but they are particularly strong in Europe, and I think we
all have an interest in maintaining the independence of the
standard setters and we want to put pressure on them to do a
good job.
Senator Schumer. Yes.
Mr. Volcker. But I think that is a promising area and a
very difficult area.
Senator Schumer. Yes, it has been difficult, the most
difficult. My worry is a year from now, when we begin to see
the light at the end of the tunnel here, say China will decide
they want to gain the immediate advantage and just set up
rather sophisticated----
Mr. Volcker. No, but we----
Senator Schumer.----trading operations, and it just----
Mr. Volcker. We said----
Senator Schumer. My experience----
Mr. Volcker. We said earlier, if we have got good
regulation, and good is not synonymous with a lot of regulation
necessarily, but if we have intelligent regulation and the rest
of the world doesn't follow us, well, that is too bad, because
I think in the end, it will be recognized that we have the best
and the business will come here.
I am tempted to say, because this is not the first time I
have been before this Committee and this problem arising in the
United States, where when you talk about--the Senator talked
about everybody wants to tweak the regulation to their
advantage.
Senator Schumer. Yes.
Mr. Volcker. That is true of American States. They are
always trying to tweak----
Senator Schumer. Of course.
Mr. Volcker.----financial regulation to the advantage of
particular States. So we have had a certain experience there.
But all I can say is if we can't deal with this now, given
the extent of the problem not just in the United States----
Senator Schumer. Around the world.
Mr. Volcker.----but around the world, we have an
opportunity to do it.
Senator Schumer. Yes. I agree, it is a unique opportunity.
It is just my experience has shown everyone agrees 10,000 feet
up, and you start getting into the details and they don't, and
then there are new instruments that come along and new
opportunities for one country to gain on the other and they
trade that short-term benefit to everyone's long-term
detriment. But good. I am glad you are optimistic.
Mr. Volcker. One thing I would say in that connection,
maybe I am optimistic and out of it and don't know what is
going on, but there are bodies----
Senator Schumer. I doubt that.
Mr. Volcker.----internationally to deal with this, and to
the extent it can be left to these more or less expert bodies,
and accounting is one example, but the Basel Committee is
another example----
Senator Schumer. Yes.
Mr. Volcker.----and there are several other examples, the
political leaders ought to put pressure on those expert groups.
When they try to do it themselves----
Senator Schumer. I understand.
Mr. Volcker.----I think you get a problem.
Senator Schumer. All you need is one significant outlier to
throw off the--to toss up the apple cart.
One other question, because my time is running out, credit
rating agencies, where there has been real trouble. Do you
think the model ought to change, that we ought to----
Mr. Volcker. I mean, I can answer that question yes. But if
you ask the next question, how----
Senator Schumer. Yes.
Mr. Volcker.----I will tell you, I am not ready to make a
pronouncement. I think that----
Senator Schumer. Well, what about the old model, where
instead of the issuer paying for it, it was the investor that
did?
Mr. Volcker. Well, I was surprised to learn, or I had
forgotten, because ever since I have been compos mentis and an
adult, I think the AAA ratings or AA or whatever they were, but
20 or 30 years ago, they were paid by the investor.
Senator Schumer. Exactly. Yes, and it worked.
Mr. Volcker. And it worked. It seemed to work. So why can't
it work again? I don't know the answer.
Senator Schumer. The one--and this will be my last, because
my time is expiring--the one thing people say is that when the
investor pays, the investor doesn't want to make it public and
there is sort of a public good.
Mr. Volcker. Yes.
Senator Schumer. What would you think of some quasi-
governmental intervention here?
Mr. Volcker. I can't see the governmental agency making the
credit rating. The potential political pressures that will come
on, everybody----
Senator Schumer. Well, that is why I said quasi. Don't you
think the Fed is pretty well removed from political pressures?
Mr. Volcker. Well, I think the Fed is more removed,
properly so----
Senator Schumer. Yes, it should be.
Mr. Volcker.----than any other agency, and I like to think
it has earned that in part over time by competence in the way
it acts. But I don't think you just want to pile everything on
the Federal Reserve. At some point----
Senator Schumer. Yes.
Mr. Volcker.----it breaks.
Senator Schumer. Well, to clarify, my view would be to go
back to the investor-paid initially. We have got to do
something to change it.
Mr. Volcker. Well, I agree with that.
Senator Schumer. Thank you. Thank you, Mr. Chairman.
Chairman Dodd. I won't ask you to comment on this, but
since your knowledge and background in accounting, the FASB
model, and I realize they are very different functions we are
talking about here, but a FASB model has worked fairly well in
accounting standards, particularly when we got away from the
industry supporting it and financially underwriting it.
Mr. Volcker. Well, that is--the IASB is the FASB model writ
large internationally.
Chairman Dodd. So there is a value in maybe talking about
that model, as well.
Senator Crapo has been, of all the members of this
Committee, probably has worked as hard on Government
regulation, reform regulation as any member, so we welcome your
continuing participation in the Committee, Mike. Thank you.
Senator Crapo. Thank you, Mr. Chairman.
Chairman Volcker, I want to go back to the Group of 30
report just to kind of try to understand maybe in a little more
detail with you what was intended by it. I am going to first
focus on one of the concepts that Senator Schumer mentioned--I
apologize for my voice, I might lose it during the questions--
and that is the principle of unifying our regulatory system.
For some time even before we ran into this crisis, I have
been arguing that we need to unify our regulatory system and
really make sure that we had the right regulatory system for
our financial system and for our capital markets. In that
context, as I look at what we have today, it seems to me we
have a lot of overlap that is unnecessary. We have gaps where
there is no regulation where there should be. And we have
weaknesses in some parts of our system. And what we need to do,
as I think you said earlier, we need to get good regulation,
not necessarily a lot of it. We have got to be thorough. We
have got to cover everything, and in my opinion, eliminate
overlaps.
As I look at the first principle of the Group of 30's
report, it talks about dealing with gaps and weaknesses and so
forth in the system. But one of your first points is that the
activities of banks should be subject to prudential regulation
and supervision by a single consolidated regulator. Do I
understand you or the report at that point to be talking about
something like merging the functions of the OCC and the OTS and
perhaps other regulators?
Mr. Volcker. Well, we deliberately did not get into the
specifics. We were at a high level of generality when it came
to the administrative arrangements. But we do recognize the
problem that you just described and that you had to have some
kind of a unified system, at least for banks.
Senator Crapo. And when you say at least for banks, I
noticed one of your other points was that the activities of
large insurance, investment banks and broker dealers require
consolidated supervision. Are you not saying essentially the
same thing there in other contexts?
Mr. Volcker. Well, I can't say, speaking in the report, we
were saying the same thing, because we deliberately didn't want
to get into the detail. I think it is an important subject, but
we were concentrating on what the substance of the regulation
should be. At some points, we said it should be consistent. But
we didn't opine about who should do what.
Senator Crapo. Well, let me try to take you there, and you
don't have to speak for the report right now. A lot of
discussion has been made about whether we should have a single
regulator like they have in England, whether we should have
three regulators, one for the systemic, one prudential, and one
consumer protection----
Mr. Volcker. Well, one of----
Senator Crapo. Do you agree with those approaches or that
idea of consolidating?
Mr. Volcker. I think you should at least explore the idea
of two regulators, which was raised by Secretary Paulson's
report a year or so ago, that you have one on so-called
business practices and consumer protection and investor
protection and one on prudential safety and soundness concerns.
They overlap. They are not entirely separate, but there is
substantial difference between those two approaches. In fact,
there is enough difference in approaches you will get a clash
between those agencies. But maybe that is healthy----
Senator Crapo. Right.
Mr. Volcker.----instead of just having one. Now, you take
the English pattern, they went all one way and away from the
Central Bank. Now, that didn't work so well in terms of crisis.
So how do you get----what we did say very clearly is whatever
system you have, you had better get the Central Bank involved
enough so they can respond effectively to a crisis.
Senator Crapo. And that is consistent also with Secretary
Paulson's blueprint----
Mr. Volcker. Yes.
Senator Crapo.----in terms of the suggestions made there?
Mr. Volcker. Yes.
Senator Crapo. One other point that was made in the report
is that the money market mutual funds that were wanting to
continue to offer bank-like services should be required to be
reorganized as special purpose banks. Could you expand on that
a little bit? What was intended by that?
Mr. Volcker. Well, what was intended by that--you go back
in history a little bit. Money market funds developed because--
to escape regulation, effectively. This is a way to provide a
banking service outside of banks, and they had some competitive
advantages because they weren't banks and they didn't subject
to banking regulations. So when a crisis came along, the
framework was not adequate. In some cases, they were owned by
rich parents and it was OK. When they weren't owned by a rich
parent, you had a collapse with widespread repercussions.
We said, you should not essentially say we should not have
institutions out there that promise to act like a bank, but
they are not regulated and protected like a bank. And if they
are going to be protected de facto, which is what happened
here, in effect, they got a free ride, and they shouldn't have
gotten a free ride. So if they are going to act--if they are
going to talk like a bank and squawk like a bank, they ought to
be regulated like a bank.
Senator Crapo. Well, one of the principles that I tend to
follow as I approach this issue is that similar products or
similar functions should be regulated with the same rules or by
the same regulators. Would you agree with that principle?
Mr. Volcker. Well, I think if you adopted that regulation
on money market mutual funds, the natural thing would be to
have the same regulator as the banking regulator.
Senator Crapo. Thank you. One more thing I would like to
ask a little clarification on and that is your comment and the
report's comments about the way we should handle our GSEs,
Fannie and Freddie. You indicate that a clear separation of
Government financial support from the private profit-seeking
sector of this should be done. It is not clear again whether
you are saying that we should nationalize the Fannie and
Freddie functions or whether we should withdraw the Federal
guarantees or accomplish the Federal guarantees in some other
way. What exactly are you saying?
Mr. Volcker. We are saying that is your choice. You ought
to do one or the other.
[Laughter.]
Senator Crapo. All right.
Mr. Volcker. You shouldn't leave them hung up in between,
because it is confusing and when you got into trouble, were
they public agencies or were they not? And if they were acting
in the public interest, were they doing right for their
fiduciary responsibility to the stockholder? I think they got
placed in an impossible position. They were supposed to be
important constructive factors in the mortgage market. The
crisis came along and they were so over-extended in pursuit of
their stockholder interests that they couldn't perform the
public function. And if they performed the public function,
their stockholders would squawk. And you shouldn't permit that
to happen.
Senator Crapo. Thank you very much. Just one last question,
and really, this is sort of a summary to go back to what we
have already talked about and that you have already expressed a
comment on, but I would just like to explore it a little
further with you, and that is it seems to me that right now,
depending on whether you count the FDIC, there are six or seven
Federal regulators with overlapping responsibilities in some
cases, and as I said earlier, gaps in some places and so forth.
It seems to me that regardless of the specifics, that
Secretary Paulson's blueprint, the Group of 30 report, even
though it didn't get into the details, and a number of the
other reports that have dealt with this same issue have all
concluded that we have too complex a system that needs unifying
and simplification. Now, whether we go to a single regulator or
whether we go to a smaller number than the seven that we have
now, that we need to simplify and reduce the number of
regulators and clearly identify the functions they are
regulating and then move forward from there. Is that general
statement something you could agree with?
Mr. Volcker. Yes, I agree with that, but I guess what I
would say is when you get to that stage, that stage ought to be
second. I don't mean it should be way off, but you ought to
have some feeling about the substance of the regulation and
then decide who should do it rather than decide who should do
it and worry about the substance afterwards.
Senator Crapo. Agreed, and in that context, just to help me
in my mind, I am starting to think of that substance part of it
as something focusing on systemic risk, prudential regulation,
and then consumer protection, and there may have to be some
other insurance aspects or whatever.
Mr. Volcker. Yes.
Senator Crapo. But would that tend to be the kind of thing
you were talking about?
Mr. Volcker. I think it is one of the possibilities, yes. A
good possibility.
Senator Crapo. Thank you very much.
Mr. Volcker. The report doesn't say so, but----
Senator Crapo. I understand. I understand.
Chairman Dodd. No, and let me just say, too, I appreciate
Senator Crapo's longstanding involvement in this and I think we
are sort of heading in the same direction on a lot of this.
Obviously, the devil is in the details, a lot of it, but you
are getting sort of a consensus emerging up here and some ideas
and thoughts in this direction. That is why your testimony is
so tremendously helpful.
I can't--first of all, I don't disagree at all about the
conflicting missions of the GSEs of protecting your shareholder
interests and the public policy notion of housing. I am struck
by the notion that we are sort of doing--aren't we doing the
same thing now? When I look at Citi and Bank of America and
Goldman Sachs and the infusions of massive amounts of taxpayer
money, once again, now you have got the exact same situation we
talked about with the GSEs. In effect, we have a massive amount
of public money going in, so that we are setting public
criteria on private institutions. What is the difference?
Mr. Volcker. Well, the difference, I hope, is that this is
a reaction to a particular emergency and it is transitional and
nobody is thinking you are keeping it that way.
Chairman Dodd. All right. I hope so.
Senator Crapo. You are right, and I hope so, too.
Chairman Dodd. Let me just also, and Senator Shelby had to
go on to another meeting, let me just in a sense respond and
ask, as well. I mean, look, we obviously know that we have got
to go back. We are reviewing all the time how we get here. We
are asking everyone what their thoughts were on how this
happened and it is a very important question. None of us
disagree with it.
As the Chairman of a committee here, and all my members
serve on other committees, as well, and we have obviously got a
very important agenda to deal with, not the least of which is
the modernization of the regulatory structure and some sense of
urgency, I happen to believe, and I think you have implied
this, if there is any silver lining in all of this right now,
it is that I think there is a willingness and an understanding
that we have to move. In the absence of this moment, if this
were, quote, ``normal'' times, I think we would have a hard
time engaging in this debate and discussion because of the
vested interests that don't want anything to change at all. So
we have been given a moment, unfortunately, here, tragically, I
might add. But it is a moment.
Now, what do we do with the moment, and my fear is that if
I end up squandering a year going back and reviewing for the
next number of months how we got here--not an illegitimate
question--that I may miss the moment, and I will look back and
this Committee will look back and say, we had an opportunity.
Recognizing the moment, we need to do something about this.
And so I respect immensely the idea that we ought to spend
time, and I want to move carefully, obviously, and
deliberately. But my concern is if we miss the moment, we will
find ourselves in a deeper hole for a good many years to come.
So let me ask you, Doctor, if I can, do you sense that, as
well? Should this Committee and the others responsible,
obviously the House and the President, the executive branch,
move? And again, as I sensed it, your priority would be to deal
with systemic risk up front and soon. Is that correct?
Mr. Volcker. Yes, you know, with all deliberate speed.
Chairman Dodd. I agree.
Mr. Volcker. I am not enchanted by, you know, talking about
combining the SEC and the CFTC. It is an important issue, but
do that as part of the whole thing. Just don't pick out
particular issues like that, in my view, but I----
Chairman Dodd. Deal with the totality of it. And an issue
that Senator Crapo brought, and I care about, as well, is sort
of the forum shopping that went on by the major interests that
restructure themselves in order to pick out a regulator. It is
all backwards, in a sense. We should be determining who is
going to be regulated, not you choosing who you are going to be
regulated by, and that has been a constant problem, as well.
So as I hear you say it, the systemic risk would be the
area you think we ought to be aggressively pursuing, carefully
but aggressively pursuing. Am I correct?
Mr. Volcker. Yes.
Chairman Dodd. Do my colleagues have any additional
questions? Senator Warner?
Senator Warner. One quick question. Thank you, Mr.
Chairman, and I had to step out for a moment, so if Senator
Crapo asked this question, I apologize.
One of my questions earlier was about the argument over the
last decade, if we added more regulation, how the capital
markets would migrate elsewhere, and it seemed like, and I was
one of those folks who held up what looked like the model in
the U.K. as maybe one to go after. Clearly, it has not proven
to be all it was made out to be. Is there some other--as we
think through this, is there some other nation around the world
that has got a regulatory structure that you say, hey, as you
think through this in America, look at country X or country Y?
Mr. Volcker. I hate to make an advertisement for the Group
of 30, but we just issued a big report on that subject. We
described, I don't know, what, two dozen countries, different
systems. We refrained from saying which is best, but we did
pronounce a lot of pros and cons, what looked more promising
and the advantages, disadvantages of different systems.
There seems to be some intellectual and other movement
toward what the Senator was describing of two agencies, one for
business practices and one for prudential. I can't claim that
that is widespread, but there are two or three countries, or
four or five countries that now follow that. For a while, this
business of putting everything in one agency seemed to attract
a following. That enthusiasm has been a bit dampened by the
fact it didn't solve all the problems in the U.K.
But those are the two alternatives that need to be looked
at. The United States is big enough and complicated enough, we
may have a system like nobody else's, but I don't think anybody
is very happy with the system we have and it takes this kind of
a crisis to change it.
Senator Warner. Well, you could, Dr. Volcker, maybe you
could share with the Chairman at some point which of those
countries you think might be models or might give us some
guidelines or lessons we could learn from.
Mr. Volcker. We do have--your staff can, I am sure, look at
the report we have on that subject because it does try to
describe the strengths and weakness of different approaches.
And there is a pretty strong feeling, which is not the case in
the United States historically, that similar functions should
be subject to the same regulator and the same regulations,
which is----
Senator Warner. So focused on function rather than on
institution?
Mr. Volcker. Than by institution, yes.
Senator Warner. Thank you, Dr. Volcker.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much, and Doctor, we thank
you immensely. Let me just recommend, as well, and I am sure
you will agree based on your last comment, why don't we make
available the staff of the Group of 30, and for any interested
members and their staffs, we will try and set something up and
have a session where they can go through and do exactly that,
get into more details and the questions back and forth as part
of our ongoing effort here. It might be very worthwhile and we
will arrange that to occur, as well.
And I should have said at the outset, by the way, and I
apologize, Doctor, you and the Group of 30, the people who are
involved in this, I know the names are listed in the report
itself, but I want the record to reflect how much we appreciate
that effort. This was a very comprehensive effort made to
examine this----
Mr. Volcker. Thank you.
Chairman Dodd.----and it is appropriate that our first
witness in a series of hearings we are going to be having on
this subject matter comes from this very group that brings a
wealth of knowledge and expertise to this subject matter. We
are going to hear from the GAO and staff, who have also been
involved in this. I am going to bring them up here shortly, but
I want the record to reflect how much we appreciate that
effort.
You have begun a very important discussion, obviously not a
completely comprehensive one, but one that touches on the very
major issues we will have to address in the coming days if we
are going to effectively respond to the challenge of
modernizing our regulatory structure, so I thank you.
Mr. Volcker. Well, I think I can speak for my colleagues
that engaged in the study that we appreciate your interest. We
feel it was worthwhile, so----
Chairman Dodd. Well, this is the moment. This is the
moment. We have been given, unfortunately, a moment.
Mr. Volcker. And just in terms of all this competition
between countries and so forth, this is an international
report.
Chairman Dodd. I know that.
Mr. Volcker. There is no sharp cleavage between people from
different nationalities.
Chairman Dodd. Thank you very much.
We will leave the record open a little bit. There may be
others who couldn't be here today who would like to maybe
submit some ideas and questions to you, as well, and if you
have a chance to respond to those. We thank you.
Mr. Volcker. Thank you.
Chairman Dodd. I will invite our second witness up, our
second panel. Welcome to Dr. Gene Dodaro, who is the Acting
Comptroller General of the U.S. Government Accountability
Office, the GAO. Mr. Dodaro has worked for over 30 years in a
number of key positions at GAO, including Chief Operating
Officer. He will also be testifying tomorrow before the
Committee on the Troubled Asset Relief Program, so he is a busy
man with being here today and tomorrow.
Mr. Dodaro will be accompanied by two GAO staff members,
Rick Hillman and Ms. Orice Williams. We thank you for joining
us, as well.
Why don't you come on up and sit with--have both of you
come up and sit there, because I know you worked very closely
on the details of all of this and I know Mr. Dodaro would
appreciate having you sit there with him, as well, and respond
to some of this.
Again, we thank you very, very much. I am sorry about the
delay, but obviously a lot of questions for Dr. Volcker. So we
welcome your comments, and again, congratulations on this. All
of us have great respect for the GAO and the work you do, but
this is a very important effort you have put forward and sort
of a template for us to begin this very important discussion of
regulation modernization.
STATEMENT OF GENE L. DODARO, ACTING COMPTROLLER GENERAL, U.S.
GOVERNMENT ACCOUNTABILITY OFFICE
ACCOMPANIED BY RICHARD J. HILLMAN, U.S. GOVERNMENT
ACCOUNTABILITY OFFICE; AND ORICE M. WILLIAMS, U.S. GOVERNMENT
ACCOUNTABILITY OFFICE
Mr. Dodaro. Thank you very much, Mr. Chairman. I appreciate
the opportunity to appear before you and the members of the
Committee this afternoon to assist your deliberations on the
financial regulatory system.
As you mentioned, we in this report embarked on an effort
to assist this Committee and the Congress in tracing the
evolution of the financial regulatory system over the last 150
years, how it has evolved; to talk, second, about some of the
developments in the market that has really challenged that
regulatory system; and to put forth a framework to help guide
decisions on how to craft and evaluate proposals to change the
system going forward.
Our bottom line conclusion is that the current system is
outdated, it is fragmented, and it is ill suited to meet the
21st century needs of our nation. There are many reasons for
this. Three I would point out, trends that we identified in the
report.
First is that the regulators have struggled and often
failed to mitigate the systemic risks of large interconnected
financial conglomerates or to adequately ensure that they have
managed their own risks. There is no one single regulator
charged with looking at risk across the financial system. This,
as mentioned in the earlier discussions today, is a problem
that needs to be addressed.
Second, regulators have been confronted with some large
market participants that are less regulated. Non-bank mortgage
lenders, credit rating agencies have been mentioned here. They
are two that we point out in our report, as well.
Third, both the regulators, consumers, investors have all
been challenged by the emergence and growth of complex
financial instruments, whether it is collateralized debt
obligations, credit default swaps, over-the-counter
derivatives. All these products have really evolved and
introduced new dimensions into the system that really outpace
the regulators' ability to be able to handle that.
Now, going forward, we think that action needs to be taken.
It needs to be deliberative, as pointed out here in the
discussion so far. And in order to assist this, we outline nine
characteristics in our report which we think are good
touchstones.
First is that the regulatory goals need to be clear and
articulated in statute, and the goals really ought to drive the
substance of the organization, as Dr. Volcker mentioned
earlier, and they ought to be in statute so that they can be
used to hold the regulators accountable going forward and can
provide consistency over a period of time and ensure that there
is consistency in the regulation going forward.
Next, it has to be--reform has to be comprehensive. The
current institutions and products that, where there are gaps,
the gaps need to be closed and it needs to be looked at in an
interrelated set of, as has been mentioned, in a unified basis
going forward.
System-wide risk needs to be addressed. Somebody needs to
be in charge of making sure that the system-wide risks are
monitored going forward.
It needs to be flexible and adaptable, and by that we mean
it has to allow for innovation, but somebody has to be staying
abreast of risks that are emerging going forward. We know where
the risks are now. What shape they will take in the future is
really anybody's guess at this point, but we need to have a
monitoring system in place that can triage those risks, make
determination, not be totally reactive to the situations going
forward.
It needs to be efficient and effective. By this we mean
there is overlapping jurisdictions right now that can be
consolidated or looked to to consolidate so we have an
efficient system going forward.
Consumer protection has to be also a paramount
consideration here. Every time we have evaluated an activity
for this Committee or another committee in Congress in terms of
whether it is credit card fees or whether it is mutual fund
fees, the disclosures invariably aren't adequate enough going
forward, and I believe there also needs to be more attention to
financial literacy concerns. The Federal Government has a
commission on this, but it hasn't been--had a strategic plan,
been resourced properly. That needs to be part of the package,
as well.
The regulators have to have the right authorities. They
have to have proper independence, and that involves the funding
sources that they draw upon to ensure that independence going
forward.
And last, taxpayer exposure has to be minimized. We believe
that whatever structure is put in place, that future failures
are borne by the cost of the market participants and not by
taxpayers going forward. An example here is what is set up
currently in the Bank Insurance Fund, where fees are paid and
then institutions, if they fail or are taken over, then the
fund is recapitalized by the participants in the fund and not
by taxpayers going forward.
Now, to your point about seizing the moment, one of the
things that we did in order to highlight attention to dealing
with this issue was add the need to modernize the financial
regulatory system to our most recent update for the High-Risk
List that we keep for the Congress and unveil at the beginning
of each new Congress, and this is important because we have
added areas in need of broad-based transformation as one of the
criteria to be put on the High-Risk List. We think it was
important to do that, to feature this as the attention of need
of change both by the executive branch and importantly by the
Congress, in this case, through legislative initiatives.
So that sort of concludes my opening statement. My
colleagues and I would be happy to answer any questions that
you have.
Chairman Dodd. I must say, you are always a spectacular
witness. That was his testimony given without reading, and your
comprehensive knowledge of your own report is pretty
impressive. You have testified before us on numerous occasions
and you always do an excellent, excellent job, and so I command
you and your staff for your depth of understanding and
appreciation of the issue.
Am I to understand, by the way, when you listed the list,
the list is not necessarily in the order of importance, because
consumer protection comes sort of at the mid-point in that list
and I don't interpret that to mean that that is less important
than the first issue you raised.
Mr. Dodaro. That is correct. Basically, these nine
characteristics all have equal value. The only thing I would
say is we list the regulatory goals articulation up front,
which could include--and should include--consumer protection as
sort of an overarching starting point. But other than that,
they are all of equal importance.
Chairman Dodd. And the last comment you made is I
understand to be that you believe this ought to be a high-
priority item for this Congress, the 111th Congress.
Mr. Dodaro. Definitely.
Chairman Dodd. Yes. Let me, if I can, begin with the first
question I asked Dr. Volcker, because again, while obviously we
are looking forward here, Senator Shelby's point, whether you
want to have this Committee do it or someone else do it or
however, and I think you can walk and chew gum, that we can
actually do both functions maybe simultaneously, that is
analyze how we got here as we decide what steps to take going
forward, is an important question.
And so the question I asked Dr. Volcker was, I will repeat,
and that is your, in fact, the report here states, and I quote
here:
Mechanisms should be included for identifying, monitoring, and
managing risk to the financial system regardless of the source
of the risk.
What was the source of the risk?
Mr. Dodaro. I think, you know, basically the three areas
that I pointed out in terms of these developments that have
occurred that have outpaced the ability of the financial
regulatory system. It depends on how you want to frame it. Our
report frames it in terms of market developments compared with
the regulatory system. Our report is not a comprehensive
inventory of every, perhaps, poor decision that was made by
individual regulators or by companies or by other institutions
going forward. Clearly, that is worthy of investigation.
But our point was that there are these broad trends, and
these trends, you know, we have seen emerge over a period of
time. In 1994, we issued a report on the problems that were
emerging in derivatives. In 2004, at the request of this
Committee, we issued a report talking about the need to
modernize the financial regulatory system. So a lot of the need
to change the system, I believe has been emerging over a period
of time. It was definitely brought to the forefront over this
past year in the scope and dimensions of the problem. But I
think there is enough basis of study being done that could
begin to build the record that Senator Shelby was talking
about.
But until action is taken, we continue to have these
exposures and vulnerabilities, and I don't think, you know,
some of this can proceed on a parallel path.
Chairman Dodd. I agree with you, as well.
Let me--the structure of the financial regulation. Again,
we have heard a lot of different ideas today. I keep sensing
some commonality among members up here and I would like to
raise, if I can, in order to address the problem, should we
consolidate regulatory agencies? If so, which agencies should
be consolidated and what public policy goals would such
consolidation achieve? Is there a role for maintaining a State-
Federal system of optional bank charters, for instance, in your
view? What are the advantages and disadvantages of creating a
Federal insurance regulator?
We are debating up here, and this subject has been before
us, on the Optional Federal Charter. A lot of people think
there is not much debate over life issues. There is a
significant debate over property casualty issues of how we go.
What are your thoughts on those questions?
Mr. Dodaro. I will ask Mr. Hillman to comment on the
insurance industry. He has done a lot of work on that area. But
in terms of your first question about consolidation, some of
our work in the past, in the banking regulators agency, we
raised the issue of the potential benefits of merging OTS and
OCC and perhaps the supervisory responsibilities of the FDIC as
a potential area that ought to be examined going forward.
Obviously, many people have mentioned the SEC-CFTC potential
issue going forward.
But my point would be, at this juncture, those decisions
need to be made in concert with identifying who the systemic
regulator would be, because the relationship between that
regulator and the other regulators that may have more specific
prudential responsibilities, I think needs to be thought of in
a holistic fashion. Otherwise, we are going to put in place
another potentially fragmented system to replace a fragmented
system that we already have.
Chairman Dodd. So get to the systemic risk issue first?
Mr. Dodaro. First, and then in parallel with that decide
how to make the other system support that, and it will also
help the systemic risk regulator because they won't be having
to deal with as many other entities going forward and it does
address the issue of regulatory arbitrage that you mentioned
earlier, Mr. Chairman.
But Rick can comment on the insurance area.
Chairman Dodd. Yes.
Mr. Hillman. The notion of an alternative national
insurance regulator is something that is deserving of
significant merit, that we need to best understand the
tradeoffs associated with that. But in recent years, the
preponderance of evidence, particularly amongst the larger
insurance companies, suggests that they are at a disadvantage
compared to the banking and security sectors in that the
banking and security sectors can bring new products to the
market more swiftly that are similar to products that are also
being sold by the insurance industry. However, the insurance
industry, rather than having one or a small number of
regulators to get product approval, has 54 separate regulators
from the 50 different States and four different Territories. So
the idea of having some commonality associated with the
introduction of products of similar nature in the marketplace
is something that deserves close attention.
Chairman Dodd. Yes. Well, it does and this Committee cares
a lot about it. What about the State-chartered versus federally
chartered institutions?
Mr. Dodaro. I think what we have seen and observed over
time, the State function, particularly as it relates to
consumer protection, has provided an important safeguard and we
think the benefits of that need to be preserved going forward.
There needs to be obvious coordination in this area. There
are--it is important always to have some checks and balances in
the system, and I think the Federal-State issue is one of the
important checks and balances that needs to be maintained in a
revised system. Most of our work is focused on the Federal
level, of course.
Chairman Dodd. Let me jump, if I can, to the issue of
failing institutions. The GAO report suggests that a regulatory
system should have adequate safeguards that allow financial
institution failures to occur while limiting taxpayers'
exposure. Can you give us an example of some of those
safeguards?
Mr. Dodaro. I mentioned, alluded to one in my opening
statement. The Bank Insurance Fund, I think, is the model that
we have in mind going forward here extended across the system
whereby the banks pay fees into the system. The fund is then
capitalized. There is a statutory ratio that is set, and if the
fund falls below that ratio, FDIC has a number of years in
order to recapitalize the fund----
Chairman Dodd. Right.
Mr. Dodaro.----but that is done by the financial
institutions in the system and not supported by taxpayer funds.
I mean, that was something that was modernized during the
savings and loan and banking crisis we had in the 1990s.
Chairman Dodd. Yes.
Mr. Dodaro. We think there ought to be something like that
more broadly speaking in this system so that the taxpayers
aren't turned to to provide anywhere near the level of
investment that we are being asked to provide today.
Chairman Dodd. The former SEC Chairman, Bill Donaldson,
once warned against executive compensation plans that
emphasized rewards for short-term financial targets, and I
quote him here. He says, ``People with targets and jobs
dependent on meeting them will probably meet the targets, even
if they have to destroy the enterprise to do it,'' end of
quote.
I wonder if you might explain the relationship of
compensation to risk taking, particularly when oriented toward
short-term goals and discuss how they should be addressed.
Mr. Dodaro. This is an area that we haven't studied
extensively going forward, but clearly the role of incentives
here are important going forward and you are seeing some of
that. We point some of that out in our report in terms of the
number of mortgages lent, for example, and the incentives
systems build into it. So I think that is an area that needs a
lot more study and attention, but clearly, the incentives in
the corporate governance aspects of this can't be overlooked
going forward.
Chairman Dodd. So the issue of proxy voting and so forth on
compensation issues, it has been discussed a little bit in the
past, but to what extent shareholders at what level have a
right to participate in making--first of all, they find out
invariably a lot of these contracts are entered into and you
don't discover all the details of them until someone is
leaving.
Mr. Dodaro. Mr. Chairman, let me go back and look at what
we have done in the past. I don't have a ready answer for you
on that today and we will provide one.
Chairman Dodd. I appreciate it. I thought you might, but it
was one I wanted to raise.
Let me turn to Senator Johanns.
Senator Johanns. Thank you, Mr. Chairman.
A couple of thoughts. Having run a State government from
the Governor's office and having a Director of Insurance which
I appointed and regulating insurance at the State level, I will
tell you, and we were a fairly small State population-wise, at
least, that there was a closeness of regulation there that
never got very far away from you.
Now, I compare that with having run a Federal department,
very large, 110,000 employees in 75 foreign countries. We
regulated a whole bunch of things. These regulatory enterprises
can be so big and the diversity so enormous around the country
that what happens is exactly what your report points out. It
just breaks down.
And so when you start comparing State charter versus
Federal charter, et cetera, I think we have to keep that in
mind. I really do. Having run both, I can tell you, a
department that regulates on a national basis is always going
to fight that battle. That is my observation.
My question, though, deals with kind of a follow-up on this
whole issue of risk analysis. How do you figure out that this
basketful of assets has value and what is its value and what
exposure do you want to take to that risk? I would like to hear
your thoughts on that. Is this something where you would
suggest that our regulatory framework have kind of a pre-
approval feature to it, because once the investments are made,
the horse has pretty well galloped out of the barn, if you know
what I am saying. I would just like to hear your thoughts about
that.
Mr. Dodaro. Yes. Clearly, the risk management failed at
several levels in this situation. It failed at an institution
level. It failed at an industry level. It failed at the
national level and at an international level. I think the
breadth in which this moved across the globe, I think really
surprised a lot of people.
At the request of Senator Reed, in his capacity as a Chair
of one of the subcommittees of this Committee, we are looking
at risk management practices going forward and I will ask Ms.
Williams to give you a little bit of an outline on what he has
asked us to do, and we will be reporting on that shortly.
But this is an area that I think is really in need of
attention going forward. This is the role that we would see the
systemic risk regulatory playing, to monitor the developments
and to make that decision. And I think you are going to have to
rely on the regulators to make the decision as to whether to
intervene or not. There is the possibility perhaps of allowing
pilots to go forward without it being system-wide. There are
other cases where you may want to be watching it, monitoring it
for a while very closely. But this risk management that we have
in mind needs to be an active risk manager, not over-reactive,
but not under-reactive, as well.
Orice?
Ms. Williams. Basically, what we are going to do on this
engagement, we are looking at risk management oversight. We are
specifically interested in what the Federal regulators do when
they look at risk management at an institution, how they
actually go about examining that particular aspect of a
financial institution, and then we are looking at how the
regulators identify risk that they are going to focus on in an
examination, because they do risk-based examinations, to see
how often risk management bubbled up in the past several years
up to the current point. And then finally, we are looking at
the resources that are dedicated to the examination function
across the banking regulators, as well as the SEC.
Senator Johanns. One other thing I wanted to ask you about
as you start to look at this is the whole issue of offloading
risk, and maybe there is no solution to that, but it seemed to
me this system got created in such a way that the premium for
me as the broker was to write the loan at all costs, whatever I
could do to get that person to sign on the dotted line, then it
is packaged and it is sold off and the risk goes to somebody
else and somebody else or whatever.
I would really like to hear your thoughts on how to deal
with that, because--and maybe that gets back to the issue of
valuation again. But to me, that seems to be an important
element as we think about what we want to do with the
regulatory system.
Mr. Hillman. When you go back a decade or more, the process
that depository institutions typically followed in funding
mortgages is they would have their own underwriters review the
competency of individuals to pay those loans and they would go
through a detailed process before making a decision to provide
a loan to an individual. Once that decision was made, they
would hold that risk or hold that loan on their books
themselves.
Today, most oftentimes that is not the case. The case is a
model of originate to distribute, where institutions are making
decisions and receiving a fee for that service and passing that
risk on to others. This originate to distribute model is one of
the reasons why we have resulted in the crisis that we are in
today and some say that additional attention is going to be
needed in the future to help to ensure that at least some
responsibilities are being held by each of the individual
parties along the way to ensure the appropriateness of
decisionmaking at each of those levels.
Senator Johanns. Can I often one last piece to this? That
piece would be the thought of rating the risk. Is that an
appropriate governmental function? For example, if my bank
wants to go out and originate junk in the hopes of marketing
it, we should call it that. If, on the other hand, they are
following a model of caution and due diligence and doing the
very best they can to make sure that those loans are going to
be repaid, that should be viewed differently.
But the important thing is, how do we let the consumer know
that? How do I, Mike Johanns, going in to make my deposit, how
do I know that those practices have been employed, so if I buy
their stock or invest my money in that stock or whatever, I am
an informed consumer? These are complicated issues, but I think
that is what we are trying to get to here, is to protect the
consumer.
Mr. Dodaro. I think basically the answer to that question,
Senator, I think involves safeguards at various levels. You
need to have the regulators in the examination be clear that
the institutions are following due diligence, good practices;
second, there is proper disclosure; and then third, there is
education, and then a consumer protection safeguard in place.
So it is a very important question. It runs--the threat of
it runs through all these various areas that we are talking
about. I don't think there is one solution to it, but it is
something that needs to be looked at on a comprehensive basis
because it is pivotal to the decisionmaking that takes place
within all these various levels of institutions and products.
Senator Johanns. We have run out of time, but my final
thought, Mr. Chairman, is this. If we don't figure this piece
out, the mechanism won't make a bit of difference. We can
create this. We can put it under the Fed. We can do whatever,
whatever, but if you don't solve that piece of it, then they
are almost guaranteed to fail as a regulator and we will be
back to reports like you just wrote.
Mr. Dodaro. Yes, and basically, that is why we set out
those characteristics, because if you address all the
characteristics, we believe you will get at this issue. This
isn't just the question of moving boxes around and solving a
problem. It is not anywhere near that simple.
Senator Johanns. I went over my time, so thank you.
Chairman Dodd. No, you didn't, Senator. You just made a
very, very valuable point to me, because if there is that
common denominator, as Mr. Dodaro just described that thread, I
believe it is consumer protection. I think we have operated for
far too long, over the last number of years, where there has
been a notion that consumer protection was antithetical to
economic growth, that if you were talking consumer protection,
you were creating hurdles, barriers to economic growth.
And the painful lesson we have all learned in these last
number of months, several years now, is that when consumer
protection is foremost in your minds, what happens to that
investor, what happens to that customer who walks in, if you
are guarding and watching out for them, that you can avoid the
very problems we got into.
We didn't watch out, that is we, the regulators, the
Government itself, was not watching out for what happened to
that purchaser of that mortgage. We were assuming somehow that
the system was taking care of them, and they weren't, and so
they got cheated in the process. When you abandon the consumer
in your analysis of all of this, you put economic growth at
risk, and I think your question is right at the heart of it.
We just move boxes around here and create different
structures and make it look more simple, but without providing
that kind of protection, coming back to the notion that
protecting the consumer is absolutely essential for economic
growth and the avoidance of the very situation we find
ourselves in today, I think is an excellent point. Thank you
for it.
Senator Warner?
Senator Warner. Thank you, Mr. Chairman.
Mr. Dodaro, nice to see you again and, again, compliments
on initiating this report and listing it as a top priority for
the Congress to take on and the country to take on.
I want to follow up on Senator Johanns' point. One of the
areas that has been suggested--and I do not know if you all
have weighed in--is if you are originator of one of these
mortgages or one of these loans, you keep a stake in the game,
that you cannot sell off 100 percent of that risk.
Have you taken a position or do you have a comment on that
``stake in the game'' notion?
Mr. Dodaro. Now, we have not looked at that particular
issue, Senator.
Senator Warner. Mr. Chairman, that is one way, if you are
not taking the whole--selling off 100 percent of the risk, as
Mr. Hillman mentioned earlier. A decade ago the bank, the
originator of the loan, would keep that loan on its books and
have a long-term obligation. As they have been securitized and
sliced and diced, that connection and bond between the lender
and the lendee has disappeared. And one proposal is
reconnection and making sure that if you originate, you keep
some skin in the game.
Chairman Dodd. Absolutely.
Senator Warner. But let me also follow up on, I think, your
appropriate point about protecting the consumer, and it is kind
of, again, from a--I keep coming back to, you know, this kind
of way we approach this. My concern is, Mr. Chairman, that we
clearly need to do a better job of protecting the consumer, but
I think we have operated on the premise that transparency and
disclosure alone would be enough to protect the consumer. And
it seems like we have had two contradictory policy goals. On
one level, we want to protect the consumer. On the other level,
as we push out these more challenging mortgages or credit
cards, the population that we are dealing with are oftentimes
the least financially literate.
So what I question, even with more focus on financial
literacy programs, is whether disclosure alone is going to get
us there and, you know, will there need to be some type of
restrictions--again, I come back to my bright lines--on certain
products that if you are not, for example, a qualified
investor--I spent 20 years in the venture capital business. You
know, to invest in my venture capital funds, which were high
risk, you had to be a qualified investor.
Do we need to have, in addition to--if we are going to
truly protect the consumer, in addition to disclosure and
transportation, are we going to need actually some bright-line
prohibitions?
Mr. Dodaro. I definitely think that the systemic regulator
that we are talking about would fulfill that function, or at
least that could be one of the functions they fulfill, is to
assess the risk level, and there have to be tolerances put in
place and balances and decisions made on a case-by-case basis
as to whether the risk--you know, assuming you have these clear
goals of consumer protection as one of your goals, along with,
you know, allowing innovation and capital formation. But, I
mean, all those things have to be balanced. But I think you
definitely need that in place.
I agree with what you are saying, that, you know,
disclosure, transparency alone are not going to be enough. I
think you need to have it sort of from one end to the other.
One is the regulators need to be protecting the consumers as
well as allowing for innovation, all the way through
transparency, disclosure, down to educating people more to make
them more financially literate.
Senator Warner. I had a family member who I warned time and
again do not get into this adjustable rate mortgage. All the
warnings in the world, all the transparency in the world, would
not have precluded her from taking a bad long-term action. I
was able to bail her out, but now we are looking to a national
Uncle Sam bailing everybody out because at some point people
with information may still not be making good financial
judgments here.
Mr. Dodaro. I agree completely.
Senator Warner. So there has to be some protection
component.
Mr. Dodaro. Right.
Senator Warner. I know our time is getting short, but one
last question. We have spent a lot of time, again, about all
these new financial tools and the over-financial engineering
that is taking place. How do we make sure that the regulators
stay abreast of these tools and have the skills and the
technology and the competency to make sure that they actually
understand these new products as they emerge?
Mr. Dodaro. Well, I clearly think--and I will ask Ms.
Williams to comment on this because she has been doing a lot of
our work on these instruments. But, first, clearly the goal has
to be set for them to do that. And I think if the Congress sets
a statutory--as part of the regulatory goal, an expectation
that occur, that is there, I think they need to be given then
the authorities to be able to hire the necessary people and
compensate them appropriately for doing that. And I do think
they would have the capability to be able to do it.
There is no doubt in my mind that you have some very
talented people in the regulatory system right now that, given
the proper goals and expectations, can, you know, develop in
that area. It will not be easy because of the ingenuity of many
of the market participants, but I think it is achievable.
Orice, do you have anything?
Ms. Williams. The only thing that I would add is that this
is an area that the regulators are always going to be at a
disadvantage in dealing with because the markets are always
looking to come up with new and innovative products. But I
think one of the things that would really help--and we tried to
speak to this with our principal, focused on having, you know,
a flexible, nimble process for regulators to be able to adjust,
is to get beyond the type of product and the label that is
attached to a particular product and really be able to focus on
the risk that that product may pose to the system and making
that the focus and the driver for whether or not products need
to be brought under a regulatory umbrella.
Senator Warner. So actually making a risk assessment of the
product, and then if the assessment was the product was too
risky, then perhaps saying some universes of consumers might
not be eligible to----
Ms. Williams. Or that it needs to be, you know, regulated
or looked at from a regulatory perspective and not just focus
specifically on it meets this statutory definition so,
therefore, it falls out of a regulatory jurisdiction versus it
poses this particular risk to the system, therefore, it needs
to be subject to some level of regulation and oversight.
Senator Warner. We had that situation last week in the
Madoff hearing where we had both SEC and FINRA here, and, you
know, asked very much suddenly, you know, on broker-dealers, if
somebody says they were an investment adviser and FINRA is
looking, they are going to suddenly stop and not turn over that
information. These regulatory lines clearly in that case might
have precluded exposing a real financial scam.
Ms. Williams. Exactly. And one example, we have worked
looking at credit default swaps, and that is another example of
a product that meets a definition and, therefore, there is----
Senator Warner. No examination beyond meeting the
definition.
Ms. Williams. Exactly.
Senator Warner. Amen. Thank you very much.
Ms. Williams. You are welcome.
Senator Akaka.
[Presiding.] Thank you very much, Senator Warner.
Mr. Dodaro, it is good to see you again, and our panel. I
am so glad that we have a new team that is addressing the
problems that we are facing immediately. And I think you know
the history of the so-called Financial Literacy and Education
Commission. That is chaired by the Secretary of Treasury, and
it has a mission that has really not been carried out. And I
think that is an answer to some of the problems that have been
mentioned here.
Previously, I heard about protecting the consumers. Well
before the current economic crisis that we are facing at this
time, financial regulatory systems were failing--failing to
adequately protect working families from predatory practices
and exploitation. And this Commission was really put in place
to try to prepare strategies that would deal with the problems
that people in the country would have.
I would tell you that one of the huge problems that this
country has is that this country is financially illiterate. And
so these financial literacy programs fill that void, and we
need to really, I feel, try to bring that back to life and to
help the causes here.
Families have been pushed into mortgage products with
associated risks and costs that they could not afford. And
instead of utilizing affordable, low-cost financial services
found at regulated banks and credit unions, too many working
families have been exploited by the high cost of fringe
financial service providers such as payday lenders and check
cashers. I would tell you--and I am sure it is not only in
Hawaii--that you find offices like these outside of our bases,
and so our military personnel really suffer on this.
So my question to you, Mr. Dodaro, is: How do we create a
regulatory structure that better protects working families
against predatory practices?
Mr. Dodaro. I will ask Rick to elaborate on the Financial
Literacy Commission, Senator Akaka, but first, it is a pleasure
to see you again as well.
We have studied the Financial Literacy Commission. We have
also studied issues relating to information being provided to
our military families to educate them. Ms. Williams was
involved in that, and we can provide that information for the
record as well.
But I think, clearly, the issue first has to be a clear
articulation of consumer protection being a clear goal of the
regulatory system, to have it organized properly, resourced
properly, and there needs to be continual congressional
oversight. I think this is an area that the whole financial
regulatory system needs to have some ongoing oversight
activities. Even if the Congress makes the determination that
the system is going to be modernized and a new system is put in
place, the idea that that would operate effectively from day
one without continual refinement and oversight I think is an
unrealistic goal.
And so I would say there needs to be a proper transition
and it needs to be followed through on oversight. But let me
have Rick talk about the Financial Literacy Commission, because
I could not agree with you more about its importance.
Senator Akaka. Thank you.
Mr. Hillman. We recently completed a report assessing the
Financial Literacy Commission at the Department of Treasury.
Exactly as you have said, this Commission was established to
help to promote financial literacy on a nationwide level. It
brought together over 20 departments and agencies who had
financial literacy programs with the hope of consolidating
those efforts and distributing those out to the nations in
need. What we have found, however, though, is that the
Commission itself is well understaffed and unable to achieve
the mission which it was set up to accomplish.
For example, one of the activities that the Commission
undertook was to ask each of these agencies to determine the
extent to which they had any overlap or duplication in the
individual financial literacy initiatives that they had
undertaken. And due to a lack of resources, they asked each of
the agencies to themselves make that assessment as opposed to
having some sort of expert assessment done by an outside party.
That internal assessment came up with very limited
suggestions as to how the financial literacy programs could be
improved, and we made a recommendation that they seek
additional expertise to assess the effectiveness of those
programs.
Regarding the notion on the military bases, we have done
significant work and we have work ongoing now that is looking
at the extent to which sales of financial products to the
military, particularly egregious insurance products, are
continuing to cause havoc on bases. Sadly, we are finding that
that continues to be the case.
One of the major limitations associated with the oversight
of payday lenders and other types of establishments that you
mentioned in your State that is rampant across all States has
to do with the fact that those types of associations that fall
outside of the reach of a financial services regulator are
under the regulatory authority of the Federal Trade Commission.
The Federal Trade Commission is largely an enforcement agency,
not an oversight agency. It is a small organization with
significant responsibilities, and currently configured, it is
simply unable to achieve the level of oversight that most would
like to have.
Senator Akaka. Yes, and I also understand that the
Commission, as you said, has been understaffed. Also, they are
having problems trying to come to some consensus among
themselves, the 20 Federal agencies, and simply because they
have different missions and perspectives. But I hope that we
can look at these missions and perspectives as a means of
bringing a solution to this particular problem. And part of the
mission, of course, is education, and this is one thing that we
really need to press across the country. And I feel that if
more of the citizens of this country were better educated
financially, some of the problems we are facing now may not
have been as large as this.
But I think we need to, Mr. Dodaro, work on this Commission
to make it more effective and to use its efforts to deal with
financial literacy in the country.
Mr. Dodaro. I agree, Mr. Chairman, and we would be happy to
follow up on our report and provide a follow-up activity report
on how well they have implemented the recommendations to the
Committee.
Senator Akaka. Well, let me thank you for your January 2009
report, and I have seen parts of it, and your report states
that:
New and more complex products raise challenges for regulators
in addressing financial literacy. Without sufficient financial
literacy, individuals will not be able to effectively evaluate
credit and investing opportunities or be able to cope with
difficult economic situations.
And we agree with that.
My question to you is: How can we ensure that in a new
regulatory structure financial literacy is effectively
addressed?
Mr. Dodaro. I think in the characteristics that we point
out in our January report, Senator, we point out a couple
things, characteristics that are pivotal to this issue. One is
clear articulation in statute of a regulatory goal. So this
needs to be clearly articulated. Someone has to be given the
responsibility for doing it, proper resources, proper
accountability back to the Congress, and I think that there
needs to just be follow-up.
This is not a hugely difficult task in the sense if we make
a priority and then we apply the proper resources and we ensure
people are following through on this initiative. Plus I think
this is one that if there is work to be done with our education
system, there needs to be an integrated fashion, you know, put
in place to be able to do this.
One of the things that I almost did rather than come to GAO
many, many years ago is I had an idea to start a class to be
taught in high schools on this very issue at that point in time
because I think it is very important. It has got to start early
with people and be built into the education system, and then it
has to be reinforced on a more sophisticated level as people
take on additional responsibilities and begin working and
making larger purchases going forward.
Senator Akaka. Well, I want to thank our witnesses today
for appearing here, and I apologize for Chairman Dodd, who was
called away. That is why he is not here. And I want to thank
you again for your responses.
The hearing record will remain open for additional
statements and questions, and, again, I thank you for your
responses and look forward to having you in hearings in the
future.
This hearing is adjourned.
[Whereupon, at 5:36 p.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
STATEMENT OF SENATOR CHARLES SCHUMER
First, I'd like to thank Chairman Dodd for holding the first of
what I'm sure will be many hearings on financial regulatory reform. For
decades, America generally, and New York in particular, have been the
financial capitals of the world. Our markets have been the deepest,
most liquid and safest. Our dominant position was built not only on our
talent, ingenuity and expertise, but also on a foundation of strong but
efficient regulation, and a reputation for fairness, that demonstrated
to investors that they would be protected from fraud and financial
recklessness here. The events of past 24 months have destroyed our
reputation as the system has been gripped by a financial crisis that
resulted from years of regulatory neglect at all levels.
Eight years of the Bush Administration's one-sided, laissez-faire,
deregulatory ideology have helped cripple our financial system, and an
outdated and overmatched regulatory system in this country compounded
their failure. Even former Federal Reserve Chairman Alan Greenspan,
once an ardent defender of deregulation and the free market, recently
acknowledged that there was a ``flaw'' in his belief that markets could
and would regulate themselves. I hope that we've learned that as
appealing as deregulation may seem in good times, the price we
ultimately pay will be far higher than had we exercised the good
judgment and restraint imposed by responsible regulation.
Designing a regulatory system is a complicated and difficult task.
Regulation must strike a delicate balance--providing a sense of safety
and security for investors, without snuffing out the flame of
entrepreneurial vigor and financial innovation that drives economic
growth.
It's easy, and even tempting, to go to the ideological extremes on
either end of the spectrum. But threading this needle correctly is an
essential component of restoring confidence and long-term stability to
the financial system.
For many years, the United States had struck that balance very
well. However, new factors, including technology, globalization, and
industry consolidation and evolution have left our regulatory
infrastructure too far behind the reality of today's global financial
system.
Where does this leave us? Well, it leaves us needing significant
reform. As we go forward, I believe there are a number of clear
principles that we must adhere to. I've discussed these principles
before, but I think they're worth repeating now as we begin the
discussion of regulatory reform under a new Administration.
1.) We must focus on controlling systemic risk and ensuring
stability.
In increasingly complex markets, even the most sophisticated
financial institutions don't always understand the risks their
decisions involve. Smaller institutions like some hedge funds and
private equity firms, can also create systemic risk in today's world
and cannot escape regulation, particularly when it comes to
transparency. We need regulation that looks at risk systemically and
above all, we need to ensure that whatever may happen to any individual
financial actor, we can be confident that the financial system itself
will remain strong and stable.
2.) We need to look closely at unifying and simplifying our
regulatory structure.
In this era of global markets and global actors, we cannot maintain
the older model of separate businesses with separate regulators. Right
now there are too many regulators at the Federal level with overlapping
authority. This creates a regulatory ``race to the bottom'' as less
responsible firms are able to play the regulators off one another in
their efforts to operate with as little oversight and as few
restrictions as possible.
3.) It is clear that we must figure out how to regulate currently
unregulated parts of the financial markets and opaque and
complex financial instruments.
There are too many vital players and products in the financial
markets that operate beyond the scope of Federal regulators, yet have
the ability to put the system at risk. We must create an effective
regulatory framework for those actors and for more exotic financial
instruments like complex derivatives and even the relatively plain
vanilla credit-default swaps, which have grown into a multi-trillion
dollar part of the financial system.
4.) We must recognize that a global financial world requires global
solutions.
In this era of global finance, while we have international markets,
we still have national regulations. The danger is that there is often a
rush to the place where regulation is lightest and least effective.
This may be our toughest challenge.
5.) Increased transparency must be a central goal.
We must continue to emphasize transparency among all market
participants. The ability of investors, lenders and especially
regulators to evaluate the quality of holdings and borrowings is
essential for restoring confidence.
A complete overhaul of this nation's financial regulatory system
will be difficult, complex and time consuming. I look forward to
working with President Obama, and under the leadership of Chairman Dodd
to advance this process so that as we begin to recover from the current
financial crisis in the coming months, we have a system in place to
prevent its repetition.
______
PREPARED STATEMENT OF PAUL A. VOLCKER
Chairman, Steering Committee of the Group of 30
February 4, 2009
Mr. Chairman and Members of the Senate Banking Committee:
I appreciate your invitation to discuss the recent Report on
Financial Reform issued by the ``Group of 30''. I remind you that the
Group is international, bringing together members with broad financial
experience from both the private and public sectors and drawn from both
highly developed and emerging economies. While certainly relevant to
the United States, most of the recommendations are generally applicable
among globally active financial markets.
I understand that the text of the Report has been distributed to
you and your staff and will be included in the Committee record.
Accordingly, my statement will be short.
What is evident is that we meet at a time of acute distress in
financial markets with strongly adverse effects on the economy more
broadly. There is a clear need for early and effective governmental
programs both to support economic activity and to ease the flow of
credit. It is also evident that fundamental changes and reform of the
financial system will be required to assure that strong, competitive
and innovative private financial markets can in the future again
support economic growth without risk of a systemic financial breakdown.
It is that latter challenge to which the G-30 Report is addressed.
I understand that President Obama and his administration will soon
place before you a specific program for dealing with the banking
crisis. Such emergency measures are not the subject of our Report.
However, I do believe that the implementation of the more immediate
measures will be facilitated by an agreed sense of the essential
elements of a reformed financial system.
In that respect, the basic thrust of the G-30 Report is to
distinguish among the basic functions of any financial system. First,
there is a need for strong and stable institutions serving the needs of
individuals, businesses, governments, and others for a safe and sound
repository of funds, as a reliable source of credit, and for a robust
financial infrastructure able to withstand and diffuse shocks and
volatility. I think of this as the service-oriented part of the
financial system dealing with customer relationships. It is
characterized mainly by commercial banks that have long been supported
and protected by deposit insurance, access to Federal Reserve credit,
and other elements of the Federal safety net.
What has become apparent during this period of crisis is increasing
concentration in banking and the importance of official support for
systemically important institutions at risk of failure. What is
apparent is that a sudden breakdown or discontinuity in the functioning
of such institutions risks widespread repercussions on markets, on
closely interconnected financial institutions, and on the broader
economy.
The design of any financial system raises large questions about the
appropriate criteria for, and the ways and means of, providing official
support for these systemically important institutions.
In common ground with virtually all official and private analysts,
the Report calls for ``particularly close regulation and supervision,
meeting high and common international standards'' for institutions
deemed systemically critical. It also explicitly calls for restrictions
on ``proprietary activities that present particularly high risks and
serious conflicts of interest'' deemed inconsistent with the primary
responsibilities of those institutions. Of relevance in the light of
recent efforts of some commercial enterprises to recast financial
affiliates as bank holding companies, the Report strongly urges
continuing past U.S. practice of prohibiting ownership or control of
Government-insured, deposit-taking institutions by non-financial firms.
Secondly, the Report implicitly assumes that, while regulated
banking institutions will be dominant providers of financial services,
a variety of capital market institutions will remain active. Organized
markets and private pools of capital will be engaging in trading,
transformation of credit instruments, and developing derivatives and
hedging strategies, and other innovative activities, potentially adding
to market efficiency and flexibility.
These institutions do not directly serve the general public and
individually are less likely to be of systemic significance.
Nonetheless, experience strongly points to the need for greater
transparency. Specifically beyond some minimum size, registration of
hedge and equity funds, should be required, and if substantial use of
borrowed funds takes place, an appropriate regulator should be able to
require periodic reporting and appropriate disclosure. Furthermore, in
those exceptional cases when size, leverage, or other characteristics
pose potential systemic concerns, the regulator should be able to
establish appropriate standards for capital, liquidity and risk
management.
The Report does not deal with important and sensitive questions of
the appropriate administrative arrangements for the regulatory and
supervisory functions. These are in any case likely to be influenced by
particular national traditions and concerns. What is emphasized is that
the quality and effectiveness of prudential regulation and supervision
must be improved. Insulation from political and private special
interests is a key, along with adequate and highly competent staffing.
That implies adequate funding.
The precise role and extent of the central bank with respect to
regulation and supervision is not defined, and is likely to vary
country by country. There is, however, a strong consensus that central
banks should accept a continuing role in promoting and maintaining
financial stability, not just in times of crisis, but in anticipating
and dealing with points of vulnerability and risk.
The Report deals with many more specific issues cutting across all
institutions and financial markets. These include institutional and
regulatory standards for governance and risk management, an appropriate
accounting framework (including common international standards), reform
of credit rating agencies, and appropriate disclosure and transparency
standards for derivatives and securitized credits. Specifically, the
Report calls for ending the hybrid private/public nature of the two
very large Government-sponsored mortgage enterprises in the United
States. Under the pressure of financial crisis, they have not been able
to serve either their public purposes or private stockholders
successfully. To the extent the Government wishes to provide support
for the residential mortgage market, it should do so by means of
clearly designated Government agencies.
Finally, I want to emphasize that success in the reform effort, in
the context of global markets and global institutions, will require
consistency in approach among countries participating significantly in
international markets. There are established fora for working toward
such coordination. I trust the forthcoming G-20 meeting, bringing
together leaders of so many relevant nations, can provide impetus for
thoughtful and lasting reform.
______
______
PREPARED STATEMENT OF GENE L. DODARO
Acting Comptroller General, U.S. Government Accountability Office
February 4, 2009
______
RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON FROM PAUL A.
VOLCKER
Q.1. There is pressure to move quickly and reform our
financial regulatory structure. What areas should we address in
the near future and which areas should we set aside until we
realize the full cost of the economic fallout we are currently
experiencing?
A.1. I recognize the desire to move quickly to reform the
financial regulators structure, but more important is to get it
right. Speed should not become the enemy of the good, and a
piece-meal approach may inadvertently prejudice the
thoroughgoing comprehensive measures we need. There may be a
few measures--such as the proposed new crisis resolution
procedure--that may be usefully enacted promptly, but we still
have much to learn from unfolding experience and about the need
to achieve international consistency.
Q.2. The largest individual corporate bailout to date has
not been a commercial bank, but an insurance company. Given the
critical role of insurers in enabling credit transactions and
insuring against every kind of potential loss, and the size and
complexity of many insurance companies, do you believe that we
can undertake serious market reform without establishing
Federal regulation of the insurance industry?
A.2. Consideration of Federal regulation of insurance
companies and their holding companies is an example of the need
for a comprehensive approach. A feasible starting point should
be the availability of a Federal charter, at least for large
institutions operating inter-state and internationally, with
the implication of Federal supervision.
Q.3. As Chairman of the G-30, can you go into greater
detail about the report's recommended reestablishment of a
framework for supervision over large international insurers?
Particularly, cm you provide some further details or thoughts
on how this recommendation could be developed here in the
United States? Can you comment on the advantages of creating a
Federal insurance regulator in the United States?
A.3. As indicated, the absence of a Federal charter and
supervision for insurance companies is a gap in our current
regulatory framework. I am not prepared now to opine whether
the Federal regulator should be separate from other supervisory
agencies but some means of encouraging alignment is necessary.
Again, I'd prefer to see the issue resolved in the context of a
more comprehensive approach; in this case including
consideration of appropriate and feasible international
standards.
Q.4. How should the Government and regulators look to
mitigate the systemic risks posed by large interconnected
financial companies? Do we risk distorting the market by
identifying certain institutions as systemically important? How
do foreign countries identify and regulate systemically
critical institutions?
A.4. The question of mitigating systemic risks is a key
issue in financial reform, and can be approached in different
ways. Specifically identifying particular institutions as
systemically important, with the implication of special
supervisory attention and support, has important adverse
implications in terms of competitive balance and moral hazard.
I am not aware of any foreign country that explicitly
identifies and regulates particular systemically critical
institutions, but in practice sizable banking institutions have
been protected.
An alternative approach toward systemic risk would be to
provide a designated regulatory agency with authority to
oversee banks and other institutions, with a mandate to
identify financial practices (e.g., weak credit practices,
speculative trading excesses, emerging ``bubbles'', capital
weaknesses) that create systemic risk and need regulatory
supervision. Particular institutions need not be identified for
special attention.
Q.5. In your testimony you say that you support continuing
past U.S. practice of prohibiting ownership or control of
Government-insured, deposit-taking institutions by non-
financial firms. What are your thoughts on the commercial
industrial loan company (ILC) charter? Should this continue to
exist?
A.5. I do believe recent experience only reinforces long-
standing American aversion to mixtures of banking and commerce.
The commercial industrial loan companies and other devices to
blur the distinction should be guarded against, severely
limited if not prohibited.
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON FROM GENE L.
DODARO
Q.1. There is pressure to move quickly and reform our
financial regulatory structure. What areas should we address in
the near future and which areas should we set aside until we
realize the full cost of the economic fallout we are currently
experiencing?
A.1. As we noted in our January 2009 report, financial
regulators have been appropriately focused on limiting the
damage from the current crisis to the United States economy and
its financial system.\1\ Given the experiences of other
countries, particularly Japan that suffered stagnation for a
decade likely as a result of its ineffective attempts to
address its financial crisis in the 1990s, Congress and
regulators should likely continue to address in the near term
efforts to further stem the crisis and restore our financial
institutions to more normal operating conditions, including
finding an appropriate and effective solution to the issue of
troubled assets being held by so many institutions.
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\1\ GAO, Financial Regulation: A Framework for Crafting and
Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory
System, GAO-09-216 (Washington, D.C.: Jan. 8, 2009.)
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However, directing actions more to the current crisis
should not preclude Congress from exploring with regulators
plans for modernizing the United States financial regulatory
system. As we pointed out, taking piecemeal actions and
creating new regulations and regulatory bodies in the aftermath
of past financial turmoil is one reason why our current
structure is so fragmented and has the gaps and inconsistencies
in oversight that have contributed to the current crisis. As a
result, careful consideration of how best to develop a
structure and financial regulatory bodies within it that more
holistically embodies aspects like the nine elements of an
effective regulatory system that we described in our report is
important. Taking adequate time to consider and complete this
critical task is more advisable than taking quick actions that
could lead to gaps or inconsistencies later.
Q.2. The largest individual corporate bailout to date has
not been a commercial bank, but an insurance company. Given the
critical role of insurers in enabling credit transactions and
insuring against every kind of potential loss, and the size and
complexity of many insurance companies, do you believe that we
can undertake serious market reform without establishing
Federal regulation of the insurance industry?
A.2. Over the years, GAO has reported on the inconsistency
and lack of uniformity of regulation that insurance companies
receive across states. This lack of consistency can lead to
uneven protections for consumers across states as well as
inefficiencies for insurers that could lead to higher premiums.
We currently have a study under way looking at reciprocity and
uniformity of State insurance regulation in three key areas:
product approval, producer licensing, and market conduct
regulation. The study will touch on issues of consistent
oversight across states. Having an optional Federal charter for
insurance would be one way to potentially increase the
consistency of oversight of insurance companies.
Although the problems experienced by AIG and the subsequent
action by the Government to address them demonstrates that the
United States has significant gaps in its oversight of
significant financial institutions, the extent to which this
case demonstrates the need for Federal insurance oversight is
unclear. Although some of AIG's financial difficulties arose
from the securities lending activities engaged in by its life
insurance companies, and some of the Federal assistance went
toward unwinding those transactions, the insurance company
operations were, and have remained, stable. Those companies
have been negatively affected by the damage to the parent
company's reputation, and may no longer benefit to the same
extent from the parent company's financial strength, but they
appear to be financially sound. While it's possible closer
review by State insurance regulators may have more quickly
identified the risk associated with the life insurance
companies' securities lending operations, the primary problems
appear to have originated in one of AIG's non-insurance
subsidiaries. In addition, State insurance laws require State
insurance regulators to approve any significant transactions
between an insurance company and its parent company or other
subsidiaries, and, according to State regulatory officials and
AIG securities filings, some State regulators did not allow
transactions that would have transferred capital from AIG's
insurance companies to the parent company.
Q.3. The GAO recommends consistent financial oversight--to
ensure that similar institutions, products, risk and services
are subject to consistent regulation oversight and
transparency. In the case of insurance, the regulation and
oversight is not consistent. Shouldn't insurance receive the
same consistent financial oversight that is desperately needed
for other financial institutions?
A.3. In our January 2009 report on the need for regulatory
reform, we noted that the United States needs a financial
regulatory system that is appropriately comprehensive and
provides consistent oversight of institutions engaging in
similar activities and risks. In addition, we advocated that
consumer protections be similarly consistent across
institutions and products. As a result, to the extent that
insurance companies conduct activities, such as over-the-
counter derivatives trading or market products as investment
alternatives to securities or bank saving products, we
advocated that they be overseen with similar risk management,
capital, and consumer disclosure requirements.
In general, the operations of most insurance companies
themselves do not appear to have given rise to the complexities
that made regulation difficult in the case of AIG. For entities
that just engage in insurance activities, having Federal
oversight could be one way that more uniformity of oversight is
achieved. However, our report also noted that State regulators,
including those for insurance, have played important roles in
identifying and taking actions to address problems for
consumers. As noted above, we have a study under way looking at
reciprocity and uniformity of State insurance regulation that
will touch on issues of consistent oversight across States.
Q.4. The GAO's report suggests that Congress should
consider establishing a Federal insurance regulator; can you
comment on the advantages of creating a Federal insurance
regulator in the United States?
A.4. As we noted above, a Federal insurance charter could
have the potential to alleviate some of the challenges in
harmonizing insurance regulation across States. However, we
also note that such an approach could have various
disadvantages. Currently, property and casualty insurance
activities are heavily influenced by State laws--including
those relating to insurance, torts, and business operations--
and having Federal oversight of such varying requirements could
be very challenging. In addition, State regulators assert that
because of their greater familiarity with the particular
demographics of their jurisdictions, they are in a better
position to protect consumers. Another issue that would have to
be addressed in implementing a Federal insurance charter would
be the loss of income to states from taxes paid on insurance
premiums by consumers. These taxes generally provide funds
beyond what is required to fund the regulation of insurance.
Q.5. How should the Government and regulators look to
mitigate the systemic risks posed by large interconnected
financial companies? Do we risk distorting the market by
identifying certain institutions as systemically important? How
do foreign countries identify and regulate systemically
critical institutions?
A.5. Various options exist for addressing the systemic risk
posed by large interconnected financial institutions. As we
advocated in our January 2009 report, such institutions should
receive comprehensive and consistent regulation from both a
prudential and consumer protection standpoints.\2\ Having such
oversight should reduce the potential for such institutions to
experience problems that threaten the stability and soundness
of other institutions and the overall financial system itself.
In addition, we advocated that our regulatory system needs a
systemwide focus to address the potential threats to system
stability that can arise from institutions, products, and
markets. Such a focus could be achieved by designating an
existing regulator or creating a new entity to be tasked with
overseeing systemic risk in the United States. Such an entity
could also be tasked with prudential oversight of the large
interconnected financial institutions or their primary
oversight could remain the responsibility of another regulator
with the systemic risk regulator supplementing this oversight
by collecting information, examining operations, and directing
changes from the large institutions as needed.
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\2\ GAO-09-216.
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While one obvious way of ensuring that these large
institutions are all subject to similar regulatory requirements
and oversight would be to designate them as systemically
important and place them under the regulation of a single
regulatory body, such an approach also has disadvantages. Some
market observers have expressed concerns that designating
certain institutions as systemically important could distort
competition in the financial market sectors in which these
entities operate by providing the designated institutions with
funding advantages and reducing market discipline of the firms
that do business with them because of the belief that the
Government will not allow such institutions to fail. In light
of the experience of the housing Government-sponsored
enterprises recently, such concerns should be taken seriously.
However, the more extensive oversight that systemically
important financial institutions would likely receive could
offset some of the competitive advantage they receive from
being designated as so. Given such institutions greater
potential than other institutions to create systemic problems,
they should appropriately be subject to higher prudential
standards for capital, liquidity, and counter-party risk
management, etc. So although their status as systemically
important institutions could possibly create competitive
distortions or moral hazard, increased prudential standards
would seek to mitigate that (and any systemic risks they might
pose).
Other countries have not generally had to face the issue of
whether their systemically important institutions should be
supervised separately because of the differences in the
regulatory and market structures outside the United States. In
many countries, the primary financial institutions are
universal banks that offer a range of services across sectors,
including banking, securities, and insurance activities, and
that are overseen by a single regulatory body, which reduces
the potential for inconsistent oversight. In addition, the
number of financial institutions in many countries is
relatively small, which also reduces the potential for less
consistent oversight across institutions that might provide a
competitive advantage for those designated as systemically
important.
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