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SEN. DODD: The committee will come to order.
I've just been notified that Senator Shelby is in his office. He'll be along shortly but asked us to commence the hearing. So we'll begin this morning. Let me welcome my colleagues, welcome our witnesses as well. We have another long table here this morning of witnesses and trying to move through these series of hearings on the modernization of financial regulations. So I'm very grateful to all of you for your testimony. The testimony's lengthy I might add. Going through them last evening, the comments and -- there's Senator Shelby -- and very, very helpful, though. Very informative testimony. So we thank you all for your contribution.
I'll open up with some comments, I'll turn to Senator Shelby and then we'll get right to our witnesses. We've got votes this morning as well, I'd notify my colleagues, coming up, so we're going to have to stagger this a bit so we don't delay the hearing too long. And we'll try to -- each one of us will go out, come back and vote so we can continue the hearing uninterrupted if that will work out. So I'll ask my colleagues' indulgence in that regard as well.
Well, again, we're gathering here again this morning to discuss the modernization of bank supervision and regulation. This hearing marks yet another in a series of hearings to identify causes of the financial crisis and specific responses that will guide this committee's formulation of a new architecture for the 21st century financial services regulation. Today we're going to explore ways to modernize and improve bank regulation supervision to protect consumers and investors and help grow our economy in the decades ahead.
A year ago this committee heard from witnesses on two separate occasions that the banking system was sound and that vast majority of banks would be well positioned to weather the storm. A year later, and taxpayers are forced to pump billions of dollars into our major banking institutions to keep them afloat. Meanwhile every day, 20,000 people we're told are losing their jobs in our country, 10,000 families their homes are in jeopardy for foreclosure, and credit, the lifeblood of our economy is frozen solid. People are furious right now and they should be. But history will judge whether we make the right decisions and as President Obama told the Congress last month, we cannot afford to govern out of anger or yield to the politics of the moment as we prepare to make choices that will shape the future of our country literally for decades and decades to come.
We must learn from the mistakes and drawn upon those lessons to shape a new framework for financial services regulation, an integrated, transparent, and comprehensive architecture that serves the American people well through the 21st century. Instead of the race to the bottom we saw in the run-up to the crisis, I want to see a race to the top with clear lines of authority, strong checks and balances that build a confidence in our financial system that is so essential to our economic growth and stability.
Certainly there's a case to be made for a so-called systemic risk regulator within that framework. And whether or not those vast powers will reside in the Fed remains an open question, although the news this morning would indicate that maybe a far more open question in light of the balance sheet responsibilities -- and Mr. Tarullo, we'll be asking you about that question this morning to some degree as well. This news this morning adds yet additional labors and burdens on the Fed itself and so the question of whether or not in addition to that job we can also take on a systemic risk supervisory capacity is an issue that I think a lot of us will want to explore.
As Chairman Bernanke recently said, the role of the systemic risk regulator would entail a great deal of expertise, analytical sophistication and the capacity to process large amounts of disparate information. I agree with Chairman Bernanke, which is why I wonder whether it wouldn't make more sense to give authority to resolve failing and systemically important institutions to the agency with actual experience in the area, the FDIC.
If the events of this week have taught us anything, it is that the unwinding of these institutions can sap both public dollars and public confidence essential to getting our economy back on track. This underscores the importance of establishing a mechanism to resolve these failing institutions. From its failure to protect consumers to regulate mortgage lending to effectively oversee bank holding companies, the instances in which the Fed has failed to execute its existing authority are numerous.
In a crisis that has taught the American people many hard earned lessons, perhaps the most important is that no institution should ever be too big to fail, and going forward we should consider how that lesson applies not only to our financial institutions but also to the government entities charged with regulating them. Replacing Citibank- sized financial institutions with Citibank-sized regulators would be a grave mistake.
This crisis has illustrated all too well the dangers posed to the consumer and our economy when we consolidate too much power in too few hands with too little transparency and accountability. Further, as former Fed chairman Volcker has suggested, there may well be an inherent conflict of interest between prudential supervision -- that is, the day-to-day regulation of our banks -- and monetary policy, the Fed's primary mission, and an essential one I might add.
One idea that has been suggested that could compliment and support an entity that oversees systemic risk is a consolidated safety and soundness regulator. The regulatory arbitrage duplication and inefficiency that comes with having multiple federal banking regulators was at least as much of a problem in creating this crisis as the Fed's inability to see the crisis coming and its failure to protect consumers and investors.
And so systemic risk is important but no more so than the risk to consumers and depositors, the engine behind our very banking system. Creating that race to the top starts with building from the bottom up. That is why I'm equally interested in what we do to the prudential supervision level to empower regulators, the first line of defense for consumers and depositors, and increase the transparency that is absolutely essential to checks and balances and to healthy financial system.
Each of these issues leads us to a simple conclusion, the need for broad, comprehensive reform is clear. We cannot afford to address the future of our financial system piecemeal or ad hoc without considering the role that every actor at every level must play in creating a stable banking system to help our economy grow for decades to come. That must be our collective goal.
And with that, let me turn to Senator Shelby.
SEN. RICHARD SHELBY (R-AL): Thank you, Chairman Dodd.
We're in the midst of an unprecedented financial crisis. I believe the challenge before us involves three tasks. First, we must work to stabilize the system; second, we must understand the origins of the current crisis; and third, we must work to restructure our regulatory regime to meet the demands of a 21st century financial system.
Today the committee will focus primarily on the third task, rebuilding the regulatory structure. I believe the success of our effort will depend a great deal on our ability to determine what led us to this point. Without that knowledge, we won't know whether we're regulating the right things in the right way. We need to determine whether the regulators had sufficient authority and whether they used the authority they had to the fullest extent.
We need to consider here whether market developments outpace current regulatory capabilities. We also need to better understand the impact regulation has on the private sector's due diligence and risk management practices.
After understanding the nature of the regulatory structure, I believe we need to come to an understanding as to the specific cause or causes of the regulatory failure. We then need to address those failures in such a manner where we create a durable, flexible and robust regime that can grow with markets while still protecting consumers and market stability.
This is a very tall order. It will take an intensive and extended effort on our behalf. But in the end, getting this thing done right is more important than getting it done quickly.
Thank you, Mr. Chairman.
SEN. DODD: This is -- we've got a lot of witnesses, but I -- some of my colleagues may want to make some very brief opening comments on this. And I'd -- Senator Brown, you're next in line if you want to make a brief opening comment on this at all?
SEN. SHERROD BROWN (D-OH): No.
SEN. DODD: No? Senator Bunning?
SEN. JIM BUNNING (R-KY): (Off mike.)
SEN. DODD: As well. Senator Tester?
SEN. JON TESTER (D-MT): (Off mike.).
SEN. DODD: As well. Senator Crapo? Let me see, Senator Warner. Have a trend going here. (Laughter.) Senator Bennett? Well, I know that I was told by my staff that some members wanted to be heard. So I'm just responding to the staff that --
SEN. : I just want to thank you for holding the hearing and recognize that it's going to be the first in a series because there's probably nothing more important that we will do in this committee this year than deal with this problem. The future is a very -- there are many demands that we have to deal with with respect to the future here.
SEN. DODD: Thank you. Senator Schumer.
SEN. CHARLES SCHUMER (D-NY): Pass.
SEN. DODD: All right. Then Senator Merkley. Senator Bennet.
SEN. MICHAEL BENNET (D-CO): I appreciate the opportunity to make a --
SEN. DODD: All right.
SEN. BENNET: -- lengthy opening statement.
SEN. DODD: I know. We've got to -- (laughter) --
SEN. SCHUMER: Statements will be still be for the record.
SEN. DODD: Statements are on the record -- will be included in the record. Make sure that happens.
We'll begin with our witnesses here. We're very fortunate to have a good strong group of folks who know these issues well and have been involved and before this committee on numerous occasions. Let me briefly introduce them each.
It'll begin with John Dugan, who's currently the comptroller of the currency. We thank you for coming back before the Committee once again; Sheila Bair, who's chairperson of the Federal Deposit Insurance Corporation, been before the Committee on numerous, numerous occasions; we have here my next -- it says Michael Fryzel -- is that how you pronounce it --
MR. FRYZEL: Fryzel.
SEN. DODD: -- Fryzel -- is chairman, of the National Credit Union Administration and we appreciate your participation;
Dan Tarullo is with the Federal Reserve -- and we thank you Dan, congratulations on your recent confirmation as well; Scott Polakoff is currently serves as the acting director of the Office of Thrift Supervision; Joseph Smith is currently North Carolina Commissioner on Banks and is appearing on behalf of the State Bank Supervisors -- and we thank you for being here; and George Reynolds is the Chairman of the National Association of State Credit Union Supervisors and Senior Deputy Commissioner of the Georgia Department Of Banking and Finance. And we thank you as well for joining us.
I'm going to ask here, given the magnitude of the size of our committee here this morning -- I notice for instance John here your testimony is about 18, 20 pages long last night as I went through it, and I'm hopeful you're not going to try and do all 20 pages here this morning. And Sheila, I think yours was -- Dan, yours was about 16 of 17 pages as well. If you could abbreviate this down to about five or six minutes or so. And it's important we hear what you have to say, so I don't want to constrain you too much, but I'd like to be able to get through everyone so we can go through the question period.
We'll begin with you, John.
MR. DUGAN: Can you hear me? Can you hear me? Is it on? Okay.
Well thank you Chairman Dodd, Ranking Member Shelby and members of the Committee.
The financial crisis has raised legitimate questions about whether we need to restructure and reform our financial regulatory system, and I welcome the opportunity to testify on this important subject on behalf of the OCC. Let me summarize the five key recommendations from my written statement, which address issues raised in the Committee's letter of invitation.
First, we support the establishment of a systemic risk regulator which probably should be the Federal Reserve Board. In many ways, the Board already serves this role with respect to systemically important banks. But no agency has had similar authority with respect to systemically important financial institutions that are not banks, which created real problems in the last several years as risk increased in many such institutions. It makes sense to provide one agency with authority and accountability for identifying and addressing such risks across the financial system.
This authority should be crafted carefully however to address the very real concerns of the Board taking on too many functions to do all of them well, while at the same time concentrating too much authority in a single government agency.
Second, we support the establishment of a regime to stabilize, resolve and wind down systemically significant firms that are not banks. The lack of such a regime this past year proved to be an enormous problem in dealing with distressed and failing institutions such as Bear Stearns, Lehman Brothers, and AIG. The new regime should provide tools that are similar to those the FDIC currently has for resolving banks as well as provide a significant funding source if needed to facilitate orderly dispositions such as a significant line of credit from the Treasury.
In view of the systemic nature of such resolutions and the likely need for government funding, the systemic risk regulator and the Treasury Department should be responsible for this new authority.
Third, if the Committee decides to move forward with reducing the number of bank regulators, and that would of course shorten this hearing, we have two general recommendations.
The first may not surprise you, we believe strongly that you should preserve the role of a dedicated prudential banking supervisory that has no job other than bank supervision. Dedicated supervision produces no confusion about the supervisor's goals or mission, no potential conflict with competing objectives, responsibility and accountability are well-defined, and the result is a strong culture that fosters the development of the type of seasoned supervisors that we need.
But my second recommendation here may sound a little strange coming from the OCC given our normal turf force. Congress I believe should preserve a supervisory role for the Federal Reserve Board, given its substantial experience with respect to capital markets, payment systems and the discount window.
Fourth, Congress should establish a system of national standards that are uniformly implemented for mortgage regulation. While there were problems with mortgage underwriting standards at all mortgage providers, including national banks, they were least pronounced at regulated banks, whether state or nationally chartered. But they were extremely severe at the non-bank mortgage companies and mortgage brokers regulated exclusively by the states accounting for a disproportionate share of foreclosures.
Let me emphasize that this was not the result of national bank pre-emption which in no way impeded states from regulating these providers.
National mortgage standards with comparable implementation by federal and state regulators would address this regulatory gap and ensure better mortgages for all consumers.
Finally, the OCC believes the best way to implement consumer protection regulation of banks, the best way to protect consumers, is to do so through prudential supervision. Supervisors continual presence in banks through the examination process creates especially effective incentives for consumer protection compliance, as well as allowing examiners to detect compliance failures much earlier than would otherwise be the case.
They also have strong enforcement powers and exceptional leverage over bank management to achieve corrective action -- that is when examiners detect consumer compliance weaknesses or failures, they have a broad range of corrective tools from informal comments to formal enforcement action. And banks have strong incentives to move back into compliance as expeditiously as possible.
Finally, because examiners are continually exposed to the practical effects of implementing consumer protection rules for bank customers, the Prudential Supervisory Agency is in the best position to formulate and refine consumer production regulation for banks. Proposals to remove consumer protection regulation and supervision from prudential supervisors, instead consolidating such authority in a new federal agency, would lose these very real benefits -- we believe.
If Congress believes that the consumer protection regime needs to be strengthened, the best answer is not to create a new agency that would have none of the benefits of the prudential supervisor. Instead, we believe the better approach is for Congress to reinforce the agency's consumer protection mission and direct them to toughen the applicable standards and close any gaps in regulatory coverage.
The OCC and the other Prudential bank supervisors will rigorously apply any new standards and consumers will be better protected.
Thank you very much. I'd be happy to answer questions.
SEN. DODD: Sorry. Thank you for joining us.
MS. BAIR: Chairman Dodd, Ranking Member Shelby and members of the committee, thank you for the opportunity to testify today.
Our current regulatory system ahs clearly failed in many ways to manage risk properly and to provide market stability. While it is true that there are regulatory gaps which need to be plugged, U.S. regulators already have broad powers to supervise financial institutions. We also have the opportunity to limit many of the activities that undermine our financial system.
The plain truth is that many of the systemically significant companies that have needed unprecedented federal help were already subject to extensive federal oversight. Thus, the failure to use existing authorities by regulators casts doubt on whether simply entrusting power in a new systemic risk regulator would be enough.
I believe the way you reduce systemic risk is by addressing the size, complexity and concentration of our financial institutions. In short, we need to end "too big to fail". We need to create regulatory and economic disincentives for systemically important financial firms.
For example, we need to impose higher capital requires on them, in recognition of their systemic importance, to make sure they have adequate capital buffers in times of stress. We need greater market discipline by creating a clear legal mechanism for resolving large institutions in an orderly manner that is similar to the one for FDIC insured banks.
The ad hoc response to the current crisis is due in large part to the lack of a legal framework for taking over an entire, complex financial organization. As we saw with Lehman Brothers, bankruptcy is a very poor way to resolve large complex financial organizations. We need a special process that is outside bankruptcy, just as we have for commercial banks and thrifts.
To protect taxpayers, a new resolution regime should be funded by fees charged to systemically important firms, and would apply to any institution that puts the system at risk. These fees could be imposed on a sliding scale so the greater the risk, the higher the fee.
In a new regime, rules and responsibilities must be clearly spelled out to prevent conflicts of interest. For example, Congress gave the FDIC backup supervisory authority and the power to self- appoint as receiver when banks get into trouble. They did this to ensure that the entity resolving a bank has the power to respectively exercise its authority, even if there is disagreement with the primary supervisor. As Congress has determined for the FDIC, any new resolution authority should also be independent of any new systemic risk regulator.
The FDIC's current authority to act as receiver and to set up a bridge bank to maintain key functions and sell assets is a good starting point for designing a new resolution regime. There should be be a clearly defined priority structure for settling claims, depending on the type of firm. Any resolution should be required to minimize losses to the public, and the claims process should follow an established priority list.
Also, no single government entity should have the power to deviate from the new regime. It should include checks and balances that are similar to the systemic risk exception for the least cost test that now applies to FDIC-insured institutions.
Finally, the resolution entity should have the kinds of powers the FDIC has to deal with such things as executive compensation. When we take over a bank, we have the power to hire and fire. We typically get rid of the top executives and the managers who caused the problem. We can terminate compensation agreements, including bonuses. We do whatever it takes to hold down costs. These types of authorities should apply to any institution that gets taken over by the government.
Finally, there can no longer be any doubt about the link between protecting consumers from abusive products and practices and the safety and soundness of America's financial system. It is absolutely essential that we set uniform standards for financial products. It should not matter who the seller is -- be it bank or non-bank.
We also need to make sure that whichever federal agency is overseeing consumer protection that it has the ability to fully leverage the expertise and resources accumulated by the federal banking agencies.
To be effective, consumer policy must be closely coordinated and reflect a deep understanding of financial institutions and the dynamic nature of the industry as a whole.
The benefits of capitalism can only be recognized if markets reward the well managed and punish the lax. However, this fundamental principle is now observed only with regard to smaller financial institutions. Because of the lack of a legal mechanism to resolve the so-called systemically important -- regardless of past inefficiency or recklessness -- non-viable institutions survive with the support of taxpayer funds.
History has shown that government policies should promote, not hamper, the closing and/or restructuring of weak institutions into stronger, more efficient ones. The creation of a systemic risk regulator could be counterproductive, if it reinforced the notion that financial behemoths designated as systemic are in fact "too big to fail."
Congress's first priority should be the development of a framework which creates disincentives to size and complexity and establishes a resolution mechanism which makes clear that managers, shareholders and creditors will bear the consequences of their actions.
Thank you.
SEN. DODD: -- the hearing, Mr. Reynolds.
MR. REYNOLDS: Thank you, Chairman Dodd, Ranking Member Shelby and members of the committee.
As chairman of the National Credit Union Administration, I appreciate this opportunity to provide the agency's position on regulatory modernization.
Federally insured credit unions comprise a small, but important part of the financial institution community and I hope NCUA's perspective on this matter will add to the understanding of the unique characteristics of the credit union industry and the 90 million members they serve.
The market dislocations underscore the importance of your review of this subject. I see a need for revisions to the current regulatory structure in ways that would improve federal oversight of not just financial institutions, but the entire financial services market.
My belief is that there is a better way forward -- a way that would enable federal regulators to more quickly and effectively identify and deal with developing problems.
Before I express my views on possible reforms, I want to briefly update you on the condition of the credit union industry.
Overall, credit union maintained reasonable performance in 2008, aggregate capital level finished the year at 10.92 percent, and while earnings decreased due to the economic downturn, credit unions still posted a .30 percent return on assets in 2008.
I am pleased to report that even in the face of market difficulties, credit unions were able to increase lending by just over 7 percent. Loan delinquencies were 1.3 percent and charge offs were .8 percent, indicating that credit unions are lending prudently.
Credit unions are fundamentally different in structure and operation than other types of financial institutions. They are not- for-profit cooperatives owned and governed by their members. Our strong belief is that these unique and distinct institutions require unique and distinct regulation, accompanied by supervision tailored to their special way of operating. Independent NCUA regulation has enabled credit unions to perform in a safe and sound manner, while fulfilling the cooperative mandate set forth by Congress.
One benefit of our distinct regulatory approach is the 18 percent usury ceiling for federal credit unions that enhances our ability to act as a low-cost alternative to predatory lenders. Another is the existence of a supervisory committee for federal charters. Unique among all financial institutions, these committees comprised of credit union members have enhanced consumer protection by giving members peer review of complaints and has supplemented the ability of NCUA to resolve possible violations of consumer protection laws.
NCUA administers the National Credit Union Share Insurance Fund -- the federal insurance fund for both federal and state charted credit unions. The fund currently has an equity ratio of 1.28 percent. The unique structure of the fund, where credit unions make a deposit equal to 1 percent of their insured shares, augmented by premiums as needed to keep the fund above a statutory level of 1.20 percent, has resulted in the very stable and well-functioning insurance fund.
Even in the face of significant stress in the corporate credit union part of the industry -- stress that necessitated extraordinary actions by the NCUA board to stabilize the corporates -- the fund has proven durable.
I want to underscore the benefits of having the funds administered by NCUA. Working on concert with our partners in the state regulatory system, NCUA uses close supervision to control risks. This concept was noted approvingly by GAO studies over the years, as were the benefits of streamlined oversight and insurance function under one roof.
This consolidated approach has enable NCUA to manage risk in an efficient manner and identify problems in a way that minimizes losses to the fund. NCUA considers the totality of our approach for mixed deposit and premium funding mechanism, to unified supervisory and insurance activities, to be the one that attached significant public policy benefits and one worth preserving.
Whatever reorganization Congress contemplates, National Credit Union Share Insurance Fund should remain integrated into the federal credit union regulator and separate from any other federal insurance funds.
Regarding restructuring of the financial regulatory framework, I suggest creating a single oversight entity whose responsibilities would include monitoring financial institution regulators and issuing principles-based regulations and guidance. The entity would be responsible for establishing general safety and soundness of standards, while the individual regulators would enforce them in the institutions they regulate. It would also monitor systemic risk across institution types.
Again, for this structure to be effective for federally insured credit unions and the consumers they serve, the National Credit Union Share Insurance Fund should remain independent in order to maintain the dual NCUA regulatory and insurance roles that have been tested and proven to work for almost 40 years.
I appreciate the opportunity to provide testimony today and would be pleased to answer any questions.
SEN. DODD: Thank you very, very much.
Dan Tarullo, thank you very much for being here on behalf of the Fed.
MR. TARULLO: Thank you, Mr. Chairman, Senator Shelby and members of the committee.
We're here this morning because of systemic risk. We've had a systemic crisis. We're still in the middle of it and I would endorse wholeheartedly Senator Shelby's three-part approach to responding to that crisis.
In the weeks that I've been at the Federal Reserve, the discussions that have taken place internally -- both among staff and among the members -- have focused in on the issue of systemic risk and how to prevent it going forward.
The important point that I would make as a prelude to recommendations is that the source of systemic risk in our financial system has to some considerable extent migrated from traditional banking activities to markets over the last 20 or 25 years.
If you think about the problems that led to the Depression, that were apparent even in the 1970s among some banks, the concern would be that there would be a run on a bank. That depositors would be concerned about the safety and soundness of that bank and that there would be contagions spreading to other institutions as depositors were uncertain as to the states of those institutions.
What we've seen more recently is systemic problems starting in the interactions among institutions in markets. Now, banks are participants in markets, so it can still be something that affects banks. But we've also seen other kinds of institutions at the source of the systemic problems that we're undergoing right now. So I think you cannot focus on a single institution or even just look at institutions as a series of silos, as it were, and concentrate solely on trying to assure their safety and soundness. We need to look at the interactions among institutions.
Sometimes that means there're actual counterparty relationships with one another. Sometimes it means the fora in which they interact with one another, the payment systems and the like. Sometimes it even means the parallel strategies which they may be pursuing, all, for example, requiring -- relying on the same sources of liquidity if they have to change their strategies. So they may not even know that they are co-dependent with other actors in the financial markets.
For all of these reasons, our view is that the focus needs to be on an agenda for financial stability, an agenda for systemic risk management. And I emphasize that because although there is, rightly, talk about a systemic risk regulator, it's important that we understand each component of an agenda, which is going to be fulfilled by all the financial regulators over which you have jurisdiction going forward.
So what does that mean? Well, I tried, in my testimony, to lay out five areas in which we should pay attention.
First, we do need effective consolidated supervision of any systemically important institution. We need consolidated supervision and it needs to be effective.
There are institutions which are systemically important, certainly were systemically important over the last few years, which were not subject to consolidated supervision of a prudential sort by any regulator.
But that supervision needs to be effective. And I think everybody is aware and everybody ought to be aware of the ways in which the regulation and supervision of our financial institutions in recent years has fallen short. And unless, as Senator Shelby suggests, we all concentrate on it and do it without defensiveness, we're not going to learn the lessons that need to be learned.
Secondly, there is need for a resolution mechanism. I'm happy to talk about that in the back-and-forth with you but I think Controller Dugan and Chair Bair -- Chairman Bair have laid that out very well.
Third, there does need to be more oversight of key areas in which market participants interact in important ways. We have focused, in particular, on payment systems, payment and settlement systems because there the Fed's oversight authority derives largely from the coincidence that some of the key actors happen to be member banks. But if they weren't, if they had another corporate form, there's no statutory authority right now to exercise prudential supervision over those markets in which problems can arise.
Fourth, consumer protection. Now, consumer protection is not and should not be limited to its relationship with potential systemic risk. But, as the current crisis demonstrated, there are times in which good consumer protection is not just good consumer protection but it is an important component of the containment of systemic risk.
And fifth and finally, the issue of systemic risk regulator. This is something that does seem to fit into an overall agenda. There are gaps. There are gaps in covering systemically important institutions. There are also gaps in attempting to monitor what is going on across the system. I think in the past there has been times in which there was important information being developed by various regulators and supervisors which, if aggregated, would have suggested developing issues and problems. But without a charge to one or more entities to try to put all that together, one risks looking at things, as I said, in a more siloed fashion.
The extent of those authorities for a systemic risk regulator is something that needs to be debated in this committee and, indeed, in the entire Congress.
But I do think it's an important compliment to the other components of this agenda and the improvements in supervision and regulation under existing authorities and that's something that ought to be considered.
I'm happy to answer any questions that you may have.
SEN. DODD: Thank you very much.
I'm going to suggest -- I said to my colleagues that we have -- I didn't realize there were three or four consecutive votes that are going to occur. So regretfully we're going to have to recess I think. And I'm going to do it here now and then get over there. They're going to be, I think, 10 minute votes, not 15 minute votes and I apologize to our witnesses but all of you have been here before in the past when this occurs. And we'll go and stay for the three or four votes -- is it three or -- it may even be two, in fact, maybe a voice vote on one so we may get back much more quickly. And then we'll come right back and pick up with Mr. Polakoff.
We will stand in recess.
(Recess.)
SEN. DODD: Can I invite all of you to come back in and let me tell you how we'll proceed here. And I apologize to our witnesses. We have --- there's going to be another vote but I thought we could complete the testimony from our witnesses and by that time I think that the third vote might begin. I've been advised the members could probably stay over there for the vote rather than running back and forth. As I said, we'll complete your testimony and then we'll stagger our presence here to engage in the questioning for the remainder of the time.
So with that, Mr. Polakoff, we welcome you. Thank you.
MR. POLAKOFF: Well good morning, Chairman Dodd. Thank you for inviting me to testify on behalf of OTS on the modernizing bank supervision and regulation.
As you know, our current system of financial supervision is a patchwork with pieces that date back to the Civil War. If we were to start from scratch no one would advocate establishing a system like the one we have, cobbled together over the last century and a half.
The complexity of our financial markets has, in some case, reached mind boggling proportions. To effectively address the risk in today's financial marketplace, we need a modern, sophisticated system of regulation and supervision that applies evenly across the financial services landscape.
Our current economic crisis reinforces the message that the time is right for an in depth, careful review and meaningful fundamental change. Any restructuring should take in to account the lessons learned from this crisis.
At the same time, the OTS recommendations that I'm presenting here today do not represent a realignment of the current regulatory structure. Rather, they represent a fresh start using a clean slate. They represent the OTS vision for the way financial services regulation in this country should be. In short, we are proposing fundamental changes that would affect virtually all of the current financial regulators.
It is important to note that these are high level recommendations. Before adoption and implementation many details would need to be worked out and many questions would need to be answered.
The OTS proposal for modernization has two basic elements. First, a set of guiding principles. And second, recommendations for federal bank regulation, holding company supervision, and systemic risk regulation.
So what I'd like to do is offer the five guiding principles.
Number one, a dual banking system with federal and state charters for banks.
Number two, a dual insurance system with federal and state charters for insurance companies.
Number three, the institutions operating strategy and business model would determine its charter and identify its responsible regulatory agency. Institutions would not simply pick their regulator.
Number four, organizational and ownership options would continue, including mutual ownership, public and private stock entities, and subchapter S corporations.
And number five, ensure that all entities offering financial products are subject to the consistent laws, regulations, and rigor of regulatory oversight.
Regarding our recommendations regulatory structure, the OTS strongly supports the creation of a systemic risk regulator with authority and resources to accomplish the following three functions.
Number one, to examine the entire conglomerate.
Number two, to provide temporary liquidity in a crisis.
And number three, to process a receivership if failure is unavoidable.
For federal bank regulation the OTS proposes two charters, one for banks predominantly focused on consumer and community banking products, including lending, and the other for banks primarily focused on commercial products and services.
The business models of a commercial bank and a consumer and community bank are fundamentally different enough to warrant two distinct federal banking charters.
These regulators would each be the primary federal supervisor for state chartered banks with the relevant business models.
A consumer and community bank regulator would close the gaps is regulatory oversight that led to a shadow banking system of uneven regulated mortgage companies, brokers, and consumer lenders that were significant causes of the current crisis.
This regulator would also be responsible for developing and implementing all consumer protection requirements and regulations.
Regarding holding companies, the functional regulator of the largest entity within a diversified financial company would be the holding company regulator.
I realize I have provided a lot of imformation and I look forward to answering your questions, Mr. Chairman.
SEN. DODD: Thank you very, very much.
Mr. Smith, welcome to the committee.
MR. SMITH: Thank you, Mr. Chairman.
I'm Joe Smith, the North Carolina Commissioner of Banks and Chair-elect of Conference of State Banks Supervisors, on his behalf I'm testifying. I very much appreciate this opportunity today.
My colleagues and I have submitted to you written testimony. I will not read it to you today. I would like to emphasize a few points that are contained in it.
The first of these points is that proximity or closeness to the consumers, businesses, and communities that deal with our banks is important. We acknowledge that a modern financial regulatory structure must deal with systemic risks presented by complex global institutions.
While this is necessary, sir, we would argue that it is not itself sufficient. A modern financial regulatory structure should also include, and as more than an afterthought, the community and regional institutions that are not systemically significant in terms of risk but that are crucial to effectively serving the diverse needs of our very diverse country.
These institutions were organized to meet local needs and have grown as they have met such needs, both in our metropolitan markets and in rural and exurban markets as well.
We would further suggest that the proximity of state regulators and attorneys general to the marketplace is a valuable asset in our efforts to protect consumers from fraud, predatory conduct, and other abuses.
State officials are the first responders in the area of consumer protection because they are the nearest to the action and see the problems first.
It is our hope that a modernized regulatory system will make use of the valuable market information that the states can provide in setting standards of conduct and will enhance the role of states in enforcing such standards.
To allow for this system to properly function, we strongly believe that Congress should overturn or roll back the OTS and OCC preemption of state consumer protection laws and state enforcement.
The second and related point that we hope you will consider is that the diversity of our banking and regulatory systems is a strength of each. One size does not fit all, either with regard to the size, scope, and business methods of our banks or the regulatory regime applicable to them.
We are particularly concerned that in addressing the problems of complex global institutions, a modernized financial system may inadvertently weaken community and regional banks by undue support for the larger institutions and by burdening smaller institutions with the costs of regulation that are appropriate for the large institutions but not for the small and regional ones.
We hope that you agree with us that community and regional banks provide needed competition in our metropolitan markets and crucial financial services in our smaller and more isolated markets.
A corollary of this view is that the type of regulatory regime that is appropriate for complex global organizations is not appropriate for community and regional banks.
In our view, the time has come for supervision and regulation that is tailored to the size, scope, and complexity of a regulated enterprise. One size should not and cannot be made to fit all.
I'd like to make it clear the my colleagues and I are not arguing for preservation of the status quo. Rather, we're suggesting that a modernized regulatory system should include a cooperative federalism that incorporates both national standards for all market participants and shared responsibility for the development and enforcement of such standards.
We would submit that the shared responsibility for supervising state chartered banks is one example, current example, of cooperative federalism and that the developing partnership between state and federal regulators under the secure and fair enforcement for mortgage licensing, of SAFE Act, is another.
Chairman Dodd, my colleagues and I support this committee's efforts to modernize our nation's financial regulatory system.
As always, sir, it's an honor to appear before you. I hope that our testimonies are of assistance to the committee and would be happy to answer any questions you may have.
Thank you very, very much.
SEN. DODD: Thank you very much, Mr. Smith. And if you don't save yourself enough and in the committee, maybe elsewhere. The tendency today is to use the word bank and I'm worried about it becoming, sort of, pejorative. There are 8,000 banks and I think there are 20, Governor Tarullo can correct me on this, but I think the 20 controls about 70 to 80% of all the deposits in the country and the remaining 7,000 plus are community banks, they do a terrific job and have been doing a great job as well. And the tendency to talk about lending institutions in broad terms is not fair to a lot of those institutions which have been very prudent in their behavior over the last number of years and it's important that we recognize that from this side of the dais. And so your comments are appreciated.
Mr. Reynolds.
MR. REYNOLDS: Chairman Dodd, I appear today on behalf of NASCUS, the National Association of State Credit Union Regulators. My comments focus solely on the credit union regulatory structure and four distinct principles vital to the future growth and safety and soundness of state chartered credit unions.
NASCUS believes regulatory reform must preserve charter choice and dual chartering, preserve the state's role in financial regulation, modernize the capital system for credit unions, and maintain strong consumer protections.
First, preserving charter choice is crucial to any regulatory reform proposal. Charter choice is maintained by an active system of federalism that allows for clear communications and coordination between state and federal regulators.
Congress must continue to recognize and affirm the distinct roles played by state and federal regulatory agencies.
The nation's regulatory structure must enable state credit union regulators to retain their regulatory authority over state-chartered credit unions. Further, it's important that new policies do not squelch the innovation and enhanced regulatory structure provided by the dual-chartering system.
The second principle I will highlight is preserving the state's role in financial regulation. The dual-chartering system is predicated on the rights of states to authorize varying powers for their credit unions. NASCUS supports state authority to empower credit unions to engage in activities under state-specific rules.
States should continue to have the authority to create and to maintain appropriate credit union powers in any new regulatory reform structure. Preemption of state laws and the push for more uniform regulatory systems will negatively impact our nation's financial services industry and ultimately consumers.
The third principle is the need to modernize the capital system of credit unions. We encourage Congress to include capital reform as part of the regulatory modernization process. State credit union regulators are committed to protecting credit union safety and soundness. Allowing credit unions to access supplemental capital would protect the credit union system and provide a tool for regulators if a credit union faces declining net worth or liquidity needs.
Further, it will provide an additional layer of protection to the National Credit Union Share Insurance Fund, the NCUSIF, thereby maintaining credit unions' independence from the federal government and taxpayers. A simple fix to the definition of "net worth" in the Federal Credit Union Act would authorize regulators the discretion, when appropriate, to allow credit unions to use supplemental capital.
The final principle I will discuss is the valuable role states play in consumer protection. Many consumer protection programs were designed by state legislators and state regulators to protect citizens in their states. The success of state programs have been recognized at the federal level when like programs have been introduced. It is crucial that state legislators -- legislatures have the primary role to enact consumer protection statutes for their residents and to promulgate and enforce state regulations.
I would also mention that both state and federal credit unions have access to the NCUSIF. Federally insured credit unions capitalize this fund by depositing 1 percent of their shares into the Fund. This concept is unique to credit unions and it minimizes exposure to the taxpayers. Any modernized regulatory system should recognize the NCUSIF. NASCUS and others are concerned about any proposal to consolidate regulators and eliminate state and federal credit union charters. If Congress examines a regulatory reform system for credit unions, the following should be considered:
Enhancing consumer choice provides a stronger financial regulatory system, therefore charter choice and dual-chartering must be preserved; preservation of the state's role in financial regulation is vital; modernization of the capital system for credit unions is critical for safety and soundness; and strong consumer protections should be maintained, and these should be protected against federal preemption.
NASCUS appreciates the opportunity to testify and share our priorities. We urge the committee to be watchful of federal preemption and to remember the importance of dual-chartering and charter choice in regulatory modernization. Thank you.
SEN. DODD: Thank you very much, Mr. Reynolds.
And, again, my appreciation to all of you here this morning. We're going to have an ongoing conversation with you, obviously, in formal hearings like this, but as well -- I know all of my colleagues were interested, deeply interested in the subject matter of modernization of financial regulations -- are going to want to have as many conversations as we can with you as we move forward and how to develop these ideas.
We all understand, I think, the critical importance of this. And all of you can play a very critical role in helping to shape that. And so today you should -- as I know you do understand, this is a formal hearing and setting for this, but there will be other opportunities, I hope, for us in the coming weeks to sit down and have more detailed conversations with you and others about how we shape this product.
Let me begin, if I can, with the issue of regulatory arbitrage, because all of you, I think, in your testimony, one way or another, addressed this issue of, sort of, the forum shopping. In 1994, when this committee considered legislation to comprehensively reform the financial regulatory system, then Treasury secretary Lloyd Bentsen appeared before the committee.
And let me quote him for you, on that that day some 15 years ago, he said, "What we're seeing is a situation that enables banks to shop for the most lenient federal regulator." In those very same hearings, on that very same proposal, the chairman of the Federal Reserve at the time, Alan Greenspan, said the following, and I'm quoting him, "Every bank should have a choice of federal regulator."
So, let me ask the panel here, very quickly, beginning with you, Mr. Dugan, if I can, with whom do you agree? Should financial institutions be allowed to choose their regulators, leading to a potential race to the bottom? Or should we attempt to end the regulatory arbitrage that's going on?
MR. DUGAN: Well, I guess what I would say is this: Institution should not be able to, when they have a problem with one regulator, to leave that regulator to go to another regulator where they think they're not going to have the problem.
I will say, from the point of view of the OCC, we don't have any ability to stop someone from leaving, but we have ample authority to stop them from coming in, and we exercise it. And so we will not allow someone to transfer in, to become a national bank unless they've resolved their problems with their own institution. And we make that clear.
And we have had, during my tenure as comptroller, several instances -- companies wanting to come in and deciding not to when they realize that that would be the case. It is not a good situation to have people try to leave one problem to go to another.
I'm not sure you have to have only one charter to solve that problem. I think there are other ways to solve it, you know, where it does occur. And I think there can be some benefits that some charters offer, over others that are not what I just spoke about. And in those cases, I think that's a good thing.
But, it has to be clear: to go to competition at the bottom I think is a bad thing.
SEN. DODD: Yeah.
Chairman Bair?
MS. BAIR: I would just say, I think the problems with regulatory arbitrage have been more severe regarding banks and non-banks, especially on capital constraints, leverage constraints; certainly with regard to investment banks, versus commercial banks; and bank lenders -- mortgage lenders versus non-bank mortgage lenders with regard to lending standards.
So, I think there do needs to be some baseline standards that apply to all types of financial institutions, especially with consumer protection and basic prudential requirements such as capital standards.
I think there are still some problems among -- within the category of banks. We have four different primary regulators now and I think there have been some issues. There have been issues with -- we've seen with the banks converting charters because they fear perhaps a regulatory approach by one regulator. We've seen banks convert charters because of getting preemptions, which is always not a good thing.
So, I think there is more work to be done here. I think part of that may be Congress' call, in terms of whether they want to establish basic consumer protections that cannot be preempted; whether you want federal protection to be a floor or a ceiling for consumer protection.
I think, among us, as regulators, we could do more to formalize agreements among ourselves that we will respect each other's CAMEL ratings and enforcement actions even if a charter is converted to remove the bad incentives for charter conversion.
So, I think there's some steps to be taken, but I do think -- what Joe said, we need both state and federal charters. There's a long history of dual-banking -- the dual-banking system in the United States, and I think that should be preserved.
SEN. DODD: You mentioned the four bank regulators. And, again, Mr. Dugan made the point -- I think he made the point earlier that this could be a briefer hearing -- (laughter) -- given the fact that we have the four regulators involved in all of this.
Is this making any sense at all? And I'm not -- I'm not jumping to one, but I just -- and maybe that's not the way to approach the question. I think that maybe the question ought to be starting about what do we need out there to provide the safety and soundness to consumer protection? And so I'm not interested in just moving boxes around, or take four and make it one -- as attractive as they may seem to people, because that may defeat the very purpose of why we gather and talk about this issue.
But, the question is a basic one: Are we -- do we have too many regulators here, and has that contributed, in your view, Sheila, to the -- to some of the issues we're confronting?
MS. BAIR: I think that you probably could have fewer bank regulators. I do think you need at least a national and a state charter. I think you should preserve the dual structure. But, I also think, in terms of the immediate crisis, the bigger problems with the bank- versus non-bank arbitrage, not arbitrage within the banking system.
SEN. DODD: Yes, Mr. Fryzel.
MR. FRYZEL: Thank you, Senator. I agree with my colleagues with regards to -- (inaudible) --
SEN. DODD: Mike -- you've got to have your mike on there. We've got to -- speak into that. Bring it up closer to you.
MR. FRYZEL: Thank you. I agree with my colleagues, Senator, that there should be the dual chartering system between state and federal banks, as well as credit unions. Chairman Bair says that there probably are too many bank regulators, well, fortunately we only have one credit union regulator, so I think that's something we should maintain.
But, again, I think we need to look at: where are the problems? Which regulator, perhaps, hasn't done the job that they should have done? And maybe that's where the correction should be. I think the majority of the regulators have done the best they possibly can, considered what the circumstances are. I've taken the -- I think they've taken the right types of moves to correct the situation that is out there with the economy the way it is.
But, for a restructuring, I think we need to see, where is the problem? Is it with the banks? Is it with the insurance companies? Is it with other types of financial institutions? And address that. And then, making that improvement, determine whether or not we need the systemic risk regulator above these other institutions.
SEN. DODD: Governor?
MR. TARULLO: Thank you, Mr. Chairman.
I agree with my colleagues that we neither -- we shouldn't undermine the dual banking system in the United States. And so you're going to have at least two kinds of charters.
It does seem to me, though, that the question is not so much one of, can an institution choose, but what constraints are upon that choice? So, for example, under current law, with the improvements that were made to the Federal Deposit Insurance Act following the savings and loan crisis, there are now requirements on every federally insured institution that apply whether you're a state or a federal bank.
I think that Chairman Bair was alluding to some areas in which she might like to see more constraints within the capacity to choose, so that you can't escape certain kinds of rules and regulations by moving from one to the other.
SEN. DODD: Well, you know -- because I think -- to make a distinction here -- I don't know that anyone is really going to argue -- some may, about the idea of having state-chartered and nationally- chartered institutions. But, maybe I heard you wrong -- not any one in particular here, but it seems to me having dual charters, but having a common regulator.
You're not suggesting -- did anyone -- maybe I'll go back and just ask: Are you suggesting to having separate regulators or could we talk about a common regulator and dual charters?
MR. TARULLO: I think you have choices. I mean, basically we have -- of the four regulators of banks, you have two of federal charters, two for state charters. And the question is, does that make sense?
I mean, you could reduce -- you could have a single one for federals, you could have a single one for states, you could have a single one that cuts across all of them and still have two charters. There are complexities and issues with respect to each of those, but -- and I shouldn't leave out that you have 12 Federal Reserve banks --
SEN. DODD: No, I know -- yeah.
MR. TARULLO?: -- and so -- which is another set of people at the table.
My own view, I think there are too many. And I do, I think -- I agree with Chairman Bair. I don't think was a substantial cause of the problems that we've seen, but if you're looking at creating more efficiency and providing a system that's more flexible and works better. I think you don't need -- we don't have four FDAs. We have, you know -- .
SEN. DODD: Would you agree with that, Sheila, that you can have a common regulator and dual charters?
MS. BAIR: Well, I think it's tricky with the state charter, because you still have 50 -- we shouldn't leave out the 50 states' regulators --
SEN. DODD: No.
MS. BAIR: -- that we have. And so the Fed and the FDIC partner with the state regulators in our examination activities.
So, I think you can certainly consolidate all the federal oversight with one federal regulator, but you would still, I would assume -- if you preserve a state charter you'll still have shared responsibilities with the state regulator. And so there's been historical competition between national and state charters --
SEN. DODD: But doesn't that lend itself to shopping again here, in a sense? I mean, lend ourselves -- we don't have -- you know, the point that Mr. Dugan raised here, the FDA doesn't have a national regulator and a state regulator when it comes to food and drug and safety. What do we -- why not financial products? Why shouldn't they be as safe?
MS. BAIR: I think for the smaller banks or the community banks, they like having the state option. They have the -- like having the regulator that's a little closer, more local to them, more accessible to them. So, I think there's some benefits too.
I strongly support continuation of the community banking sector here. I think maintaining the state charter is essential to that.
SEN. DODD: Just let me jump to --
MR. REYNOLDS: Yeah -- (inaudible) --
SEN. DODD: -- and continue -- (inaudible) --
MR. REYNOLDS: In our written testimony, and I tried to synopsize it in my oral, but we believe the dual banking system, state and charter, makes sense, but we believe that the business model and the strategy of the organization should then dictate what regulatory agency oversees it.
So, from our perspective, there's a clear distinction between a commercial bank and a community and consumer bank. And it doesn't make a difference whether it's a federal charter or state charter, under our approach we would submit to you that you have a federal regulator and a federal charter for commercial banks, and you have the same for community and consumer banks. And then if it's a state- chartered entity that fits one of those two business strategies, the relevant federal regulator works with it.
So, it retains the dual banking system; it prevents the ability of individual institution to select a regulator.
Instead, the schematic would suggest that the business strategy determines the regulator.
SEN. DODD: Yeah, absolutely. Let me finish up, and I apologize to my colleagues. I'll just get the comments then go quickly to the --
MR. SMITH: I would say that as a state charter who has good experience with both of our federal colleagues, we need to say that the current state system involves what we call constructive or cooperative federalism now, and state charter banks are not exempt and not free from federally enforced standards. And, to be frank, we're grateful we've been included in the FDI Act because in that case we work with our federal colleagues to establish standards that we understand have to apply across the board.
As I say in my testimony, we understand we've got to raise our game. In other words, we understand that going forward, working with our federal colleagues, we will have -- we would like to have a place in setting national standards and enforcing them, but I think actually, even in light of the current problems we have, that the system has, the state system, in partnership with the Fed and the FDIC, is holding up so far. We've got our issues but we're holding up pretty well. So I think there's a question in the future about our continuing to work more cooperatively with our federal partners, and I think that can help.
SEN. DODD: Mr. Reynolds?
MR. REYNOLDS: Well, my observation as a regulator that's been involved in financial institutions regulation for over 30 years is that we don't have any tolerance for forum shopping, we don't have any tolerance for trying to arbitrage safety and soundness, and it's been my experience in dealing with other state regulators, that that same approach applies. I think the state system does provide choice but I don't believe there is any tolerance for that type of behavior in a state system.
SEN. DODD: Thanks very much. Senator Corker.
SENATOR BOB CORKER (R-TN): Thank you, Mr. Chairman, and thank all of you for your testimony and your service.
Ms. Bair -- Chairman Bair, let me ask you this: Do you think that not having an entity that can do the overall resolution for complex entities is affecting the policies that we have in place right now as it relates to supporting them?
MS. BAIR: It absolutely is. There is really no practical alternative to the course that's been set right now because there is no such political for resolution.
SEN. CORKER: So much of the actions that we're taking as a Congress and as an administration to support some of these entities have to do with the fact that we really don't have any way to unwind them in a logical way. Is that correct?
MS. BAIR: I would agree with that.
SEN. CORKER: Okay. I know the chairman mentioned the potential of FDIC being the systemic regulator. What would be the things that the FDIC would need to do to move beyond bank resolution but into other complex entities like AIG, Lehman Brothers and others?
MS. BAIR: Right. Well, I think -- we think that if we had resolution authority, it actually should be separate from where we have systemic requirements for prudential supervision -- a systemic institution. Those responsibilities are actually separated now and I think it's a good check and balance to have the resolution authority with some backup supervisory authority working in conjunction with the primary regulator, who has responsibility for prudential supervision.
In terms of resolution authority, I think that the current -- that we would like, if we were given that, I think the current system is a good one. We can set up bridge banks, conservatorships that should provide for the orderly unwinding. There is a clear set of priorities so investors and creditors know in advance what the imposition of loss will be. We do have the flexibility to deviate from that, but it's an extraordinary process and it includes a supermajority of my board, the Federal Reserve, the concurrence of the secretary of the Treasury and the president. So it is a very extraordinary procedure to deviate from their baseline requirement to minimize cost.
So I think the model we have now is a good one and could be applied more broadly to complex financial organizations.
SEN. CORKER: It sounds like, in your opinion, in a fairly easy way.
MS. BAIR: Well, I think one easy step would be just to give us authority to resolve bank -- (inaudible) -- holding companies. I think that would be -- I think there are going to be larger, more complex issues in terms of going beyond that category, what is systemic when you talk about insurance companies, hedge funds, other types of financial institutions. But, yes, I think that would be a relatively simple step that would give us all some additional flexibility, yes.
SEN. CORKER: Thank you.
Mr. Dugan, you know, we talk about capital requirements and institutions, but regardless of the capital that any particular institution has, if they make really bad loans or make really bad decisions, it really doesn't matter how much they have, as we've seen, right? Are we focusing enough on minimum lending standards as we think about the overall regulation of financial institutions?
MR. DUGAN: I think that's a very good question. I think capital is not enough by itself. I think you're right.
And, as I mentioned in my testimony, in the area of mortgages, I think if we had had or if we would have in the future some sort of more national standard in the area of -- and if I think of two areas going back that I wish we had over again 10 years ago, it's in the area of stated income or no-documentation loans, and it's in the area of loan to value ratios or the requirement for a significant down payment. And those are underwriting standards. They're not -- there are loan standards and I think if we had more of a national minimum as, for example, they've had in Canada and as we had in the GSE statutes for GSE-conforming loans, I think we would have had far fewer problems.
Now, fewer people would have gotten mortgages -- there would have been fewer people that would have been able to purchase homes and there would be pressure on affordability, but it would have been a more prudent, sound underwriting standard that would have saved us from a lot of problems.
SEN. CORKER: I hope that as we move forward with that you will continue to talk about that because I think that's a very important component that may be left by the wayside. And I hope that all of us will look at a cause-neutral solution going forward. Right now we're focused on home mortgages and credit default swaps that we don't know what the next cause might be.
Mr. Tarullo -- did I pronounce your name right? Okay. You mentioned something about credit default swaps, and I'm not advocating this but I'm just asking the question: In light of the fact that it looks like as you go down the chain -- I mean, we end up having far more credit default swap mechanisms in place than we have actual loans or collateral that is being ensured, right? I mean, it's multiplied over and over and over, and it looks like that the person that's at the very end of the chain is kind of the greater fool, okay, because everybody keeps laying off. Is there any thought about the fact that credit default swaps may be okay but the only people who should enter into those arrangements ought to be people that actually have an interest in the actual collateral itself and that you don't, in essence, put off this -- put in place this off-racetrack betting mechanism that has nothing whatsoever to do with the collateral being insured itself. Have there been any thoughts about that?
MR. TARULLO: Senator, I think that issue has been investigated and discussed by a number of people, in and out of the government. Here I think are the issues: There is a group of market actors who have a reason why they want to hedge a particular exposure or instrument, and the most efficient way for them to do that is to have a credit default swap associated with a particular institution or product, even when they don't own the underlying product, because there is a relationship.
The difficulties a lot of people have pointed out would come in trying to craft a rule which would allow that to occur while ending the kind of practice I think that you're worried about, which is much less tethered to a hedging kind of strategy.
I do think when it comes to credit default swaps we can make a couple of observations, though. One, they do underscore, again, the importance of monitoring, overseeing the arenas in which big market actors come together. Making sure that there is a central counterparty, for example, helps to contain some of the risk associated with the use of credit default swaps. And, secondly, the problems with credit default swaps that we associate with this crisis didn't come from institutions that were being regulated by Mr. Dugan, for example, or bank holding companies being regulated by the Fed. What does that tell you? It tells us that although looking at the interaction of entities is important, you still should do good, solid supervision of particular institutions, and if they have to have capital requirements and liquidity requirements and good risk management practices, then whatever use a particular trade, an entity is putting a credit default swap to, you don't allow them to acquire too much exposure.
SEN. CORKER: Mr. Chairman, I know my time's up. Thank you all.
SEN. DODD: Let me just say, what I want to do is -- this vote has started. I'm going to go over and make the vote and come right back. So if you've finished up, Senator Merkley, do you want to have time for questions as well for yourself? And I'll try and get right back, and the other members as well.
Senator Warner.
SENATOR MARK WARNER (D-VA): Well, thank you, Mr. Chairman. Thank you for holding this hearing and your leadership on reform efforts that are going forward.
You know, I know the subject today is how do we reform on a prospective basis, but in the interim we've seen the Republican congressional outrage over AIG and with certain other actions by a number of our institutions -- until we get this new regulatory structure in place, what I think we keep hearing is, well, we don't really have any tools to stop these actions. And one are that I've had some folks talk to me about it and I'd like to get your opinions is under the Federal Deposit Insurance Act, which obviously all of the federal regulators have the ability to enforce -- not only FDIC but the OCC and the OTS and the Fed -- my understanding is regulators do have at least a statutory ability to issue cease and desist orders to institutions or individuals if somebody has engaged in unsafe or unsound practices, if somebody has engaged in a breach of the fiduciary duty, or if somebody has received financial gain or other benefits that show willful disregard for the safety and soundness of the institution.
And I understand that the case law is fairly new here, but my understanding of the remedies you've got is you can ban somebody from banking, you can get restitution, you can impose a series of other penalties but, boy oh boy, even with a narrow case law, it sure does seem that some of the actions that have taken place -- and, again, case in point being AIG -- and I know the fact that it was offshore, off-balance sheet in the lemon derivatives entities, but it sure seems like this tool could be used or could be pushed because there sure has been a whole lot of activities that have led to either financial enrichment or unsound practices, at least in retrospect now. And I just question, you know, have you thought through this tool? Have you investigated? Have you not used it because you felt that the case law wouldn't allow it? And why not take a little bit of risk in pushing the edge, particularly with the amount of abuse and the amount of public outrage that we see today?
Mr. Polakoff, do you want to start, and I'd love to hear from all of the regulators.
MR. POLAKOFF: If I could offer some thoughts regarding AIG, as you know, September 15th, 2008, with the government's action, caused AIG to not -- to no longer be a savings and loan holding company. So six months have passed since that time. I can assure you that if AIG was still a savings and loan holding company, we would have taken enforcement action under safety and soundness to say those bonuses were an unsafe and unsound practice and would have not allowed it. But it's not a savings and loan holding company.
SEN. WARNER: I know the government owns -- but even though the fact that there is a Treasury-earned trust so that -- I know you've testified here a week ago that, yes, you had oversight over AIG and maybe have missed a bit and now you're saying you have no regulatory ability to take any of these actions?
MR. POLAKOFF: Once the government took ownership, by statute it's no longer a savings and loan --
SEN. WARNER: But the government -- and I know you would know the law better than I, but I thought the government has not taken full ownership, that there is still a trust in which the Treasury and others helped put members, but you're saying even though the trust is an independent trust it is not owned entirely and controlled entirely by the government. As an independent trust, wouldn't you still have regulatory --
MR. POLAKOFF: No, our legal analysis says that the control is with the government. I mean, we would be thrilled if we could get to the legal status that it's still a savings and loan holding company. It would allow us to take action.
SEN. WARNER: Let me hear from the other -- the regulators on the panel whether, beyond just the AIG-specific example, whether this tool -- or whether you thought them using this tool, as we've seen in other actions -- AIG being the most egregious but there are other institutions that I think fall into that category.
Yes, ma'am?
MS. BAIR: Well, I would say the FDI Act applies to depository institutions, and obviously AIG had a small thrift depository institution --
SEN. WARNER: Right.
MS. BAIR: -- regulated by OTS, and OTS was their holding company later --
SEN. WARNER: Right.
MS. BAIR: -- but our authority as backup supervisor and PFR, primary federal regulator, of nonmember state-chartered banks is only for the depository institution. When we take a bank over as receiver conservator, typically we have separate authorities to extinguish, repudiate all employment contracts, so typically the boards are gone, obviously. The senior management is generally let go, and those who were responsible for the bank's problems are typically let go as well.
So we do very aggressively pick and choose who we want to keep and who we think needs to leave when an institution fails and we become receiver conservators. So we do use it in that context but, again, that's just for a bank, the depository institution part, and AIG certainly is a much larger risk, predominantly --
SEN. WARNER: Well, since the Fed and the OCC also have the ability to enforce those actions, have you thought of using this tool for actions that you may find to be unsafe or where individuals might have received financial benefit with willful disregard to the safety and soundness of the underlying institution?
MR. TARULLO: I think, Senator, your question raises two questions -- one about where we are now, but an important one about going forward as well. With where we are now in respect to the compensation issues, by and large, as you know, those have been for TARP-recipient institutions.
Those have been things that are either congressionally mandated or put in place by the Treasury Department, and so far as I'm aware, with respect to institutions over which the Fed has regulatory authority, there has not been thought of going beyond the congressional and Treasury policies on compensation. I think, though, that the larger question you raise is one, again, of regulatory gaps. You know, in order -- as Chairman Bair said, in order to be able to exercise any authority, you've got to have the basic supervisory structure in place.
And so, as we think going forward about where problems which we can't anticipate are going to arise, it underscores the importance of making sure that each of these systemically important institutions is in fact subject to the kinds of rules that you're talking about.
SEN. WARNER: Mr. Dugan, I know my time is about expired but I just --
MR. DUGAN: Yeah, well, we have a range of tools, of course, both informal and formal, for a number of different things in the compensation area to find willful disregard that causes a safety and soundness problem. It is, in fact, a quite high standard to meet. There is separate authority under Part 30 of the Federal Deposit Insurance Act, the so-called safety and soundness standards that were adopted in FDICIA that also -- a somewhat lower standard but still tied to the safety and soundness of the institution that possibly you could make a connection to, and we do look at these but the -- as I said, to make that connection to the safety and soundness thing is not an easy thing to do.
SEN. WARNER: My only sense -- I'd love to pursue this a bit more -- is that we all understand that we've got to fix this problem on a prospective basis, but there is still an interim time between now and when Congress would act and these new rules and regulations would be in place. I would just urge you to perhaps revisit with your legal staffs this tool because, as we've seen, it's not healthy for the public's confidence in the overall financial system when we see the kind of excesses and everybody is saying we don't have any tools to go after this when it appears there may be at least partial tools still here.
MS. BAIR: And I just wanted to reemphasize what I indicated earlier about our inability to have a resolution authority that it applies to.
SEN. WARNER: Excellent.
(Cross talk.)
MS. BAIR: -- broad authority to repudiate these contracts. You don't have to make this type of -- it's really pretty much up to the discretion of the receiver conservator. So I think AIG is a good example of if the bank regulators had resolution authority of the entire organization --
(Cross talk.)
SEN. WARNER: Very, very valid point, but again, we still have some interim period that may be a narrow period of months, and if the public has lost all confidence in the fairness and soundness of the actions of some actors in the financial community, it's going to make our challenge and task in terms of striking that appropriate balance between the full market system and an appropriate regulatory oversight even more difficult going forward. So thank you very much.
SEN. DODD: Senator Merkley?
SENATOR JEFF MERKLEY (D-OR): Thank you very much, Mr. Chair. Very quick responses because I understand it's four minutes until the closing of the vote.
Chairman Bair, you noted the need to address the issue of too big to fail and I believe talked in your testimony about increasing financial obligations as the size of organizations creates greater risk and perhaps regulating the public funds available to very large financial institutions. Do we need to also explore the issue of how mergers and acquisitions affects the growth of individual institutions? Is there any point in the process of a firm growing through mergers, acquisitions that this issue needs to be addressed? And I'd open that up to any of you, and please speak quickly. Thank you.
MS. BAIR: Well, and I will speak quickly and turn it over to Dan because the Fed reviews the merger and acquisition activity but, yes, I think that's part of it. I think compensation tied to successful mergers and acquisitions, executive compensation tied to growth for the sake of growth is another area that I think has fed into this current problem we have.
SEN. MERKLEY: Did I catch you right? You said executive compensation as it's tied into growth?
MS. BAIR: As it has been tied to merger activity and growth. Yes, I think that has helped feed the beast. I do.
SEN. MERKLEY: Thank you.
MR. TARULLO: Certainly, Senator, with respect to mergers under the Bank Holding Company Act, there ought to be and is a scrutiny under the antitrust laws to determine whether there is going to be -- there are going to be anti-competitive consequences to the merger. But you should understand that the competition analysis, as it's put forth in the statute, does not, in itself, directly feed into the issues of size and systemic risk. And so there does need to be an independent focus on systemic risk beyond the traditional antitrust question of whether a merger would reduce competition in a particular market.
SEN. MERKLEY: Does anyone else want to add to that?
MR. POLAKOFF: Senator, I would just say real quick that for thrifts of savings and loan holding companies where there is a merger, there is absolutely an assessment of what the consolidated risk profile looks like in the competency of management. And I think all the regulators go through that analysis with a merger.
SEN. MERKLEY: So you feel like this -- in your case you're saying it's really been addressed in the past, we've done a great job, and no need to change any particular approach to that issue?
MR. POLAKOFF: When it comes to mergers, I think the regulators have the right powers to assess the consolidated risk profile of the company in deciding whether to approve it or not, yes, sir.
SEN. MERKLEY: They have those powers? Have they exercised those powers?
MR. POLAKOFF: Yes, sir.
SEN. MERKLEY: Okay. Anyone else?
Okay, I want to turn to the issue of consumer protection and how this feeds into the risk -- kind of the retail issues. Certainly it's my view that the current crisis is an example of how failure to provide for adequate consumer protection compromises the safe and sound operation of financial institutions. What is your view of the role of consumer protection in supervision and regulation, and how effective do you think your particular agencies have been in addressing the consumer protection side? Whoever would like to --
MR. POLAKOFF: I'll jump in. I think, first of all, there's a keen connection between consumer protection and safety and soundness. That's one of the reasons that I believe all the regulatory agencies, as part of any safety and soundness examination, look at all of the consumer complaints. They keep a file. They look at them. They work through them. There's a keen connection when consumers are complaining they have some potential safety and soundness related issues. I think all of us -- certainly OTS has a robust system for addressing consumer complaints. We've made a number of referrals -- actually a large number of referrals to Justice for fair lending issues. And I think it's a trend that many of the agencies are seeing.
MR. TARULLO: Senator, I would say that consumer protection is related both to safety and soundness and to, as I suggested in my prepared remarks, systemic risk.
With respect to how consumer protection has done recently, I have to, in the interest of full disclosure -- as you know, I've only been at the Fed for six weeks and before that was an academic who was critical of the failure of our bank regulatory agencies to give as much attention to consumer protection as they ought to.
I do think in the last couple of years there has been renewed attention to it and that things have moved in a better direction, but I think it's something that everybody is going to need to continue to pay attention to.
MR. SMITH: Senator, if I could respond to that.
SEN. MERKLEY: Oh, please, Mr. Smith.
MR. SMITH: On behalf of the states, I will say that with regard to the mortgage issue, for example, the state response to the mortgage issue may have been imperfect and it may not have been complete. In North Carolina we started addressing predatory lending in 1999. I would say that I think that the actions of states' AGs and state regulators should have been and ought to be in the future market information that, in assessing systemic risk, ought to be taken into account. And I think this has not been done in the past. Again, I don't claim that we're perfect. I do claim that we're closer to the market, as a rule, than our colleagues in the federal government and I think we have something to add if we're allowed to add it.
And so I hope as we go forward, sir, the state role in consumer protection will be acknowledged and that we'll be given the chance to do more.
SEN. MERKLEY: Okay, well, let me just close with this comment since my time is up. The comment that this issue has had robust attention -- I believe, Mr. Polakoff, you made that -- and WaMu was a thrift, Countrywide was a thrift. On the ground it doesn't look like anything close to robust regulation of consumer issues. I will say I really want to applaud the Fed for the actions they took over subprime lending: their action regarding escrow for taxes and insurance, their addressing of abusive prepayment penalties, the ending of liar loans and subprime, but I also want to say that from the perspective of many folks on the ground, one of the key elements was booted down the road, and that was the yield spread premiums.
And just to capture this, when Americans go to a real estate agent, they have all kinds of protection about conflict of interest, but when they go to a broker, it is a lamb to the slaughter. That broker is being paid -- unbeknownst to the customer, is being paid proportionally to how bad a loan that consumer gets, and that conflict of interest, that failure to address it, the fact that kickbacks are -- essentially kickbacks are involved, that result in a large number of our citizens on the most important financial transaction of their life, ending up with a subprime loan rather than a prime loan, that's an outrage. And I really want to encourage you, sir, in your new capacity, to carry this conversation. The Fed has powers that it hasn't fully utilized. I do applaud the steps that it's taken.
And I just want to leave with this comment that the foundation of so many families financially is their homes, and that we need to provide superb protections designed to strengthen our families, not deregulation or loose regulations designed for short-term profits. Thank you.
SEN. DODD: Senator Johanns.
SENATOR MIKE JOHANNS (R-NE): Well, thank you very much. I'm not exactly certain who I direct this to, so I'm hoping that you all have just enough courage to jump in and offer some thoughts about what I want to talk about today.
As I was sitting here and listening to the great questioning from my colleague, the response to one of the questions was that we do make a risk assessment when there is a merger. We make an assessment as to the risk that is being taken on by this merger. And I sit here, I have to tell you -- and I think to myself, well, if it's working that well, how did we end up where we're at today? So it leads me to these questions.
The first one is, who has the authority, or does the authority exist for somebody to day that the sheer size of what we end up with poses a risk to our overall national, if not international, economy, because you've got so many eggs in one basket that if this your judgment is wrong about the risk assessment, you're not only wrong a little bit; you're wrong in a very magnificent sort of way. So who has that authority? Does that authority exist? And if it doesn't, should it exist?
MR. TARULLO: So, Senator, subject to correction and qualification by my colleagues, I can say that at present there is no existent authority to take that kind of --
SEN. DODD: Could you put your microphone on, please?
MR. TARULLO: Oh, sorry. There is no authority to take that kind of top-down look at the entire system and to make a judgment as to whether there is systemic risk arising not, again, out of individual actions but out of what's happening collectively.
Now, you know, one point I should have made in my introductory remarks, and I'll take your question as an opportunity to make it as well, is we all need to be -- I hope you are and we certainly will be -- we all need to be realistic about what we can achieve collectively -- that is, everybody sitting here and all of you -- in addressing this systemic risk issue because I don't think anybody should be under the illusion that simply by saying, oh, yeah, systemic risk is important and everybody ought to pay more attention to it, that we're going to solve a lot of the really difficult analytic problems.
Now, we all remember what happened four or five years ago when some people, with great prescience, raised issues about whether risks were being created by what was going on in the subprime market. And at the same time, many other people came back and said, don't kill this market. So what in retrospect appears to everybody to be a clear case of overleveraging and bad underwriting and a bubble and all the rest, in at least some cases, in real time, produces a big debate over whether you're killing the market or you're regulating in the interests of the system.
So, that's not, I know, directly responsive to your question, but I do hope that everybody understands that this is going to be a challenge for us all going forward -- to make sure that constraints are being placed where they ought to be, but to recognize that nobody wants to kill the process of credit allocation in the United States.
SEN. JOHANNS: Could we agree -- and I appreciate you offering that, appreciate the candor of your testimony -- could we agree, members of the panel, that if we really wanted today to make an assessment -- again, getting back to this, it just gets so big and there's so few left, that we're putting the whole economy at risk if one of them fails, that there really isn't anybody who can step in and say, "time out," "we can't do that merger," or whatever, based upon that premise. Or is that a false assumption on my part?
Yes, sir.
MR. KARSKY: I'd just make two points. One is, we do have, on the banking side, a Congressional limit on the amount the share of deposits that you can have in the United States, and that is an effective limit, of a kind, on growth. It doesn't prevent very large institutions, but it prevents -- we still have, by world-wide standards, a quite deep, consolidated U.S. -- or a lack of concentrated U.S. industry, and, of course, you have antitrust limits. But, there's nothing in the law, that I'm aware of, that says "just because you get large" -- other than what I just spoke about, but there's a limit on it.
And I would also say that there are large American companies that need large banks, and so you have to be careful if you put some other kind of limit on it that you wouldn't have large European or Asian institutions come and make large loans.
We have to be --
SEN. JOHANNS: Take the business away.
MR. KARSKY: -- we'll have balance there. There's a balance there.
SEN. JOHANNS: Yeah.
The second thought I want to throw out -- and I'm very close to being out of time here, and these are very complicated issues, but I would like a quick thought if the Chairman will indulge me.
SEN. DODD: Certainly.
SEN. JOHANNS: Let's say that you do have an institution; you've made your risk assessment; merger has occurred; and all of a sudden you're looking at it and saying, boy, there were some things here that if I had to do it over again I'd do it differently. Maybe they've a step two, or three or four further than you anticipated they were going to, and now you can see the risk is growing, and growing and growing to a dangerous level.
Do we have in our system the "cord we can pull"; that is, the safety valve that says, again, in effect, "time out," "we are at a level where the risk is not acceptable for our economy?"
MR. KARSKY: Senator, I think with respect to a regulated institution -- which I believe is the premise of your question, the answer is yes. The answer is yes there. If the institution is regulated, then somebody sitting at this table is going to have the authority to say, "you are assuming too many risks and you need to reduce you're exposures in a particular area; you need to increase your capital; you need to do better liquidity management," whatever the proper guidance might be.
The one footnote I'd place there, again, is that in order to get to that point we need to make sure that people are aware of the risks. And sometimes just looking at it from the standpoint of the institution is completely adequate. It's always necessary. But there are these circumstances -- and I think we've seen some of them in the last couple of years -- where you do need to have a bit more of a system-wide perspective in order to know that something is a risk.
SEN. JOHANNS: I'll just wrap up with this thought, because I am out of time, and I'll try to do so quickly.
I think it's a real frustration for us here to be faced with these issues of, "Well, Mike, this is just way too big to allow it to fail;" and, "Mike, it's going to take taxpayers' money to unravel the risk that they have gotten themselves into, and a lot of money. these are big institutions, it's going to take big money."
And so you can see from my questions what I'm trying to do is, if we're going to think about this in a global way -- I certainly don't want to stall growth in this nation. I mean, gosh, we're the greatest nation on earth. But on the other hand I would like to think whatever we're doing we're going to give some policymakers the ability, and some regulators the ability to, in effect, say, "time out."
MR. : (Off mike.) Mr. Chairman, can I just briefly --
SEN. DODD: Certainly.
MR. : Senator, I not only understand but sympathize with your perspective. And what -- with your closing remarks, here's what I would suggest back to you.
That a number of the instruments -- I would say, if I can over- generalize, a lot of what is in the prepared -- the long, prepared testimony of people at this table today, is a rehearsing of some of the instruments which are available to you. And I'm sure you and your staff, and your colleagues, after you go through them all you're not going to -- you're going to want to tweak some, you may not be for others at all.
But I think this is the opportunity that we all have, which is to take this moment, not only to do an internal self-examination but also to say, okay, how are we going to revamp this system to put in place structures that avoid exactly the kind of situation you're talking about?
So, just to use two, because I don't want to take up too much time, the resolution mechanism -- which you've heard so much from Mr. Dugan, Ms. Bair and me about, is really very important here precisely because of its association with the "too big to fail" institutions; and making sure that systemically important institutions are regulated in a way that takes that systemic importance into account -- at the first, in the first instance, with the capital requirements they have, with the liquidity requirements, will be steps along that road.
SEN. DODD: Thank you very much. And I totally agree with that. I think that's very, very important.
Senator Reed.
SEN. REED: Well, thank you, Mr. Chairman.
I want to think the witnesses. I have great respect for your efforts, and your colleague's efforts, to enforce the laws and to provide the kind of stability and regulation necessary for a thriving financial system. And I think -- I've seen Mr. Polakoff at least three times this week, so I mean, I know you put in a lot of hours in here as well as back in the office. So, thank you for that.
But, yesterday, a hearing based on a GAO report about the risk assessment capacities and capabilities of financial institutions, but one of the things that struck me is that, perhaps either inadvertently or advertently, we've given you conflicting tasks. One is to maintain confidence in the financial system of the United States, but at the same giving you the responsibility to expose those faults in the financial system to the public, to the markets, and also to Congress.
And I think, in reflecting back over the last several years or months, what has seemed to trump a lot of decisions by all these agencies has been the need, or the perceived need to maintain confidence in the system when, in fact, many regulators had grave doubts about the ability of the system to perform, the risks that were being assembled, the strategies that were being pursued. And I think if we don't at least confront that conflict or conundrum directly we could reassign responsibilities without making a significant change in anything we do.
And so in that respect I wonder if you have any kind of thoughts about this trade-off between your role as cheerleaders for the banking system, and your role as referees for the banking system?
Mr. Dugan?
MR. DUGAN: Well, I'm not sure I'd describe it as a cheerleader. The --
SEN. REED: I think, in some cases -- we heard the cheers echoing through the halls.
MR. DUGAN: But -- I guess what I would say, Senator, is there is attention with financial institutions that depend so heavily on confidence, particularly because of the run-risk that was described earlier -- and I'm not just talking about depositors getting in line, I'm talking about funding, that has always informed, and is very deeply embedded in, our whole system of financial regulation. There is much about what we do, and how we do it that is, by design, confidential supervisory and information. And we do have to be careful in everything we do and how we talk about it, about not creating or making a situation worse.
And at the same time, the tension you quite rightly talk about is, knowing that there are problems that need to be addressed and finding ways to address them in public forums without running afoul of that earlier problem. And it gets harder when we have bigger problems in a financial crisis like the one we have, and we all have to work hard to get through that and to try to work with that tension.
And I think we can do that by the kinds of hearings that you've had. But, I think we have to avoid commenting about specific open institutions, but there are many things we can talk about and get at, and I think that's what we need to do.
SEN. REED: Ms. Bair -- and I'll try to go around briefly because of the time limits.
Ms. Bair.
MS. BAIR: Well, I hope we're cheerleaders for depositors. And I think we're all about stability and public confidence. And so I think it's important to keep perspective, though, for all bank regulators, that what we do should always be tied to the broader public interest. It is not our job to protect banks, it is our job to protect the economy and the system, and to the extent our regulatory functions relate to that, that's how they should be focused.
So, I do think that the market is confused now, because different situations have been handled different ways. And I hate to sound like a "Johnny One-Note," but I think a lot of it does come back to this inability to have a legal structure for resolving institutions once they get into trouble.
And so I think whatever that structure might eventually look at -- look like, just clarity, for the market, for investors and creditors about how they will be treated, and the consistency of the treatment, I think would go a long way to promoting financial stability and confidence.
SEN. REED: Mr. Fryzel?
MR. FRYZEL: Thank you, Senator.
Paramount to NCUA is the safety and soundness of the funds of all our 90 million members in credit unions across this country. And, in an effort to maintain their confidence is not an easy task. And we've made every effort to do so by public awareness campaigns; certainly the action by Congress in raising the $250,000 limit has been fantastic in regards to the safety and their ability to think that their funds -- or to know that their funds are safe.
We try to draw the fine line in letting them know that, yes, there are problems in our financial structure but we are dealing with them and we're going to use the tools that we have to make sure that things get better. And when this economy turns around the financial institutions are again going to be in the position where they're going to be able to serve these consumers in the way they have in the past.
So, yes, Senator, it is a fine line, but I think it's one that we have to keep talking about. And we cannot let anyone think that there are not problems out there, but we have to tell them we are in a great country; this economy does come back; and everything is going to be better in the future.
SEN. REED: Mr. -- (inaudible) --
MR. : Senator, I may have misunderstood -- I understood you to be asking not about regulatory actions in the midst of a crisis, but in the period preceding it when supervision is supposed to be ongoing.
And so here's -- I have a lot of -- I think there's a lot to the question that you asked, not so much because, I would say, of a conflict of interest, as such, between different roles, but because everybody tends to fall into a notion of what operating principles for this period -- whatever period we're in may be.
And so people come to accept things. It's bankers do, supervisors, maybe even members of Congress do, that something that's ongoing is, precisely because it has been ongoing, an acceptable situation.
So, I think from both our perspective and your perspective the challenge here is to figure out what kinds of mechanisms we put in place within agencies, between the Hill and agencies, in legislation which force consideration of the kinds of emerging issues that we can't predict now because we don't know what the next crisis might look like, but which are going to be noticed by somebody along the way.
And I don't want to -- I really don't want to overstate the potential utility of a systemic risk regulator, for the reasons I said earlier, but I would say that in an environment in which an overall assessment of the system is an explicit part of mandate of one or more entities in the U.S. government, you at least increase the chances that that kind of disparate information gets pulled together and somebody has to focus on it.
Now, you know, what you do with it, that's another set of questions, but I think that gets you at least a little bit down the road.
SEN. REED: Mr. Polakoff. And my time is expiring, so brevity is to be appreciated.
(Cross talk.)
MR. POLAKOFF: -- Senator, thank you.
We're not in the current situation we're in today because of actions over the last six to 12 months by the regulators, or, in a lot of cases, the bankers. It's from three, four or five years ago.
I think the notion of countercyclical regulation needs to be discussed at some point. When the economy is strong is when we should be our strongest in being aggressive. And when the economy is struggling I think is when we need to be sure that we're not being too strong.
Any of us at this table can prevent a bank from failing. We can prevent banks from failing. But, what will happen is people who deserve credit will not get credit, because they'll be on the bubble.
The thing I love about bank supervision is it's part art and it's part science. And I think what we're doing today is going to address the situation today. We've got to be careful we're doing the right thing for tomorrow and next year as well.
SEN. REED: Mr. Smith and then Mr. Reynolds.
MR. SMITH: Thank you, Senator. I agree with my friend the comptroller with the two concepts of supervisory authority on the one hand and consumer protection on the other are intertwined. They should not be drawn apart. I will say that in the state system, sir, we have the advantage of having to partner with friends in the federal government. We have a cooperative federalism. That's a good thing because our friends in the Fed, our federal friends help us and sometimes tell us things we don't want to know, particularly about consumer compliance, that makes our system of regulation stronger.
I would suggest, sir, with some of the actions the states have taken in consumer protection in the past, if they had been listened to, would have helped in terms of determining the systemic -- understanding what the systemic risk of some activities in the marketplace were. And so I believe that as a part, as we say in our testimony, as part of an ongoing system of supervision, I would argue, and I agree with Governor Tarullo, that you need -- the fact that you have multiple regulators focusing on an issue can, in the proper circumstance, if there is cooperation, result in better regulation. The idea of a single regulator I think is inherently flawed.
SEN. REED: Mr. Reynolds.
MR. REYNOLDS: My comment would be that it is appropriate that we take a measured response. I agree with Mr. Polakoff's observation that regulators have the ability to tighten down a regulation to the point where we make credit availability an issue. On the other side, it's important that our role as safety and soundness regulators be the primary role that we play, and that we're not in the business of being cheerleaders for the industry. I'm certain that my bankers and my credit union managers in the state of Georgia don't regard me as a cheerleader.
SEN. REED: My time's expired. Thank you.
SEN. DODD: Thank you, Senator, very much. I should have taken note, and I apologize for not doing so. Senator Reed had a very good subcommittee hearing yesterday, and this is the seventh hearing we've had just this year on the subject matter of modernization of federal regulations. And we had dozens last year going back and examining the crisis, as well as beginning to explore ideas on how to go forward. So I'm very grateful to Jack and the other subcommittee chairs who are meeting as well. We had four hearings this week alone just on the subject matter, so it's very, very helpful, and I thank Senator Reed for that, for cooperating.
I'm going to turn to Senator Menendez, but I want to come back to this notion about a supervisory capacity and consumer protection because too often I think the safety and soundness dominates the consumer protection debate. That can't go on, in my view. There's got to be a better way of dealing with this, but let me turn to Senator Menendez.
SEN. ROBERT MENENDEZ (D-NJ): Thank you, Mr. Chairman. Mr. Chairman, I have a statement for the record, so I hope that can be included.
SEN. DODD: It will be included.
SEN. MENENDEZ: Mr. Chairman, I look forward to asking some questions specifically, but I want to turn first to Chairman Bair. I cannot pass up the opportunity, first to compliment you on a whole host of things you're doing on foreclosure mitigation and whatnot. I think you were ahead of the curve when others were not, and I really applaud you for that. But I do have a concern.
I've heard from scores of community banks who are saying, you know, we understand the need to rebuild the Federal Deposit Insurance fund, but you know, I understand when they say to me, look, we're not the ones who drove this situation. We have to compete against entities that are receiving TARP funds. We are not. And in some cases we're looking at anywhere between 50 and 100 percent of profit.
I understand you're statutorily prohibited from discriminating large versus small, but in this one instance, I understand this is supposedly a one-time assessment. Wouldn't it be appropriate for us to give you the authority to vary this in a way that doesn't have a tremendous effect on the one entity, it seems to me, that is actually out there lending in the marketplace as best as they can?
MS. BAIR: Well, a couple of things. We have signaled strongly that if Congress will move with raising our borrowing ability, we feel that will give us a little more breathing room.
SEN. MENENDEZ: With what? I'm sorry, I didn't hear.
MS. BAIR: If Congress raises our borrowing authority. Chairman Dodd and Senator Crapo have introduced a bill to do just that. If that can be done relatively soon then we think we would have some flexibility to reduce the special assessment. But right now we've built in a good cushion above what our loss projections would suggest. That would take us to zero because we think the borrowing authority does need to be raised just a little. It's been at 30 days since 1991, so we do think that needs to happen. But if it does, we feel it could reduce our cushion a bit.
Also the FDIC board just approved a phase-out of what we call our TLGP debt guarantee program. We're starting to raise -- we're raising the cost of that program through surcharges, which we will use to put in to the Deposit Insurance fund, and this could also reduce the need for the special assessment, and so we'll be monitoring that very closely.
We have also asked for comment about whether we should change the assessment dates for the special assessment. Right now we use domestic deposits. If you used all bank assets, that would shift the burden to some of the larger institutions because they rely less on deposits than the small institutions. So we are gathering debate, comment on that right now. We'll probably make a final decision in late May. But I think increasing the borrowing authority, plus then we do expect to get some significant revenue through this surcharge we've just imposed on our TLGP, which again in most of the larger banks are the beneficiaries of the debt guarantee program. So we think that will help a lot.
SEN. MENENDEZ: Well, I look forward, Mr. Chairman, to working with you to try to make this happen because these community banks are the ones that are actually out there still lending in communities at a time in which we generally don't see much credit available. But this is a huge blow to them. However we can -- I'll submit my own comments for the regulatory process, but however we can lighten the load I think would be incredibly important.
Mr. Dugan, I want to pursue a couple of things with you. You recently sent a letter to the congressional oversight panel essentially defending your agency. Included in that letter is a chart of the 10 worst of the 10 worst, lenders with a higher sub-prime and alternate A foreclosure rates. Now I see that three of them on this list have been originating entities under your supervision -- Wells Fargo, Countrywide, and 1st Franklin.
Can you tell us what your supervision of these entities told you during 2005 -- 2007 about their practices?
MR. DUGAN: Senator, as I've said before, we certainly did have some institutions that were engaged in sub-prime lending, and what I said also is that it is a relatively smaller share of overall sub- prime lending in the whole market, and what you see was roughly 10 to 15 percent of all sub-prime loans in 2005 and 2006, even though we had a much larger share of the mortgage market. I think you will find that of the providers of those loans, the foreclosure rates were lower and were somewhat better underwritten, even though there were problem loans and I don't deny that at all.
I would say that historically the commercial banks -- both state and national -- were much more heavily intensively regulating and supervising loans, including sub-prime loans. We had had a very bad experience 10 years ago or so with sub-prime credit cards, and as a result we were not viewed as a particularly hospitable place to conduct sub-prime lending business, so even with organizations that were complex bank holding companies, they tended to do their sub-prime lending in holding company affiliates rather than in the bank or the subsidiary of the bank where we regulated them. We did have some, but it turned out it was a much smaller percentage of the overall system than the sub-prime loans that were actually done.
SEN. MENENDEZ: Well, you know, sub-primes is one thing. The alternate A's is another. Let me ask you this. How many examiners, on-site examiners did you recently have at Bank of America, Citi, at Wachovia, at Wells?
MR. DUGAN: It's different for each one of them, but we have -- on-site examiners can vary in our largest banks from 50 to 70 examiners. It's a very substantial number, depending on which organization you're talking about.
SEN. MENENDEZ: What did they say to you about these major too- big-to-fail lenders getting heavily into no document and low document loans?
MR. DUGAN: Well, we were never the leader in no document and low document loans. We did so some of it, and the whole alt A market by definition was a lower documentation market, and it was a loan product that mostly was sold into secondary markets.
When I got and became comptroller in 2005, we began to see the creeping situation where there were a number of layers of risk that were being added to all sorts of loans that our examiners were seeing and that caused us to issue guidance on nontraditional mortgages like payment option mortgages, which we were quite aggressively talking about the negative amortization as being not a good thing for the system, and that again we were quite vocal about pushing out of the national banks that were doing it.
SEN. MENENDEZ: Well, let me ask you. You have twice been criticized by your own inspector general for keeping, quote, "a light touch," light for too long when banks under your watch were getting in trouble. And I know you've consistently told us that you like to do things informally and in private with your banks. Do you think that changing that strategy makes sense in light of what we've gone through now?
MR. DUGAN: Well, I think I would say two things. The inspector general does material loss reviews on all the agencies with respect to any bank that has more than a $25 million loss, and it's a good process, a healthy process, and we accept that constructive criticism. And they have talked about places where we could have moved more quickly with respect to a couple of institutions, and we agreed with that.
What I would say is we have as supervisors a range of tools that we can use that are both informal tools that Congress has given us, and formal enforcement tools. And on that spectrum we do different things depending on the circumstances to try to get actions and behavior corrected. Merely because something is not formal and public does not mean that we're not paying attention or getting things addressed or fixed. Many times, many times because we are on-site, have the presence, identify a problem, we can get things corrected quickly and efficiently without the need to go to a formal enforcement action. But we will not hesitate if we have to to take that action to fix those things. I think there are things that we constantly look at to correct and to improve our supervision using that range of tools.
SEN. MENENDEZ: Mr. Chairman, I know I'm -- if I may, just one more moment. Just following up on the senator's question, how many of these banks did you find that violated your guidelines? And if so, what were the punishments you meted out for them? Looking back, do you think you missed any of the violations?
MR. DUGAN: So it would -- a range from things. We have something that -- if we see something early, any kind of bank examination that you go through, there are certain kinds of violations of law. Some are less serious and some are more serious. And at one end of the spectrum we do something called matters requiring attention, which tells the directors, we expect you to fix this and we want it fixed by the next time we come in.
SEN. MENENDEZ: Jump to the more serious ones.
MR. DUGAN: On that point, we saw 123 of them in that four-year period, and we got 109 of them corrected within that period.
SEN. MENENDEZ: Were punishments meted out?
MR. DUGAN: Oh, yes. Not for those banks, but we have other situations in which we took actions for mortgage fraud, for other kinds of mortgage-related actions where we had problems, and we provided some statistics I could certainly get you that was compiled for the enforcement hearing where we're testifying tomorrow.
SEN. DODD: I'm sorry, Senator.
SEN. MENENDEZ: No, thank you, Senator Dodd. I appreciate it. Just one more line of questioning. We had a witness before the committee, Professor McCoy of the University of Connecticut School of Law, and she made some statements that were pretty alarming to me. She said the OCC has asserted that national banks made only 10 percent of sub-prime loans in 2006, but this assertion fails to mention that national banks moved aggressively into alternate A low documentation and no documentation loans during the housing boom.
Unlike OTS, the OCC did promulgate one rule in 2004 prohibiting mortgages to borrowers who could not afford to pay. However, the rule was vague in design and execution, allowing lax lending to profligate national banks and their mortgage lending subsidiaries to 2007. Despite the 2004 rules, in 2007 large national banks continued to make large quantities of poorly underwritten sub-prime loans and low and no documentation loans. The five largest U.S. banks in 2005 were all national banks and too big to fail. They too made heavy inroads into low and no documentation loans.
And so it just seems to me that some of the biggest bank failures have been under your agency's watch, and they too involved thrifts heavily into no document, low document, alternate A and nontraditionals, and it's hard to make the case that we had an adequate job of oversight, given those results. We've heard a lot here about one of our problems is regulatory arbitrage. Don't you think that they chose your agency because they thought they'd get a better break?
MR. DUGAN: I do not. And Senator, I'd be happy to respond to those specific allegations. I know there are a number of them that were raised. But I looked at that testimony and there are a number of statistics which we flatly disagree with and that were compiled in a way that actually don't give a true picture of what was happening and what was not happening. We do -- national banks increasingly have been involved in the supervision of mortgage loans. There's no doubt about that, but I would say that we have done a good job in that area. Not perfect, but we think we have excellent on-the-ground supervisors in that area, and it did not lead to all the kinds of problems in national banks from national banks that -
SEN. MENENDEZ: Well, I'll submit the question for the record because the chairman has been very generous with my time. But one of the things I'd ask is, what are you doing in comparison to state regulators who in fact -- regulators of state depositories who in fact have much better performing rates, better than yours?
MR. DUGAN: That's not true. I've seen that chart, and I'll provide -
SEN. MENENDEZ: I'd love to either sit down with you and/or to get all that information so we can dispel what you believe is not the case. Thank you, Mr. Chairman.
SEN. DODD: Let me follow up on that a bit. It's a very important line of questioning. There were hundreds of thousands, we now know, bad loans. Hundreds of thousands of them. You talk about 122 violations. I'm not just talking about the question on the OCC, but also the FDIC, the OTS, the Fed. What was your experience -- obviously, Dan, you were not there at the time but I'd like to get some information if I could from the Fed about what was going on. Hundreds of thousands of bad loans, that is the root cause of why we're here today. The reason we're sitting here today is because of what happened at that framework, in that time, going back four, five years ago, longer. So we have hundreds of thousands of bad loans going out.
It's awfully difficult to explain to people that out of that quantity 122 violations were identified.
MR. DUGAN: Well, let me say two things. One, I was referring to one particular kind of violation. There are others that we'll be happy to submit for the record. But I think the more fundamental point is this. There were many of these loans that did not violate the law. They were just underwritten in a way, with easier standards, that they had been historically. That wasn't necessarily a legal violation, but -
(Cross talk.)
SEN. DODD: I mean, maybe not specific, but the idea, even in those cases. I mean, you're the experts in this area. No documentation, these lighter loans and so forth -- was anyone watching?
MR. DUGAN: People were watching. I think what drove that initially, my own personal view on this, is that most of those loans were sold into the secondary market. They were not loans held on the books of the institutions that originated them. So for someone to sell it, didn't get rid of the risk, didn't look like it was something that was presenting the same kind of risk to the institution. And if you go back and look at the time when house prices were rising and there weren't high default rates on it, people were making the argument that these things were a good thing and provide more loans to more people.
It made our examiners uncomfortable. We eventually, I think too late, came around to the view that it was a practice that should not occur. And that's exactly why I was talking earlier, if we could do one thing, two things that we should have done as an underwriting standard earlier is, one, the low documentation loan and the other is the decline in down payments.
SEN. DODD: Well, I want to ask the other panelists here quickly on Senator Menendez' line of questioning. But the guidance isn't on the securitization of those loans, or what happens with rating agencies. The guidance is on the origination of the loans, which is the clearly the responsibility of the OCC. And so the fact that these things were sold later on is a point I take, but your responsibility is in origination. The origination involved this kind of behavior, and I'm just -- it just seems to me the numbers we're talking about- and I appreciate you're talking about one area because actually there are more numbers you can give us, but I don't think you can get away by suggesting -- I say this respectfully to you -- that because they've not held the institution -- as most of us here who have a little gray hair on our head and back with our original mortgages years ago, you don't look at it for 30 years.
MR. DUGAN: Right.
SEN. DODD: Obviously that's all changed. But your responsibility falls into origination, which is a very different question, it seems to me, than what happens in terms of whether or not the mortgage is held at the institution or sold.
MR. DUGAN: I totally agree with that point. The point I was really trying to make was, we had a market where the securitization market got very powerful. It was buying loans from people in the marketplace, standards reduced particularly from non-bank brokers and mortgage originators that were providing those. Banks were competing with them, and people were not at that time suffering very significant losses on those loans because house prices were going up. And I think -
(Cross talk.)
SEN. DODD: -- losses. It was the practice.
MR. DUGAN: I understand that, and I believe that we were too late getting the notion -- all of us -- about getting at stated income, practices, and low documentation loans. We did get to it but it was after the horse had left the barn in a number of cases, and we should have gotten there earlier.
The point I was just trying to make with you, though, is that as these things were leaving the institution, they were less of a risk to that institution from a safety and soundness point of view.
SEN. DODD: Going back, Joan Bair, and let me ask you to comment on this as well.
MS. BAIR: Well, I think John's right, these practices became far too pervasive. For the most part the smaller state charter banks we regulate didn't do this type of -- they did more traditional mortgage lending, and then obviously they do commercial real estate lending, which had a separate set of issues. We had one specialty lender who we ordered out of the business in February of '07. There had been a few others. We have had some other actions, and I would have to go back to the examination staff to get the details for you.
But I was also concerned that even after the guidance on the nontraditional mortgages, which quite specifically said you're not going to do low doc or no doc any more, that we still had very weak underwriting in '07. So I think that is a problem that all of us should look back on and try to figure it out because clearly by '07 we knew this was epidemic in proportion and the underwriting standards did not improve as well as you would have thought they should have, and the performance of those loans had been very poor as well. I do think we need to do a lot more.
SEN. DODD: Quickly on the Fed at the OTS. It's a little difficult to ask you this question, Dan, because you who weren't there at the time, but any response to this point?
MR. TARULLO: I don't, Senator, except as an external observer. But anything that you would like from the Fed, if you just -
SEN. DODD: Well, maybe at the final -- whether or not there were violations, punishments meted out at all. Again, we have, as I say, hundreds of thousands, and of course the complaint many of us have had over the last couple of years is the Congress in '94 passed the legislation which mandated that the Federal Reserve promulgate regulations to deal with fraudulent and deceptive residential mortgage practices. Not a single regulation was ever promulgated until the last year or so, and obviously that is seen as a major gap in terms of the responsibility moving forward.
OTS, quickly, any?
MR. POLAKOFF: Mr. Chairman, you're right. The private label securitization market, we could have done a better job in looking at the underwriting as those loans passed off the institutions' books and into a securitization process.
SEN. DODD: Senator, do you want to make any further comment on this point?
SEN. MENENDEZ: To me, and I know Mr. Tarullo wasn't there, but the Federal Reserve, you know, is at the forefront of what needed to be done because they had the ability to set the standards. And the lack of doing so, you know, is a major part of the challenge that we are facing today, but I appreciate, and I look forward to follow-up.
SEN. DODD: Senator Bayh.
SEN. BAYH: Thank you. I hurried back and I heard that Senator Menendez asked my question, but that's all right. This is for Sheila. I'm not used to angry bankers. I've had a great relationship with the Kentucky Bank Association and their leaders, but I did a roundtable discussion in Paducah, Kentucky. Paducah, Kentucky is a town of about 29,000 people. Two community bankers. One came to me and said, we've just been assessed by the Federal Deposit Insurance Corporation, and guess what? We will not be profitable in 2009 because of that assessment. No bad loans, no nothing. No bad securities. They keep their mortgages in-house. Everything. Just like community bankers in most places do.
There was a gentleman from BB&T. Now that's not a community bank. That's a much larger bank. The assessment for the community bank was $800,000, wiped out their total profitability. BB&T was $1.2 million. Now that didn't wipe out their profitability because they have many banks all over the country. But how can you explain to the American people that for doing your job and doing it well you are being assessed -- your total profitability in one year -- to pay for those who didn't do their job very well? Maybe you can explain that to me because I don't understand it.
MS. BAIR: Well, deposit insurance has always been funded by industry assessments. The FDIC actually has never -- we do have the full faith and credit of the United States government backing us. We do have lines of credit --
SEN. BAYH: There's a lot of other ways that you could have done it.
MS. BAIR: Sir, all banks pay -- that get deposit insurance pay for it. It is an expense that they need to factor in. And I think the regular -- we've been signaling for some time that we will need to raise premiums. We're in a much more distressed economic environment. Our loss projections are going up. I think most community banks agree that we should continue our industry funded self-sufficiency and not turn to taxpayers.
We didn't want to do the 20 basis point assessment, but our loss projections are going up significantly, and we felt it was necessary to maintain an adequate cushion above zero -
SEN. BAYH: This one community bank, there was 1,000 percent increase in their assessment.
MS. BAIR: Well, I'd be happy to go over those numbers with you --
SEN. BAYH: I'll be glad to go over them because she did. She went over them with me.
MS. BAIR: We would like to see that because they're miscalculating what the assessment is. I would say the base assessment is 12 to 15 basis points. The interim special assessment is 20 basis points. It's out for comment. It's not been finalized yet. We're hoping that through increasing our borrowing authority we can --
SEN. BAYH: Don't you have a line of credit with the Treasury? It seems like everybody else does. So I would assume that you do.
MS. BAIR: We do. It's pretty low. It hasn't been raised since 1991, and we're working with Chairman Dodd and Senator Crapo to get it raised. But I would say the FDIC has never borrowed from Treasury to cover our losses. It's only borrowed once in our entire history. That was for short-term borrowing --
SEN. BAYH: We can get you some money. I mean, that -- yesterday our chairman of the Fed announced $1.2 trillion -- not million but trillion dollars of printed money going out. It's just scary.
MS. BAIR: That is a policy call. I think a lot of community banks -- Ken Gunther had an excellent blog yesterday, who's obviously been long associated with community bankers, suggesting that would not be in community bankers' interest because right now they are not tarnished with the bailout brush, but if the FDIC starts going to taxpayers for our funding instead of relying on our industry assessment, I think that perception could change.
And we are working very hard to reduce that assessment. I've already said that if the borrowing authority is increased we feel we can reduce it meaningfully. This week we approved a surcharge to a debt guarantee program we have that is heavily used by large institutions. We will put that surcharge into our deposit insurance fund and also use that to offset the 20 basis point assessment. So we're working hard to get it down. We want to get it down.
But I do think the principle of industry funding is important to the history of the FDIC, and I think it's important to the reputation and confidence of community banks that they are not getting taxpayer assistance. They continue to stand behind their funding.
SEN. BAYH: Well, that all sounds really well and good. I'd like to take you to that roundtable and let you explain that to those two bankers.
MS. BAIR: I have talked to a lot of community bankers about this. I absolutely have. I would also like to share numbers with you, though, that show deposit insurance, even with these special assessments, is still very cheap compared to alternative sources of funding. So it really is, even with the special assessments it's much cheaper than any other sources of funding that they would have to tap into.
SEN. BAYH: We have taken up all my time. I can't ask another question. May I? Okay.
The gentleman from the Federal Reserve is here. Thank you for being here. Do you or anybody else at the Fed have concerns about the Fed being the systemic risk regulator or payment system regulator? And where would you say would be the right place to place that task?
MR. TARULLO: Senator, with respect to payment systems, I think there's a fair consensus at the Fed that some formal legal authority to regulate payment systems is important to have. And you probably know that de facto right now the Fed is able to exercise supervisory authority over payment systems, but that's because of the peculiarity of the fact that the entities concerned are member banks of the Federal Reserve system, so they've got supervisory authority. If their corporate form were to change, there would be some question about it. And payments, as you know, are historically importantly related to the operation of the financial system.
Now with respect to the systemic risk regulator, I think there's much less final agreement on either one of the questions that I think are implicit in what you asked. One, what should a systemic risk regulator do precisely? And two, who should do it? The one thing I would say, and I think this bears repeating, so I'll look for occasions to say it again -- however the Congress comes down on this issue, I think that we need all to be clear. You need to be clear in the legislation, whoever you delegate tasks to needs to be clear, not just what exactly the authorities are, which is important, but what the expectations are because we need to be clear as to what we think can be accomplished. You don't want to give responsibility without authority -
SEN. BAYH: Sometimes we give the responsibility and the authority and it's not used. It's like the '94 law, when we handed the Fed the responsibility and it was 14 years before they promulgated one rule or regulation.
MR. TARULLO: Believe me, Senator, that's something that I observed myself before I was in my present job, so I've got no -
SEN. BAYH: No, I'm not faulting you but I'm just stating the fact that even when we're sometimes very clear in our demand that certain people regulate certain things, they have to take the ball and carry it then.
MR. TARULLO: Absolutely correct. And on the systemic risk regulator issue, I think that there is a strong sense that if there is to be a systemic risk regulator, the Federal Reserve needs to be involved because of our function as lender of last resort, because of the mission of protecting financial stability. How that function is structured seems to me something that is open-ended because the powers in question need to be decided by the Congress. So let me give you one example of that.
It's very important that there be a consolidated supervision of every systemically important institution. So with bank holding companies, not a problem, right, because we've already got that authority. But there are other institutions out there currently unregulated over which no existing agency has safety and soundness supervisory authority.
SEN. BAYH: You realize that your chairman -- your two chairmen came to us and told us that certain entities should not be regulated.
MR. TARULLO: I'm sorry, which entities?
SEN. BAYH: Credit default swaps, and other things that are related to that. Your past chairman and your current chairman.
MR. TARULLO: Let me get to credit default swaps in a moment, but let me try to address the institution issue because it is the case that we believe prudential consolidated supervision is important for each institution.
SEN. BAYH: They should make a regulator for each institution, then.
MR. TARULLO: If there is a good prudential regulator for each systemically important institution then you wouldn't need a systemic regulator to fulfill that -
SEN. BAYH: That's correct. And we also wouldn't have people too big to fail.
MR. TARULLO: Well, you would hope that the regulation, including a resolution mechanism and the like would be such as to contain -
SEN. BAYH: That's what I mean.
MR. TARULLO: Yes. Exactly.
SEN. BAYH: Thank you.
SEN. DODD: Thanks, Senator Bayh, for the question because it is a -- I'm not going to ask you to respond to this because I've taken a lot of your time already today and a little confusion with the votes we've had. But we want to define it seems what we mean when we talk about a systemic risk regulator. You mean regulating institutions that are inherently and systemically risky are important. Or are you talking about regulating systemically risky practices that institutions can engage in? Or are you talking about regulating or setting up a resolution structure so that when you have institutions like AIG and Lehman Brothers you've got an alternative other than just pumping capital, as we did in the case of AIG, so you can begin to do what we did earlier?
I get uneasy about the fact because the Fed is the lender of last result, to also simultaneously fall into the capacity of being, particularly in the last function, and that is the resolution operation. It seems to me you get -- that's what we had before. I think in the thrift crisis back years ago, the role of the regulator becoming also the one that also deals with these I think is an inherently dangerous path to go down. That's my instinct.
MR. TARULLO: Let me just take 30 seconds. That little litany you had I think is it right there. I would just add one thing. You've got supervision of systemically important institutions not currently subject to supervision.
SEN. DODD: That could be one role.
MR. TARULLO: That's one role. The second role, which you also identified, practices that are pervasive in an industry, no matter what the size of the entity, which rise to the level of posing true systemic risk. Probably unusual, but certainly possible. And I think we've seen it in the last couple of years.
Third is the resolution mechanism you spoke about, that, it seems to me that shouldn't be concluded within the definition of systemic risk regulator. That you could under some configurations have the same entity doing those two functions, but I think while you would need is to ensure that the systemic regulator had a role in the decisions on resolving systemically important institutions such as Chairman Bair pointed out such as under the systemic risk exception in the FDI Act that already exists.
The fourth function that I'd add is the monitoring, the monitoring one which I understand that it's a prerequisite for some of the other ones we talked about, but it also serves an independent purpose, and I think if I'm not mistaken, this is some of what Senator Reed has been getting at in the past is the need to get focus on issues and get them out --
SEN. DODD: Right.
MR. TARULLO: -- get them discussed and get them reported. So I think that's your choice is to -- you've got four functions there. My sense is that the resolution issue is not necessarily --
SEN. DODD: (Inaudible).
MR. TARULLO: -- not necessarily top.
SEN. DODD: And the last -- your fourth point, this is sort of the -- I think it's sort of the private sector model where you have the official -- or the officer in the business that does risk assessment. As I understand it in a lot of these entities they don't have the capacity to shut something down on their own except in very extreme cases. But they will advise the individuals who are engaging in that thing that their behavior is posing risks to their company. So it doesn't have the ability to say no but it has the power -- or at least the information to warn.
I'm a little uneasy about that because it just seems to me whether or not you're going to get the decisions that actually would shut things down when they arise. There's too many dots to connect to reach that point of shutting something down before it poses even greater risks.
MR. TARULLO: Well -- but you do I think Mr. Chairman want -- again, this is why it's important for Congress ultimately to decide what scope of authorities it wants somewhere --
SEN. DODD: Yeah.
MR. TARULLO: -- and then figure out where the best place to put them is. But that does require us all to make this judgment as to how broadly we want authority reaching and under what circumstances. As you can tell from my testimony, our view is that you don't want to displace the regular prudential supervision of all the agencies --
SEN. DODD: No.
MR. TARULLO: -- but this should be something which is an oversight mechanism on top of it in the general course of things. But as I think you've pointed out, you do -- you will sometimes have practices in subprime mortgage lending that was either predatory or not well backed by good underwriting is a principle example of something that became pervasive and should have been regulated earlier.
SEN. DODD: I've said over and over again I'm sort of agnostic on all of this, I want to do what works. But if you asked me where I was inclining, it's on that point. I think you've got to watch practices. Just because something's called important doesn't mean it is. And there may be practices that may not seem important but are terribly important. And it seems to me we ought to be focusing on that, not at the exclusion of the other, but --
Let me ask the other panelists quickly to comment on that. Any comments on this from anyone else on just this discussion? Sheila, do you have any --
MR. FRYZEL: I just have one comment.
SEN. DODD: Okay.
MR. FRYZEL: If the Congress takes the action and puts in place a systemic regulator, that's certainly not going to stop or prevent some of the problems that we have now out in the financial services industry. As Chairman Bair talked about, the fact that she's asked for an increase in the lending from the Treasury as we have at NCUA which is paramount to Us taking care of the problem between now and the time the systemic risk regulator is able to take over and watch over all of our industries, so that there are tools that we're going to be coming back to the Congress for between now and then that the regulators are going to need to solve the problems that are existing out there now. We still need things -- to get those solved.
SEN. DODD: Yeah, I agree. Sheila, do you want to comment?
MS. BAIR: Yeah, I would just -- I agree with what you said about practices. I would only add that systemics are connected in that the federal government or the agencies don't have the ability both to write rules which we did have --
SEN. DODD: Right.
MS. BAIR: -- and use them late and enforce those rules for all institutions, you still get the kind of dynamic we got with mortgages where it started with the non-banks creating competitive pressure on the banks to respond in kind.
So I do think -- and another thing that you don't have the SEC and the CFTC here but I think any discussion of regulatory restructuring needs to note the need for market regulation of the derivatives market, especially the CDS market --
SEN. DODD: We don't have a table big enough. (Laughter.)
MS. BAIR: That's not institution specific, absolutely but it's another area --
SEN. DODD: But I must say -- I'd just say to you I was sitting here looking at this and we are missing the CFTC and the SEC at this table. But in a sense, and I say this very respectfully, this is the problem. With all due respect, this is the problem in a sense. We just have -- we're just -- again we talk about too big to fail in a sense in -- of private institutions, in a sense having a bureaucracy or a regulatory structure and so what -- that's too big to succeed in many ways in a sense because it is so duplicative and so forth.
And I can understand there's a value in that as well in terms of protecting and some things. But it is -- we're having the SEC, by the way -- is it next week they're testifying -- before the Committee. But in a sense if I were going to take and wanted to capture in a photograph what is the essence of the problem -- and not because of you individually here, this is the problem in a sense. And this is what we've got to try and sort out in a way that provides some clarity to the process as we go forward.
By the way, there's going to be a hearing at 2:00. I know that's what all of you want to hear on deposit insurance that Senator Johnson is hosting in 338, I think, of this -- of the Dirksen Building. Excuse me, 538, I guess right here, it'll be right here, I'm sorry. (Laughter.) That'll be good news for our panelists, they know I've got to wrap up here as we're getting near 2:00. But that's where -- and we're going to proceed on this, I say to Chairman Bair as well, and we've got -- we're trying to resolve some other issues if we can in going forward, and I know you're aware of that. And obviously we're very interested in getting the legislation adopted and we will quickly.
Any other further comment on this last point and then I want to end. If not -- yes, John.
MR. DUGAN: Senator, I would disagree with your point. It's not obvious that in many cases the gathering of the information isn't really the most important thing you need to do. For example, if you had hedge funds, it's not clear you'd want to go in and regulate them like you regulate a bank. You might want to find out what they were doing, how they were doing it, have some authority to take some action if you had to. But the gathering of information, understanding what they do was completely absent during the current crisis with respect to non-banks and it's a really important thing that you're talking about, to learn what people are doing. So that is a fundamental building block.
SEN. DODD: I can see you chaffing, go ahead, Governor.
MR. TARULLO: Senator, just one point on that -- (inaudible.). This is what I meant earlier about being clear about where we're -- where authority --
SEN. DODD: Mm hmm.
MR. TARULLO: -- and responsibility lie because --
SEN. DODD: You need the mic on.
MR. TARULLO: -- I'm sorry. Because if you say you're a systemic risk regulator, you're responsible for everything no matter where it may happen. But there's not a regular system in place for overseeing a particular market or overseeing particular institutions. That's when I think you risk having things falling between the cracks and expectations not being met. And so I come back to the point I opened with, that's why there needs to be an agenda for systemic stability which takes into account each of the roles that the various agencies do play.
SEN. DODD: Well, I thank you. And just -- and I -- if there are additional questions we'll submit them for the record, and I know my colleagues will as well. And we're going to be very engaged with all of you over the coming weeks on this matter. As I said, we've got more hearings to hold on this, the SEC next week. We've had seven already. And I thank each and every one of you for your participation. It's been very, very helpful here this morning.
The committee will stand adjourned. (Sounds gavel.)