Hearing Of The Senate Committee On Homeland Security And Governmental Affairs - Where Were The Watchdogs? Financial Regulatory Lessons From Abroad

Statement

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SEN. LIEBERMAN: The hearing will come to order.

Good afternoon and a special welcome to our guests, who -- three of whom have come from further than normal to testify, and without being summoned here by force of law, I might add. (Laughter.) So we're particularly grateful that you're here

This is our Committee's third in a series of hearings examining the structure of our financial regulatory system -- how that flawed structure contributed to the system's failure to anticipate and prevent the current economic crisis. And most importantly, looking forward, what kind of structure is needed to strengthen financial oversight.

You will note that I used the word "structure" at least three times here, and this is because that's the unique function and jurisdiction of our Committee here, (as we ?) understand that the Banking Committee particularly is leading the effort to review regulations in this field.

But we are charged with the responsibility to oversee the organization of government. And we've tried to (commit ?) this matter of financial regulatory reform with a focus on that, as opposed to the particular regulations.

We learned from our previous hearings that our current regulatory system has evolved in a haphazard manner, not just over the 10 or 20 or 30 years some of us have been here, but over the last 150 years, largely in response, usually, to whatever the latest crisis was to hit our nation and threaten its financial stability.

As a result, we have here a financial regulatory system that is both fragmented and outdated. Numerous federal and state agencies share responsibility for regulating financial institutions and markets, creating both redundancies and gaps -- redundancies in some ways and gaps in others, gaps particularly over significant activities and businesses -- and redundancies, too, such as consumer protection enforcement, hedge funds, and credit default swaps.

Our current crisis has clearly exposed many of these problems. To strengthen our financial regulatory system, an array of interested parties -- academics, policymakers, even businesspeople -- from across the political spectrum has called for significant structural reorganization.

So as we move forward and considered this question, it seemed to Senator Collins and me t hat it would be very helpful for us to examine the experiences of other nations around the world. And that is the purpose of today's hearing and why we're so grateful to the four of you.

Over the past few years, the United Kingdom, Australia, and other countries have dramatically reformed their financial regulatory systems. They've merged agencies, reconsidered their fundamental approaches to regulation, and streamlined their regulatory structures.

Many people believe that these reforms have resulted in a more efficient and effective use of regulatory resources and, certainly, more clearly defined roles for regulators.

The American economy is different in size, of course, and in scope from all the others, but there is still much we can learn by studying the examples of these free market partners of ours.

We really do have an impressive panel of witnesses today, each of whom has not only thought extensively about the different ways in which a country can structure its financial regulatory system, but also played a role in that system. And I would imagine that you all bear some scars from trying to change the regulatory status quo.

I would also imagine that you know what we have learned here, that reorganizations are complicated and very difficult. Our committee learned this firsthand through its role in creating and now overseeing the Department of Homeland Security, and in reforming our nation's intelligence community in response to the terrorist attacks of 9/11.

But reorganizations can also pay dividends in more effective and responsive and efficient and transparent government. And of course, that's what we hope for in the area of financial regulation.

I'm confident in the work that our colleagues on the Senate Banking Committee are doing to address the financial regulations, but as I said at the outset, we're focused here on structure. And the two are clearly tightly interwoven.

If we want to minimize the likelihood of severe financial crises in the future, we need to both reform our regulations and improve the architecture of our financial regulators.

As Treasury Secretary Geithner and the Obama administration prepare to announce their own plan for coming reform in the weeks ahead, the testimony presented here today will help ensure that we are cognizant of what has and has not worked abroad, and that surely can help us guide our efforts and the administration's and clarify for us all which reforms, regulatory and structural, will work best here in the United States of America.

Senator Collins.

SEN. SUSAN COLLINS (R-ME): Thank you, Mr. Chairman.

Mr. Chairman, as you mentioned, this is a series of hearings held by our Committee to examine America's financial crisis, and I commend you for your leadership in convening this series of hearings because I believe that until we reform our financial regulatory system, we are not going to address some of the root causes of the current financial crisis.

Our prior hearings have reviewed the causes of the crisis, and whether a systemic-risk regulator and other reforms might have helped to prevent it.

Testimony at these hearings has demonstrated that for the most part, financial regulators in our country failed to foresee the coming financial meltdown. No one regulator was responsible for the oversight of all the sectors of our financial market, and none of our regulators alone could have taken comprehensive, decisive action to prevent or mitigate the impact of the collapse.

These oversight gaps and the lack of attention to systemic risk undermined our financial markets. Congress, working with the administration, must act to help put in place regulatory reforms to help prevent future meltdowns like this one.

Based on our prior hearings, and after consulting with a wide range of financial experts, in March I introduced the Financial System Stabilization and Reform Act. This bill would establish a Financial Stability Council that would be charged with identifying and taking action to prevent or mitigate systemic threats to our financial markets.

The Council would help to ensure that high-risk financial products and practices could be detected in time to prevent their contagion from spreading to otherwise healthy financial institutions and markets.

This legislation would fundamentally restructure our financial regulatory system, help restore stability to our markets, and begin to rebuild the public confidence in our economy.

The concept of a council to assess overall systemic risk has garnered support from within the financial regulatory community. The National Association of Insurance Commissioners, the SEC chair, Mary Shapiro, and the FDIC chair, Sheila Bair, are among those who support creating some form of systemic risk council in order to avoid an excessive concentration of power in any one financial regulator, yet take advantage of the expertise of all the financial regulators.

As we continue to search for solutions to this economic crisis, it is instructive for us to look outside our borders at the financial systems of other nations.

The distinguished panel of witnesses that we will hear from today will testify about the financial regulatory systems of the United Kingdom, Canada, and Australia. They will also provide a broader view of global financial structures.

We can learn some valuable lessons from studying their best practices. Canada's banking system, for example, has been ranked as the strongest in the world, while ours is ranked as number 40.

I'm very pleased that Mr. Edmund Clark has joined the other experts at the panel. It was through a meeting in my office when he started describing the differences between the Canadian system of regulation, financial practices, mortgage practices, versus our system, that I became very interested in having him share his expertise officially. And I'm grateful that he was able to change his schedule to be here on relatively short notice.

I'm also looking forward to hearing from the other experts that we have convened here today.

America's Main Street small businesses, homeowners, employees, savers, and investors deserve the protection of an effective regulatory system that modernizes regulatory agencies, sets safety and soundness requirements for financial institutions to prevent excessive risk-taking, and improves oversight, accountability, and transparency.

This Committee's ongoing investigation will continue to shed light on how the current crisis evolved and focus attention on the reforms that are needed in the structure and regulatory apparatus to restore the confidence of the American people in our financial system and markets.

Thank you, Mr. Chairman.

SEN. LIEBERMAN: Thank you, Senator Collins. Thanks for that thoughtful statement.

Let's go to the witnesses now.

First, we welcome David Green, who was head of international policy at the United Kingdom's Financial Services Authority, after having previously spent three decades at the Bank of England. Mr. Green currently works for England's Financial Reporting Council.

It's an honor to have you here, and we would invite your testimony now.

MR. GREEN: Thank you, Chairman.

I give testimony, of course, as a private individual, having worked in those institutions you described. I also give testimony as a co-author with Howard Davis of a book on global financial regulation which discusses a lot of the issues that are before the Committee today.

The views expressed here are entirely my own, of course, and not those of any of the organizations I have been associated with.

There's remarkable biodiversity in arrangements for financial regulation at the global level. There're essentially four main types of structure to be found with multiple variants.

There's the sectoral type with separate regimes for banking, securities and insurance, which could be found in France, Italy, or Spain.

There is the so-called "twin peaks" type, to be found in Australia or in alternative versions in Canada and the Netherlands.

The integrated type, which you can find in Germany, Japan, all over Scandinavia, and indeed in the U.K.

And then perhaps another, fourth type, where the U.S. might fit, with extraordinary diversity. In the FSA we thought we probably had over 100 counterpart regulatory bodies in the United States.

Then there's the role of a central bank, which may or may not have responsibility for some, many, or, indeed, all aspects of supervision, as it does in Singapore, for instance.

Probably the most advanced form of the integrated regulator can be found in the FSA, where it was created remarkably rapidly when the incoming Labor government simply decided in 1997 without (really ?) debate. It was at the same time giving the Bank of England independence on the implementation of monetary policy would also create a single regulator for financial services.

That was set in train, and eventually subsumed 11 prior agencies. And a single new piece of legislation was drafted completely de novo, with new objectives for regulation and with a set of principles drafted to guide the regulators.

Not all the integrated regulators have that single piece of legislation. They carry on with sectoral legislation. That's obviously an issue to be thought about when the Committee addresses the legislative structure that's put in place.

The bodies were merged in a way which enabled the prior existing bodies simply not to be visible anymore. There was full integration. You cannot find within the regulator the bodies that were there before. And that was quite deliberate, so that no impression should be created over one of the prior entities somehow taking over the others.

The -- (inaudible) -- integrated regulation that was set out by the FSA, and in my written testimony I set out the main arguments. But the core ones, as you know, are that financial conglomerates in particular undertake a range of banking, insurance, investment business. The markets themselves have instruments. They can mingle features of all those. And it was difficult to carry on regulating on a purely functional basis when that no longer matched the structures of either firms or markets.

Integration makes it possible to (align ?) the regulatory structure with the way the firms manage themselves. So this should help with proper understanding of the overall business model and of overall risks. It also means that a regulated firm only needs to deal with one agency for its regulatory business, ideally through relationship managers on both sides.

Regulator ought to be able to manage the conflicts which inevitably arise between the different objectives of regulation, and we will no doubt discuss that later. The concept underlying the single regulator is that these conflicts exist but need to be managed in one place or another. And there have in the UK been adverse experience in the management of those conflicts in the past, which is one of the reasons why the intention was to put them together.

As regards the role of the central bank, there are a number of issues about the possible conflict of interest which might take place with the independent conduct of monetary policy. The monetary policy might be tempted to look more after the regulated community than the wider interests. And those arguments are a little bit more difficult to be certain about.

How has the model stood up? Previously the model was very widely praised. Since the crisis, like regulators in many places, there's been very wide criticism. But much of the criticism can be pinned down to failures, if you like, at a global level with the international capital rules -- (inaudible) -- having fallen short, markets inadequately understood. The way securitization would work, how markets would behave, is very widely misunderstood. That's been a common problem.

The FSA made mistakes in not doing what it was supposed to do -- simple internal management mistakes. There has been a lot of work done to go over the lessons of the crisis. Both the FSA and the Bank of England have undertaken work to see whether the structure of regulation has identified any patterns of superior models as a result of the crisis, and no patterns have been found. The Bank of England did do some work, which I think I can make available to the committee, which finds no pattern at all as between integrated prudential -- (inaudible) -- regulator and sectoral regulator.

I think the conclusion has been that the model itself does not really seem to have been implicated in the way the crisis unfolded, and indeed, the fact that banking (securiters ?) and insurance were all interlinked in the crisis in some people's minds has reinforced the underlying concept.

Obviously I'd be very happy to answer other questions as the hearing proceeds. Thank you, Mr. Chairman.

SEN. LIEBERMAN: Thank you. That was most interesting, and a good beginning.

So at this date we'd say that, in your opinion, which one of these regulatory systems was chosen didn't have much of an effect on the economic crisis that occurred.

MR. GREEN: That appears to be the case. You can find a number of examples if you take in isolation, which reinforce a particular argument. But if you look across the board, you don't find a pattern. The Bank of England work that I referred to, which I'm sorry I don't have available here, looks at, I think, about 40 or 50 different jurisdictions and can find no pattern related to structure.

SEN. LIEBERMAN: Yeah.

MR. GREEN: And the FSA work has shown that there have been problems when supervision was inside the central bank, when it was outside. And again, no clear pattern can be found there.

SEN. LIEBERMAN: That's interesting. And we will hold the questions until after everyone testifies and then we'll come back. That doesn't mean that there are not preferences for one over the other frame of regulation. I also want to thank you for your graciousness in describing the American system as diversified. That was nicely done.

MR. GREEN: (Laughs.)

SEN. LIEBERMAN: Okay, second we have Dr. Jeffrey Carmichael, inaugural chairman of the Australian Prudential Regulation Authority, with responsibility for regulating and supervising banks, insurance companies and pension funds.

Dr. Carmichael currently works in Singapore as the CEO of Promontory Financial Group Australasia.

Thank you for being here.

MR. CARMICHAEL: Thank you, Chairman. And let me say what a pleasure it is to be here.

Our government implemented a new structure in the middle of 1998. Unlike the experience that David just referred to where the UK government did it very quickly, ours was the outcome of a committee that had sat for almost 12 months looking at the options, and it was a great privilege for me to have been a member of that committee.

The new structure that was put in place realigned a previous structure a little bit like your own. It was an institutionally based structure. It was a hybrid structure of bits and pieces. We had state regulation as well as federal regulation.

What came out of the reorganization, what has become known as an objectives-based or a twin peaks type model. We don't like twin peaks because we actually have four peaks, so we think that's undercounting. But the four agencies that were put in place were, number one, a competition regulator that's set over the entire system, not only financial but the economy; a securities and investment commission, so think of a combination of your SEC and the futures regulator. They had responsibility across all financial sectors for conduct, including financial institutions, markets and participants.

The third was the Australian Prudential Regulation Authority, the one that I was involved with. We had responsibility for the prudential soundness of all deposit-taking insurance and pensions. And the third was the central bank, which was given, of course, systemic responsibility with monetary policy, liquidity support and regulation of the payment system.

At the top of that was a coordinating body, or there is now one, called the Council of Financial Regulators, which includes the Department of Treasury as well, and that's a very important add-on.

The defining characteristic of this architecture -- and I should add, this is, in some ways, very similar to your Paulson plan that was proposed earlier in 2008, but with a couple of important differences which we can talk about later -- it was unique in the world at the time it was put in place in Australia. And so far as we know, only one country, and that's the Netherlands, would claim to have the same structure in toto. The Canadian structure is similar, but a little bit less consistent.

The Australian banks under this structure, for example, would be subject to all four regulators. They have competition covered by the ACCC, their conduct by ASIC, their prudence by APRA, and if there's a liquidity support or payment system, they go to the reserve bank. So that's the defining characteristic of this model, that multiple agencies are responsible for each institution, but for a different part of their behavior or their activities. And there's a fairly clear dividing line between those activities.

Some of the advantages that we see in this structure -- and some of these, of course, are shared by other models, such as the British one -- first, by assigning each regulatory agency to a single objective -- that's either competition or prudence -- it avoids the conflict of objectives that you face under virtually any other system. So each regulator just has one thing to worry about, and that avoids getting into some of the issues, for example, that Northern Rock brought out, I think, for the FSA.

Secondly, bringing all regulators of a particular objective together, you get synergies. We learned a lot when we brought banking and insurance regulation together and we were able to develop an approach that took on the best of both of those systems and to develop synergies out of there. Likewise, ASIC, our conduct regulator, was one of the first in the world to introduce a single licensing regime for market participants.

Third, the structure helps eliminate regulatory arbitrage or jurisdiction shopping of the type that you've seen here. Prior to the creation of APRA, there were at least three different types of institutions that could issue deposits in Australia, and they were subject to nine different regulatory agencies, depending on where they were located.

Following its creation, APRA introduced a fully harmonized regime. We now have deposit-taking institutions. We don't distinguish between banks, credit unions, thrifts. They can take on that separate identity, but they are regulated as deposit-takers.

Fourth, by bringing together all of the prudentially regulated institutions under the one roof, we have a more consistent and effective approach to regulating financial conglomerates. And along with countries like the UK and Canada, Australia has been at the forefront of developing the approach to conglomerate supervision.

Fifthly, allocating a single objective to each regulator minimizes the overlap between agencies and the inevitable turf wars that are associated with that, which I'm sure you're very familiar with.

Interesting for us in our experience was that the gray areas between the agencies have tended to diminish over time rather than to increase. And I think that's been a little bit of a surprise, but a very welcome surprise to those of us who are involved with the design.

Sixth, the allocation of a single objective to each agency minimizes cultural clashes. And one of the issues that we were very conscious of in designing the distinction between the prudential and the conduct was that conduct tends to be carried out by lawyers, and prudence tends to be carried out in general by accountants and finance and economics experts, with the exception of the U.S., where lawyers tend to do it all. So culturally we found it was very useful to separate those so that we didn't have those cultural battles.

Finally, by streamlining our old state-based or partly state- based regulatory system, we got a lot of cost efficiencies out of it and we were able to facilitate strong financial sector development and innovation without having to reduce safety or soundness in the process.

In terms of outcomes, our architecture has weathered the recent financial storm better than most. I think we still have -- our four major banks are still among the few AA-rated banks left in the world. The resilience of our system was helped by exceptionally tough prudential standards, particularly in the areas of capital and securitization. There's also inevitably some good luck as well as good management. I'm not going to claim it was all brilliance.

In terms of crisis management, the coordination arrangements worked exceptionally well. And I'm told, talking with each of the agencies recently, that they found the singularity of objectives helped them enormously in terms of the coordination among the different agencies in the crisis.

On the less positive side, like everyone else, we've learned that regulators and industry know much less about risk than we thought we did. We've had to think about the way risk is measured and regulated. Most importantly, we've learned that financial stability regulation is a much bigger challenge than we thought it was. And there's a lot to go there. And to borrow the Churchillian phrase, we regulators have learned that we have much about which to be modest.

In concluding, Chairman, I'd like to offer two very general observations, and the first echoes a point you made in your opening statement. There can be little dispute that regulatory architecture matters. It is very important. There's no perfect architecture. There is no one size fits all. But there are certainly some architectures that are virtually guaranteed to fail under sufficient pressure.

That said, architecture is only half the story. A sound architecture is a necessary but not a sufficient condition for effective regulation.

The other component, which you mentioned, is how you implement and enforce those regulations. And it's very important that these are considered in tandem and not in isolation.

Finally, it is easier to tinker with the architecture than to do major reform. And major reform is about opportunity. The window for reform is usually only open very briefly. You have arguably the widest window for reform since the Great Depression. This crisis provides you with the public support, and I believe the industry acquiescence, to challenge the vested interest and inertia that normally make major reform of the type you've seen in some other countries all but impossible.

And I'm sure I speak for many of my colleagues in the international regulatory community, hoping that this opportunity is not lost. Thank you.

SEN. LIEBERMAN: Thank you very much. Well said. And I think I have a concern, many concerns, but one clearly is that the result of this crisis will be that we will change some regulations, some law, but we won't change the regulatory structure very much because of the resistance of those in the financial communities but also frankly here in Congress to changing the status quo. So your words are very much on target. I thank you.

Third is Dr. Edmund Clark, president and CEO of the TD Bank Financial Group in Canada. Mr. Clark has had a long and distinguished career in both Canadian government and private industry.

And we're very grateful that you are here today. Please proceed.

MR. CLARK: (Off mike.) Thank you, Mr. Chairman, and thank you, Ranking Member Collins, for inviting me, and thank you to the other members.

I'm obviously not here as a regulatory expert. You've got a wonderful panel here --

SEN. LIEBERMAN: Dr. Clark, could you please press the button so we --

MR. CLARK: I'm sorry. Thank you.

SEN. LIEBERMAN: Good.

MR. CLARK: So I'm going to speak much more as a CEO who operates under the regulatory regimes. We're a little unusual in the sense that we operate on both sides of the Canadian border and the United States. We have over 1,000 branches in the United States, from Maine to Florida, and we're a bank in the United States that's continuing to lend and lend aggressively. So we have double-digit lending growth. And we are one of the few AAA-rated banks left in the world. And we exited the structure products area in 2005, the source of most of the problems.

I thought I would comment on a couple of things. One was the actual management of the crisis, from the beginning of sort of August 2007 until now. And I think there what certainly distinguishes the Canadian system, which may not be typical in larger countries, is that the six banks, plus the Bank of Canada, plus us, plus the Department of Finance essentially worked almost continuously together, had a shared objective. There is a very strong feeling among us that if any one of our banks ran into trouble we'd all run into trouble. So there was no attempt by one bank to, in the sense, game the system.

And there was also fairly quickly a view that we should try to have a private sector solution to this problem, not a public sector solution. And to the extent we involve the public sector, it should be a profitable involvement on behalf of the taxpayers, not a subsidy. And we are able to successfully do that.

In terms of the structure of the industry, I think it's well- known, but there are some important differences. The dealers, all the major dealers are owned by the Canadian banks. And we did in fact absorb $18 billion of write-offs by these dealers. Two didn't have any significant write-offs. But $18 billion is a significant amount in the size of Canada. But they were able to absorb that because they were tied to larger entities with very stable retail earnings.

Secondly, the mortgage market is completely different in Canada. It is concentrated in the top banks, and we originate mortgages to hold them. And so we have resisted attempts, frankly political attempts, to have us loosen standards, because we (wouldn't ?) bear the risks of those loosening standards. So we didn't get the development in Canada of what you did in the United States.

Third, in terms of the capital requirements, our capital requirements have always been above world standards with a particular emphasis on common equity. But it's also been reinforced by insistence on our regulator that we have our own self-assessment of how much capital we need. And that, in all cases, has caused Canadian banks to hold more than regulatory minimums, not at regulatory minimums.

I think the other difference would be that our regime's binding constraint is risk-weighted assets, and that is a key feature of why we hold our mortgages rather than sell them. Where you have total asset tests, you in fact encourage banks to sell low-risk assets. And while we have a total asset test, it's not the binding constraint.

In terms of the nature of the regulatory regime, it's a principle regime, not a rule-based regime. It's rather light in terms of the actual numbers of people employed in the regulatory regime. And a high focus is on ensuring that management and the board know and understand the risks that the institution has taken and that in fact they are building the infrastructure to monitor and manage that risk.

The way I put it in turn in my organization is I'm actually on the side of the regulator, not on the side of the bank. We have the same interests in ensuring that the bank doesn't run into trouble. And so we have less of this conflict situation because I see the regulator as helping me manage the bank.

Other elements is Canada moved, in terms of compensation, some time ago to have low-cash bonuses. So in my case, 70 percent of my pay would be in the form of equity which I hold. I'm required to hold my economic interest in the bank for two years after I retire, so I can't cut and run. And all my executives, whether in the wholesale side of the bank or the retail side of the bank, are paid on the whole bank's performance, including its ability to deliver great customer satisfaction.

We have separation of the chair from the CEO. And all board meetings and all committee meetings have meetings without management present to ensure that independence.

It's clear the issue I think that you're addressing is the issue of systemic risk. And I think it is the toughest issue to deal with here. I think I would have to be in the camp to say all the systemic risk issues were well-known and well-talked-about. It's not as if there was a mystery out there that the U.S. mortgage system was in fact gone way out the risk they were doing, what most bankers would have regarded as crazy lending. It's not as if there weren't meeting after meeting of bankers around the world about the risks that are inherent in structured products. And I would say it was not as if the undersaving future of the United States economy wasn't a well-known fact.

And so I think you do have to step back and say, well, if these risks were well-known, why were there no (incensed ?) forces against that?

I can comment on our own experience. As I indicated, we did actually exit these products. We exited them because they were hard to understand, had (embedded tail risk ?) and added a lot of complexity to the organization. We also refused to in fact distribute the asset-backed paper program that blew up in Canada on the basis that if I wouldn't sell it to my mother-in-law, I shouldn't sell it to my clients.

But the real issue is that in doing that, that was a very unpopular thing to do. It was unpopular within my bank, and it was unpopular among my investors. It's very hard to run against these tides. And so I think when you are thinking about systemic risk, you have to recognize that there is this hard confluence of political, economic, profit forces actually always propelling it. It's like a lot of the literature -- (inaudible). We have the same thing to try many forces of systemic risk.

So what -- (inaudible) -- a practicer in the field? Well, I don't think there is one answer, because, as I've said, banks have failed under most regulatory regimes. But I do think a strong regulator is important. And you certainly shouldn't allow regulatory shopping. I think that's obviously a very bad thing.

And while rules are important, I actually think principles do matter. It was clear throughout the industry that people were in process of using the regulatory capital arbitrage. And if you sat there from a principle point of view, I think you might have stopped it.

Leadership matters enormously. I think the board should be held accountable to ensure that they actually have a CEO with the right value system and whose job is to preserve the institutions.

And I think it's clear to say, while all regulatory regimes may have known about systemic risk, they didn't focus on systemic risk. And I think we are lacking mechanisms where if you did come upon a (few ?) that existed, how would you in fact coordinate action to bring it to an end?

I do think going forward, though, there's also a risk that we could overreact.

And one of the things I would (plead ?) is that many elements of the regulatory reforms could leave to drive institutions to take more risk rather than less risk. And I think you have to be careful in your rules to make sure that low-risk strategies, such as the TD Bank run, aren't in fact negatively impacted by some of the rule changes.

Thank you very much.

SEN. LIEBERMAN: Thank you very much. Refreshing when you said how different the regulatory system and some of the rules of behavior were. And it's striking that one of the reasons that Canada didn't get into some of the same mortgage problems as we did was merely because of regulation, some of the things you were prohibited from doing.

MR. CLARK: Right. Even though there was an element of regulation that prohibited this but also we had a capital regime that said we could hold low-risk assets and not have large amounts of capital. And that's a critical feature to the originate-and-hold model.

SEN. LIEBERMAN: Thank you.

Our final witness this morning is from closer to home. David Nason was at the Treasury Department during March of 2008 and before and was very active in the construction of the Treasury Department's March 2008 Blueprint for a Modernized Financial Regulatory Structure, previously known as the Paulson plan. Mr. Nason is now the managing director for Promontory Financial Group here in D.C.

We have two of the four witnesses from the Promontory Group. (Laughs.) That speaks well for the group.

Mr. Nason, we welcome your testimony.

MR. NASON: Thank you for having me. Chairman Lieberman, Ranking Member Collins and members of the committee, thank you for inviting me to appear before you today on these important matters. As the United States begins to evaluate its financial regulatory framework, it is vital that we incorporate the lessons and experience from other country's reform efforts.

I recently, as you just mentioned, finished a three-year stint at the United States Department of the Treasury where I was honored to serve former Secretary Snow and Paulson. And as the assistant secretary of the Treasury for Financial Institutions, I worked hand- in-hand with the government as they tried to respond to the financial crisis.

More germane to this particular hearing is I'm particularly proud to have led the team that researched and wrote the Treasury's Blueprint for a Modernized Financial Regulatory Structure which was published in March of 2008. And many of the issues that evaluated in the writing of the blueprint are before the Congress and the focus of this hearing.

What seems clear as we think about this issue is that financial institutions play an essential role and are a large part of our U.S. economy. And given the economic significance of the sector, it is important that we examine the structure of our regulatory framework as we think about the content of regulations. And this is all the more pressing as the U.S. begins to emerge from the current financial crisis.

The root causes of the financial crisis are well-documented -- benign economic conditions, plentiful market liquidity led to risk complacency, dramatic weakening of underwriting standards for U.S. mortgages, especially subprime and a general loosening of credit terms of loans to households and businesses. The confluence of many events led to a significant credit contraction and dramatic repricing of risk. We're still living through the process right now as we have seen more government intervention in the financial markets than we have in decades.

The focus of this hearing today is perspective, however. And the financial crisis has told us that regulatory structure is not merely an academic issue. And that topics, like regulatory arbitrage, matter and have meaningful repercussions outside of the province of academia.

Indeed, if we look for something positive in the aftermath of the crisis, it might be that it will give us the courage to make the hard choices and reform our financial regulatory architecture.

We have learned all too well that our regulators and regulations were not well-positioned to adapt to the rapid financial innovation driven by capital mobility, deep liquidity and technology. Regulation alone and modernized architecture couldn't have prevented all of the problems from these developments. We can do much better. And we can position ourselves better.

Our current regulatory structure in the United States no longer reflects the complexity of our markets. This complexity and the severity of the financial crisis pressured the United States regulatory structure, exposing regulatory gaps as well as redundancies. Our system reflects a system, much of it created over 70 years ago, grappling to keep pace with market evolutions and facing increasing difficulties at times in preventing and anticipating financial crisis.

Largely incompatible with these market developments is our current system of functional regulation which maintains separate regulatory agencies across segregated, functional lines of financial services, such as banking, insurance, securities and futures, with no single regulator possessing all the information and authority necessary to monitor systemic risk.

Moreover, our current system results in duplication of certain common activities across regulators. Now, while some degree of specialization might be important for the regulation of financial institutions, many aspects of financial regulation and consumer protection regulation have common themes.

So as we consider the future construct of our United States financial regulation, we should first look to the experience of other countries, especially those who have conducted a thoughtful review recently, like we've heard today.

As global financial markets integrate and accounting standards converge, it is only natural for regulatory practices to follow suit. There are two dominant forms of financial regulatory regimes that should be considered seriously in the U.S. as we rethink our regulatory model. I'd like to focus on the consolidated regulator approach and the twin peaks approach.

Under a single consolidated regulator approach, one regulator responsible for both financial and consumer protection regulation would regulate all financial institutions. The U.K.'s consolidation of regulation within the FSA exemplifies this approach, although other countries, such as Japan, have moved in this direction.

The general consolidated regulator approach eliminates the role of the central banks from financial institution regulation but preserves its role in determining monetary policy and performing some functions related to overall financial market stability.

A key advantage of the consolidated regulator approach that we should consider is enhanced efficiency from combining common functions undertaken by individual regulators into one entity. A consolidated regulator approach should allow for better understanding of overall risks to the financial system.

While these consolidated regulator approach benefits are clear, there are also potential problems that we should consider. For example, housing all regulatory functions related to financial and consumer regulation in one entity may lead to varying degrees of focus on these key functions. Also, the scale of operations necessary to establish a single consolidated regulator in the U.S. could make the model more difficult to implement in comparison to other jurisdictions.

Another major approach, adopted most notably by our colleagues at the table in Australia and in the Netherlands, indeed is the twin peaks model that emphasizes regulation by objective. One regulatory body is responsible for prudential regulation of -- (inaudible) -- financial institutions, and a separate and distinct agency is responsible for business conducting and consumer protection.

The primary advantage of this model is that it maximizes regulatory focus by concentrating responsibility for correcting a single form of market failure, one agency, one objective. This consolidation reduces regulatory gaps -- (inaudible) -- among regulators and the opportunities for regulatory arbitrage by financial institutions while unlocking natural synergies among agencies.

And perhaps more importantly, it reflects the financial market's extraordinary integration and complexity. It does -- (inaudible) -- the key problem in that effective lines of communication between the peaks is vital to success.

There are several ideas in circulation in the U.S. I'd like to focus on some things that we focused on in the Treasury blueprint in 2008 and some other relevant policymakers that are talking about other ideas.

The March 2008 blueprint proposes that the U.S. consider an objective-based regulatory framework, similar to what Dr. Carmichael discussed, with three objectives -- market stability regulation, prudential regulation to address issues of limited market discipline and business conduct regulation.

Prudential regulation housed within one regulatory body in the U.S. can focus on common elements of risk management across financial institutions, which is sorely lacking in the United States. Regulators focused on specific objectives can be more effective in enforcing market discipline by targeting financial institutions for which prudential regulation is most appropriate.

Secretary Geithner and Chairman Bair addressed similar issues of importance in dealing with too-big-to-fail institutions and the necessity of providing systemic risk regulation.

Senator Collins, you introduced legislation that recognizes the key aspects that need to be addressed in our system to deal with these difficult problems.

So while there is an emerging consensus in the United States and among global financial regulators, market participants and policymakers that systemic risk regulation and resolution authority must be a cornerstone of reform financial regulation, the exact details of the proposals need to be settled. It's very complicated, and they require thoughtful debate and deliberation.

And one point, however, is clear. The United States regulatory system, in its current form, needs to be modernized and evolve. We should seize upon this opportunity to do this. To this end, the future American regulatory framework must be directed towards it proper objectives to maintain a stable, well-capitalized and responsible financial sector.

Thank you for inviting me.

SEN. LIEBERMAN: Thanks, Mr. Nason. Very helpful.

A vote just went off, but I think we're going to try to kind of tag team here, so Senator Collins will go over and now and I'll ask questions, and then we'll go on from there.

The testimony has been very interesting. While your testimony is in my mind, Mr. Nason, just take a moment, and if we went to the twin peaks -- or as Dr. Carmichael said, there's actually four in Australia -- but if we went to the twin peaks here, what would be under the two peaks?

MR. NASON: Well, I assume the twin peaks model, but essentially would be asking for three peaks.

SEN. LIEBERMAN: (Inaudible.)

MR. NASON: Three peaks in the U.S.

SEN. LIEBERMAN: One being the Fed.

MR. NASON: One would be market stability regulation which we recommend in the blueprint would be housed at the Fed.

SEN. LIEBERMAN: Right.

MR. NASON: One would be prudential regulation of institutions that require prudential regulation, so your banks, your insurance companies, and then business conduct regulation which is the type of consumer protection regulation that we historically see in the consumer aspects of the Fed and the banking agencies and most of what the Securities and Exchange Commission does.

SEN. LIEBERMAN: So you'd split up some of the existing regulatory agency's functions. So it's too simple or not-smart-enough a question to ask which agencies would go under which, because you take pieces of each.

MR. NASON: Yeah. The model in the United States, it's kind of a difficult way to think about it. But if you take the consumer elements of the banking agencies --

SEN. LIEBERMAN: Right.

MR. NASON: -- put them under the business conduct regulator, take the bulk of the responsibilities of the SEC, put them under the business conduct regulator, and leave the prudential or financial regulation in a separate regulatory body. Those are the two peaks. And then I think there's an important role that isn't demonstrated in those two peaks is someone taking the ownership of systemwide risks, and that's the important role that we put into the Federal Reserve in our blueprint.

SEN. LIEBERMAN: Incidentally, I like the Paulson plan's use of the word market stability regulator because I think it's more clear than systemic regulator which at least confuses me.

MR. NASON: We spent an enormous amount of time debating that. And I'm glad you notice it. And the one reason we called it market stability is to indicate to everyone that you are going to have bouts of instability, and the goal is to try to keep the markets as stable as possible. You can't prevent it.

SEN. LIEBERMAN: Right.

Let me ask Mr. Green, Dr. Carmichael and Dr. Clark, from outside the U.S. looking in and acknowledging we've heard some mixed testimony here on the question I'm about to ask and based on your experience obviously, what role do you think the fragmented nature of our current structure played in the extent of the current economic crisis here in the U.S.? Can you make a judgment on that, Mr. Green?

MR. GREEN: I think the most striking example among several was the AIG affair.

SEN. LIEBERMAN: Yeah.

MR. GREEN: Where, of course, there's no federal jurisdiction, as you know, which meant that although there was a kind of lead regulator in the New York Insurance Commission, nevertheless that jurisdiction was shared with a lot of other regulators. And the Office of Thrift Supervision also had a role. And I think it's fairly clear and widely acknowledged this meant there were gaps in terms of looking at the whole picture for a global firm.

SEN. LIEBERMAN: Right.

MR. GREEN: The other example, I think, relates to the U.S. investment banks which are sort of almost uniquely at the global level that were not regulated with the rest of the banking system. And that led to gaps or inconsistencies. Although they did business, it was very similar --

SEN. LIEBERMAN: To banks, yeah.

MR. GREEN: -- to banks, and indeed the rest of the world was done in banks. Nevertheless, they had quite different capital regime and indeed curiously their consolidated capital regime was voluntary. That of course came to an end very abruptly over a weekend. And this was a risk that a lot of people knew was waiting to crystallize. But that's an example, those are two big examples, if you like.

SEN. LIEBERMAN: So those are examples that suggest that structure had some kind of causal effect, or at least enabling effect on the crisis.

Dr. Carmichael, what would you say? And (good ?) examples, I think.

MR. CARMICHAEL: I don't have a lot to add to that because I think it's spot on. If one had to put rough percentages on it, and this has got no science, I would say it was enabled 70 percent by the structure and 30 percent by bad regulation. So I think the structure actually had more to do with the problem.

I'll add one example to what David said. I was interested when AIG regulators, of course by the state regulated the state regulators, said, we now want to regulate credit-default swaps as an insurance product. And immediately, the impossibility of that came out in that unless the other 49 states agree to do it, the business just moves over the border. And this is not a national border, it's just moving across the Hudson River, for example.

So that structure enables arbitrage, enables gravitation to the lowest common denominator. Like I said, we were mind-boggled when we found that AIG was regulated by the OTS as a conglomerate. That just seems ludicrous. So I agree entirely.

SEN. LIEBERMAN: Thanks.

Dr. Clark.

MR. CLARK: I guess what I would say is that when you get yourself trapped, but if you can't take a direct link back to the great financial crisis you shouldn't clean it up. And so I would say the U.S. system obviously has a lot of issues that if it didn't create the great financial crisis certainly don't make the system run any better. And so I think whether you have 100 regulators or 50, it doesn't matter. There is clearly regulatory shopping that goes on constantly in the United States, and that can't be. (Inaudible) -- its own system.

SEN. LIEBERMAN: Okay, that's a very important point. I mean, we're focused on this now because of the current crisis. And there are some clear linkages, as Mr. Green and Dr. Carmichael said. But there are obviously other reasons beyond that to want to alter our structure, and that's one of them, regulatory shopping. What else? So you made a reference in your gracious and diplomatic use of the term diversified.

But I presume that underneath that was some sense that it was really pretty hard to work together with the U.S. because of the way in which the regulatory system was so dispersed.

MR. GREEN: Certainly for regulators in the rest of the world. And Jeffrey will have a view on this as well. Even in the banking field, leave aside this kind of AIG problem, even in the banking field, there was no single voice in the U.S., although a case can be made for regulatory competition.

In this kind of area, it's not very clear where the advantages (came ?) sort of regulatory competition. And certainly in international discussions, it's very difficult to have a completely coherent discussion when there were three or four counterparties and some discussions even about capital. The SEC, if it wasn't there, should have been there. And it makes it very difficult to come to international consensus.

SEN. LIEBERMAN: Yeah. And obviously -- (inaudible) -- a global economy, and there are times when we want to have interactions globally that are not facilitated by the way in which we're organized. So I take your point.

I'm going to have to go in a minute, but, Mr. Nason, from the U.S. perspective, are there any negative effects for American business in a global economy, or even domestic but particularly globally, that result from this fractured system we have now?

MR. NASON: Sure. The clearest and easiest example, sorry to beat it to death, is insurance. And there are two things that are clear. One, the international community does not understand and appreciate the state regulatory system for insurance. So that American industry is not well-represented around the globe.

And secondly, in periods of crisis like this, we learned all too well at the Treasury that we would be benefited significantly by having a federal expert in insurance that you can draw upon the expertise. I mean, one of the big problems associated with dealing with the AIG failure is there is no federal person responsible for that industry, so you can't draw on federal expertise. And that was a very, very significant consequence of having this fractured system.

Other examples are you mentioned the Office of Thrift Supervision which has oversight responsibilities for the holding company of a lot of these institutions but doesn't have the appropriate stature to represent the thrifts around the world. So it's an inequality that hurts the institutions that have thrifts in the structure.

SEN. LIEBERMAN: Thank you. I'm going to ask that we stand in recess. As soon as Senator Collins comes back, I'll ask the staff to please encourage her to begin her questioning. So if you want to stand and stretch -- but don't go far. (Laughter.)

The hearing is recessed.

(Recess.)

SEN. COLLINS: Turn on my mike.

The hearing will come back to order.

Senator Lieberman has graciously allowed me to temporarily assume the role of chairman and reconvene the hearing so that we can keep proceeding through this vote.

I want to thank each of you for your very interesting testimony and bring up several issues in the hopes that I am not repeating too much of what the chairman may have already asked you.

Mr. Carmichael, you talked about the "four peaks" (sic), as you described it, and that some of the advantages were that each focuses on one aspect to avoid conflict. You have essentially a functional regulatory approach. And then you said there's also a council of regulators. Does that council of regulators have responsibility for identifying systemic risk?

MR. CARMICHAEL: In a short answer, yes. But more importantly, their role is to communicate and coordinate between the agencies and to make sure that there is a regular testing of issues. Sometimes the central bank, if it is concerned about a systemic issue, has the power to send some of their staff with the prudential paper going on inspections, for example, to learn more about what some of those issues might be. The involvement of the treasury is there for exactly the systemic-type reasons.

So while it doesn't have an authority track, there's no charter that gives it the power to do something, that -- through that coordination they're able to focus the issues and decide, for example, do we need more information about a particular area; do we need one of the agencies to collect that on behalf of the systemic regulator?

SEN. COLLINS: Mr. Nason, I know you were very involved in the Paulson blueprint for reform and I very much appreciated your insights. As I understand it, the blueprint that Secretary Paulson put out did call for a systemic risk regulator but it would be vested in, I believe the Federal Reserve. Is that correct?

MR. NASON: Yes.

SEN. COLLINS: Did the -- when you were involved in drafting the blueprint, was consideration given to the council approach?

MR. NASON: It wasn't (really ?) the council approach, but one thing we did consider was providing more authority to the President's Working Group on Financial Markets, which is very similar to the council approach. We thought about it very seriously because there's a lot of elements of attractiveness to having a council because you're bringing a lot of different sets of expertise to bear.

One of the things we got tripped up on is providing the right amount of authority. We were worried about clarity of purpose and clarity of mission among a council, but it's certainly something we considered seriously.

SEN. COLLINS: Mr. Clark, is there a system for identifying systemic risk in Canada?

MR. CLARK: The system I think would be very similar, as I understand from Dr. Carmichael, of the Australian system. There is a group that meets regularly that's chaired by the deputy minister of finance and we would have our regulator -- (inaudible) -- on it and would have the Bank of Canada on it and the CDIC, equivalent to the FDIC, on it. And in fact they have now created two committees; one which is called the -- (inaudible) -- which is designed more to deal with low-level coordination issues, and then a second one that deals with more exclusively strategic issues. And I think it's probably fair to say that as a result of this crisis, that role of that committee and making sure that they're debating what the systemic risk is and who's doing what about it has been elevated as a result of this.

SEN. COLLINS: Mr. Green, what about in Great Britain? How is systemic risk handled?

MR. GREEN: There is a so-called tripartite committee which brings together the Bank of England, the central bank, the FSA, and the Treasury, which was intended to look at the functioning of the system as a whole. And the Bank of England had a mandate in relation to the stability of the system as a whole.

I think there was insufficient clarity about just what that meant in the original draft and what that meant for -- in terms of the role of the Bank of England, which in fact leaves a bit of a question in my mind in relation to the so-called Paulson blueprint. The central bank has, as the monetary authority, the capacity to lend and to change monetary policy, but then there's an issue about what other tools does it have. Does it have the capacity then to instruct the regulators to take action on the grounds of systemic risk? I'm thinking -- in fact in the U.K., the Bank of England didn't think that it had that authority. And in the way the system worked, the clarity of objectives in retrospect proved a bit of a disadvantage. And the Bank of England spent its time thinking about the economy, and the FSA spent its time thinking about the individual firms. And one of the main lessons that's been learned from the crisis is that the regulator needs to think more about what's happening in the wider economy and the central bank needs to remember that monetary policy only has effect through the financial system. So it's quite a subtle set of links that's difficult to get precisely right.

SEN. COLLINS: I think those are excellent points.

Mr. Nason, obviously one of the failures of our system was a failure to identify high-risk products that escaped regulation and yet ended up having a cascade of consequences for the entire financial system. And I'm thinking in particular of credit default swaps, which in my mind were an insurance product, but they were not regulated as an insurance product. They were not regulated as a securities product. They really weren't regulated by anyone. And as long as we have bright financial people, which we always will, we're going to have innovation and the creation of new products -- new derivatives, new products.

One of my goals is to try to prevent these, what I call "regulatory black holes" from occurring, where a high-risk practice or product can emerge and no one regulator in our system has clear authority over it, and without a council there's nobody to identify it and figure out who should be regulating it. What are your thoughts on preventing these regulatory gaps?

MR. NASON: I think there's a lot to like about what you're trying to achieve in your legislative proposal. I think that identifying the fact that CDS and OTC derivative contracts are a source or potential source of systemic risk is very important and I'm really happy to see that you've identified it here and the administration's thinking about ideas of putting them on exchanges and things like that because I think that one of the -- OTC derivatives were typically not regulated because they were viewed bilateral contracts between sophisticated parties. But they grew so big and they're so significant in the U.S. system that they proved to be two things: one, a source of great opaqueness in financial institutions where you couldn't get a sense of how important the derivative book was to a particular institution; and two, a real channel for the too- interconnected-to-fail problems.

So I think that you're certainly right to identify them as something that needs to be looked at carefully. I think that they are certainly something that should be under the supervision, oversight, jurisdiction of a council or a systemic risk regulator. And I think that I'm happy that things are moving along in that way.

SEN. COLLINS: Mr. Clark, I admire your foresight in deciding that some of these derivative products were simply not well understood and were too high risk and getting out of that market.

In Canada, however, was there regulation of credit default swaps and those kinds of exotic derivatives or did the regulation only come about through safety and soundness regulations? If you understand what I'm saying -- is it --

MR. CLARK: I think so. So, in a sense, there was a safety in soundness and, you know, I think it's fair to say as we were exiting the business, Canadian banks were going into the business. So it wasn't as if our regulator was saying, "Don't do this."

SEN. COLLINS: I was just wondering.

MR. CLARK: And as I pointed out earlier, there were -- Canadian banks collectively took $18 billion in write-downs, so in U.S. terms that 180 billion (dollars), given the size of the country, so it's not an insignificant amount. So we weren't -- we can't stand here and say, no problems in Canada. I think that would be a misnomer.

I think this is a very difficult area because I think the reality is that people were aware of this and they were aware of that the products were getting bigger and more complex. But as we were talking during the break, I mean, the reality is that people were making lot of money on it. And it looked like it was very profitable, and I would say in its initial evolution, credit derivatives were actually a positive factor. And so for us, as a bank, we were able to lay off a significant amount of our risk by buying credit protection and in that sense we saw it as a good thing, not a bad thing. And it's only its later evolution that in a sense ended up causing I think some of the problems.

I think it underscores the capability issue -- the one we talked about earlier with AIG -- is that in this war -- (laughs) -- if you will, or race for knowledge, you have a very profitable and highly sophisticated industry in the banking system around the world. I think it does mean that you can't afford to have three or four regulators trying to go up the scale of knowledge. You do have to have a concentrated knowledge in order to attract the people to try to have a counter-push to these ideas.

SEN. COLLINS: Mr. Carmichael, any thoughts on how to prevent regulatory black holes as new products emerge?

MR. CARMICHAEL: Two things I'd add to the comments made so far -- first of all, having banking and insurance under the one regulator, as is the case in Canada, Australia, and in the U.K., gives your regulator a much better chance to pick up where those risks are being laid off. And you look at the U.S. where you've got 50 state insurance regulators, picking that up as a problem for AIG was much more difficult than it would have been under the others.

The other side of it that I would add is that in a structure where you have a clear conduct regulator -- and that regulator will have responsibility for markets -- that's where the primary responsibility for regulator -- a new market, which is a new product that springs up however it's being conducted, whether it's bilateral or in an organized exchange, should be the responsibility of that particular regulator, provided they have the mandate and the skills to pick that up and do with it what they need to. That's where you would get the primary regulation, the disclosures, the aggregation of information and so on for those markets.

SEN. COLLINS: Thank you.

Senator McCaskill.

SEN. MCCASKILL: Thank you.

I don't know if you can help, Mr. Nason, but I have had a hard time figuring out how we missed all this. And you were at Treasury for the three years prior to when we came this close to a global meltdown as it relates to our credit markets. And I guess, you know, I'm curious as to why you think no one at Treasury -- I mean, I was in a room with Secretary Paulson and I don't want to say that they were panicked, but there's a reason why there was such bipartisan support 30 days before -- what, 40 days before our political election? So if there was ever a time in this building that the two sides can't get along, it would be 40 days before our national presidential elections. And when you had both major candidates for president voting in favor and all ends of the political spectrum, that was because we all had been given very detailed and accurate information about how close we were to completely falling off the table as it related to our credit markets. And I can't get comfortable with how we're going to identify risk going forward if the best and the brightest in our country -- supposedly the best financial minds in the world did not see this coming. Can you help me?

MR. NASON: Can I -- I can try to help you. I don't have the answers and we'll be debating this for the next -- next decades as to what actually happened. But I think there was a couple things that happened. People saw individual things that they were worried about. The regulators knew that underwriting criteria had gone down for home mortgage; people had seen there was a very frothy housing market; people had seen that the covenants in debt were going down to a level that they were concerned with.

But I think what really was very surprising and what caught people off guard was the severity with which things went from going -- from being very frothy and people were taking risks that -- people weren't paying adequate attention to risk, to where -- so the pendulum was nobody cared about risk at all; people were just worried about making money, to people weren't willing to take risk at all. So there was just a complete and utter contraction of credit in the economy that caused enormous contraction.

The speed with which that happened was something that people weren't expecting. It got to a point where money center banks wouldn't lend to each other --

SEN. MCCASKILL: Right.

MR. NASON: -- for 20 days or for 10 days without paying exorbitant interest rates. So we had a complete breakdown in confidence.

And I can't give you comfort that we're going to find it again. I can give you comfort that this is that one-in-100-year event. And you can try to manage it better, you can try to prepare yourself better, but this is one of those things where I don't think you can predict it. You can just put yourself in a better position to try to deal with it.

SEN. MCCASKILL: Which of the three parts of your plan would be responsible for identifying what happened?

MR. NASON: Well, I think it will be -- the three parts of the plan -- but first of all, the plan was not created to deal with the financial crisis. It was actually written before the financial crisis happened.

SEN. MCCASKILL: Now, you wrote it in March, right?

MR. NASON: I wrote it -- well, we researched and wrote it the year going up to March, and we released it right after Bear Stearns failed but it wasn't in response to those types of events.

SEN. MCCASKILL: Right.

MR. NASON: So the plan is not a look-back plan. But I think generally speaking you would have coordination among the three parties to describe how to better position ourselves to deal with this better.

SEN. MCCASKILL: You -- but let's assume that your plan -- that Congress, instead of your plan being announced in March of 2008, let's assume -- obviously this is a fantasy -- that Congress passed it whole cloth and it was in existence.

Which of the parts of your plan -- who is -- which is the body that you would expect, under the plan that's been drawn up, would be the one to say things are nuts; people are overleveraging; they have no idea what they're buying and selling; they're chasing a number and it's all about greed?

MR. NASON: Sure. I would tell you that each of the three would have a role, and here's what they would do: On the prudential side, there would be tightened standards for capital for financial institutions and further -- more regulation on liquidity management. On the conduct side there would be stronger regulations for mortgages and things like that. And on the market stability side there would be more focus on the interconnectedness of these two institutions and also things like the derivatives markets. Those would be three ways that each of the three pillars of the Paulson plan would respond to this.

SEN. MCCASKILL: Is it possible that the three pillars of the Paulson plan -- that each one of those pillars would have said it was their job?

MR. NASON: No. That's actually one of the premises of the Paulson plan is clarity of mission and clarity of -- (inaudible). See, one of the problems that we dealt with was that there was a lot of finger-pointing. There were battles between the state regulators versus the federal regulators and who was in charge of mortgage origination. So there was concerns about who was in charge of the holding company of Lehman Brothers -- was it the OTS or the SEC? So there's much less chance for finger-pointing under an objective criteria -- an objectives-based criteria like the Netherlands and the Australians have.

SEN. MCCASKILL: Mr. Clark, I heard that you said that you originate mortgages to hold them, and I keep explaining that one of my concerns about reverse mortgages that we are now ramping up in this country is that they're very similar to subprimes in that the people who are closing the loans have no skin in the game.

Now, the scary thing about reverse mortgages is that all of the skin is taxpayer's skin. If the assets are sold at term and they're not sufficient to cover the loan, the federal government has to cover the loan. But in subprime it was all of these exotic, slice-and-dice derivatives that are spread out all over that we're trying to, like Humpty Dumpty, put back together again now. I assume that in Canada the people who are holding the mortgage are the same ones who made them, and therefore they continue to have skin in the game.

MR. CLARK: Absolutely. We originate all the mortgages. We don't buy mortgages. We originate our own mortgages, and therefore we're very concerned about the underwriting standards because we're going to take the risks.

And, you know, I do believe that this system of holding the mortgages does one -- a couple of things for you. One, it means you have the banking system trying to make sure you have conservative risk, not (loud ?) risk, but secondly it actually gives us an (asset ?). The way I always describe our bank is we're not an income statement that generates a balance sheet; we're a balance sheet that generates and income statement, and that means we have a solidity of earnings that's there because we're not originating mortgages and then selling them off and then saying, "Well, where am I getting next year's income? We've got to originate more and sell them off." We're actually holding them, and so I think it produces tremendous stability in the system. But it does require a regulatory regime that doesn't penalize you for capital if in fact you hold a low-risk asset like that.

SEN. MCCASKILL: Do you think we should have regulations that require people who close mortgages to assume some of the risk?

MR. CLARK: I think some system where the people who originate have skin in the game is quite important.

SEN. MCCASKILL: Mr. Nason, what do you think?

MR. NASON: I think that what we've seen is our securitization markets certainly got overheated. I think that -- and there's certainly some --

SEN. MCCASKILL: I think a bonfire is more like it.

MR. NASON: I'm not going to quibble with that.

SEN. MCCASKILL: Yeah.

MR. NASON: I think bonfire is just fine.

I do want to suggest though that the securitization market -- it's a bad word right now and it's an ugly word, but it has a lot of value. It provides a lot of credit to the economy. A lot of markets depend on it. It's important to get our credit -- it's important to rebuild that market so we can get more credit in the economy today. The auto industry relies on it; a lot of industries rely on it, so it is important. Whether or not it went -- as it overheated like a bonfire -- I think that's a fair characterization.

SEN. MCCASKILL: Would you mind if I asked one more?

SEN. LIEBERMAN: (Off mike.)

SEN. MCCASKILL: Are you sure?

SEN. LIEBERMAN: (Off mike.)

SEN. MCCASKILL: I just -- I'm a little uneasy about BlackRock. I'm worried that BlackRock was called in to manage at the Fed -- the New York Fed in terms of some of the valuation of the assets. And I'm worried that there is some valuation of assets, and then there was going around to the other window and participating. And you know, I keep hearing that BlackRock is the only game in town and that's why they're getting all these contracts. Their name came up again yesterday in connection with the PDCG -- the, again, chief fund for pensions in this country -- that BlackRock -- I keep hearing that they're the only one that has the model and it's proprietary, and therefore they're the only game in town and we keep going back to BlackRock. In fact, I had somebody tell me that the secretary of the Treasury talked more often to BlackRock -- (inaudible) -- BlackRock than probably a lot of other folks, and I don't know if that's true or not, but it worries me because this "too big to fail" thing -- can I get you without threat of torture to give me your take on why BlackRock is all of a sudden everywhere and is involved in everything as it relates to sorting out our financial mess?

MR. NASON: A couple things -- I can't imagine that the comment that either secretary of the Treasury spent more time talking to BlackRock than anyone else is accurate. That's --

SEN. MCCASKILL: Hyperbole.

MR. NASON: Hyperbole.

SEN. MCCASKILL: Okay.

MR. NASON: That's one thing. The second thing is, the determination of hiring BlackRock to manage the assets in the -- (inaudible) -- Bear Stearns thing, I think you're -- that was a decision made by the Fed, so that's not something I can speak about.

I think generally speaking what you're dealing with is a large (risk ?) transfer of assets from financial institutions to a variety of structures, and what the government is trying to do is, to protect the U.S. taxpayer's interest, hire someone that has some experience in managing those particular assets. BlackRock, WAMCO, PIMCO -- there's a couple of people that are very experienced in that.

The only thing I can -- I don't know the specifics with that particular situation, but the only thing I can say is that there is a lot of oversight and regulation for this process. There are the procurement rules, there is the GAO and the -- (inaudible) -- inspector general that are making sure that policies and procedures are followed. So I think you can take comfortable in the process surrounding how these asset managers are retained and the solicitations being made for them. That should give you comfort. I think there's a lot of transparency in that as well.

SEN. MCCASKILL: Okay. Okay.

Thank you, Mr. Chairman.

SEN. LIEBERMAN: Thank you, Senator McCaskill. Thanks for participating this afternoon.

We'll do a second round insofar as members want to be here or can be here.

The Paulson plan -- the Treasury Department's plan issued last March, as you probably know, envisioned a regulatory system similar to Australia's, which was objectives based. Their report was controversial here, although unfortunately it got overwhelmed by the growing crisis so it didn't receive the discussion I think it deserved, but it called for consolidation and dissolution of some existing agencies. One controversial reform which we referred to briefly here this morning was the consolidation of the Securities and Exchange Commission and the Commodity Futures Trading Commission.

I wanted to ask our three witnesses from outside the U.S. -- I think I know the answer from what you've said, but not totally -- if any of the three countries divide the regulation of securities and futures the way we do here in the U.S., or are they regulated under one roof?

Mr. Green? Your -- everything's under one roof.

MR. GREEN: Everything's under one roof, and indeed it was I think always under one roof before the great merger.

SEN. LIEBERMAN: Right.

MR. GREEN: There was no real distinction between the primary markets and the derivative markets. And I must say, I'm -- I stand to be corrected by my colleagues -- I'm not aware of any other country where there is such a distinction.

SEN. LIEBERMAN: Interesting.

Is he correct, as far as you know, Doctor?

MR. CARMICHAEL: It certainly -- in Australia it's always been under the one roof. What changed after we restructured was that we also brought it into one law. Prior to that there had been a separate law for derivatives and for securities, and there were two separate exchanges. Once the law was merged, the two exchanges also merged, and it was just simply a recognition that there is no fundamental distinction there at all.

SEN. LIEBERMAN: Right.

How about Canada?

MR. CLARK: Well, unfortunately we're the worst of all. We have multiple security regulators in Canada. So --

SEN. LIEBERMAN: Interesting. Worse than the U.S.?

MR. CLARK: Worse than the U.S., in this one respect, I'd have to say.

SEN. LIEBERMAN: Very interesting.

MR. CLARK: So, I think we're trying to get a national regulator.

SEN. LIEBERMAN: So it's easier to -- is it regulation at the --

MR. CLARK: At the state level, essentially.

SEN. LIEBERMAN: Okay.

MR. CLARK: So this has been a constant -- there's been an industry for 40 years to try to get this problem solved. I think the current government is working very hard to see whether they can get this and have a national regulator, but it has faced enormous political disagreement on it because of state rights, essentially. And so I'd say that is, if we were looking for black holes in Canada, the fact that we do not have a national regulator -- and if you take a look at the one major crisis Canada did have around asset-backed paper, sort of a contributing factor was that there was no federal regulation of this. This was all done at the provincial level and so escaped -- so it was -- I think it represents a black hole example.

SEN. LIEBERMAN: Mr. Nason, I take it that historically the reason we have both the SEC and the CFTC is that the CFTC grew up from the trading in agricultural commodities and they didn't want to be mixed with the Wall Street regulators?

MR. NASON: That's -- historically that is the genesis of the CFTC's creation in the '70s, but interestingly enough when the CFTC was being created, members of Congress and staff members of -- and their staffs asked the SEC if they wanted the jurisdiction for agricultural commodities, and they declined because it was a specialized market.

SEN. LIEBERMAN: Interesting. Right.

MR. NASON: But now I think the volume of financial futures on the futures exchanges is well over 90 percent --

SEN. LIEBERMAN: Correct.

MR. NASON: -- whereas in the '70s it was significantly bifurcated between financial and agriculture.

SEN. LIEBERMAN: Yeah. I think this has a lot of logic, but it's going to be, for those historical reasons, difficult here. We can already see the -- not just the regulated entities but the members of Congress fighting for the status quo -- that is, the Agriculture Committee fighting to keep a separate CFTC. Of course, Senator Collins and I think that's why this committee has a unique role to play, because we have no vested interest on either side -- at least not in this matter. We may in other matters. (Laughter.)

Let me go on to ask Mr. Green, Dr. Carmichael and Mr. Clark about what are, quote, "transition" challenges. As we're heading toward a time of reform, both regulatory and structural, I wonder if you could give us any counsel about transition problems that your countries faced -- particularly the two of you -- during the transition to a more consolidated regulatory system, and any warnings you'd give us as a result.

MR. GREEN: (Off mike) -- if I could, sir.

SEN. LIEBERMAN: Yeah.

MR. GREEN: We had a big bang in the UK under very unusual circumstances. It was not prepared by a great deal of discussion, but it was accepted almost without subsequent debate because so many parties thought that it solved a lot of prior problems. So there was, if you like, a consensus that the previous arrangements were unsatisfactory, and there were a lot of (corrections ?) in what was being done there. That gave a lot of advantage, though, in that because there was almost no warning and the government was able to decide, using its parliamentary majority, that this would happen. And then the people just had to get on with it, and the organizations were thrown together and told they -- well, they had to come up with a solution. There wasn't any alternative. You're not in that position in the United States.

I suppose the lesson that one would draw from it is that if it is at all possible to start with a structure that rather, as I said in my earlier remarks, doesn't have one organization clearly in the lead but you are building a true merger and a new structure out of that, there may be a greater chance of success. But the circumstances were -- the historical circumstances were quite unusual in that respect.

SEN. LIEBERMAN: Dr. Carmichael, in addition to responding to that, I wonder if you'd talk just a little bit about what the opinion is in Australia now about whether this was a good move, to go to the so-called "twin peaks," both in government, public, and I suppose in the regulated community.

MR. CARMICHAEL: Anytime you have change, you're going to have some difficulty. And I've been through this not only twice in Australia with regulatory amalgamation but in about half a dozen countries where I've worked as well, so I've seen some of the problems that can arise firsthand.

The two biggest ones are fear -- and that's mainly among staff -- fear for jobs, fear for where they will end up in the new structure; and the second is distraction, so that they have a job to do, a day job, which is regulation, but they are distracted because of the reorganization and the rebuilding. So those are two very big considerations that you have to deal with in any change.

SEN. LIEBERMAN: Did the previous agencies disappear as I take it they did in the UK?

MR. CARMICHAEL: Some did.

SEN. LIEBERMAN: But some continued and were just put into --

MR. CARMICHAEL: Yes. We plucked parts of the central bank and parts of some of the state regulators and put them together into a national regulator.

We only had one major institutional rebuild. The others were just sort of tinkering at the edges. If it happened here I suspect it would be a lot more extensive than that because of the sheer number of agencies that you have.

But they -- the two things that I guess in my experience have been absolutely critical to getting to the end without falling over are, number one, leadership, and we've found that if you identify the people who are going to be the leaders of the new organizations, you have to do that early and you have to put them in place to drive the changes because there are always people who will resist the change and undermine the process. You don't want them anywhere around when you're doing it. So it's big decisions early on and get on with it. The second one is communication so that people understand what's happening, they get involved with it. The more you can involve staff in the new structure and things, the more they'll feel the ownership for it and their part of it.

Two other things -- David mentioned big bang. In the UK they did a big bang in terms of making the decision very quickly. In terms of moving to a new internal structure, the FSA moved in gradual steps over quite a period of time. We used a very different approach.

We just kept the agencies separate for a year. We brought them together in name and people kept doing their old jobs. We redesigned how we wanted the agency to look at the end of that, and at the end of the first year we basically sacked everyone and invited them to apply for new jobs in the new agency, and for two weeks I didn't sleep, not knowing whether I would actually have an agency at the end of it. I wouldn't recommend that approach. It worked, but I wouldn't recommend it for anyone else.

The last point I'd make before getting to your comment about whether it was a success is about legal elements, and I speak here as a non-lawyer, but I've learned to respect law much more over the last 10 or 15 years than I ever did. It was a mistake in Australia to create the agency just for the piece of enabling legislation that set it up, said what its powers were, but left it to operate under each of the individual acts that were already there. So we still had a banking act and a general insurance act and so on.

What we've done in a couple of other countries is to take each of those pieces of legislation and before creating the agency, to take all of the regulatory powers out of those and move it up the agency's act. The power of that is just incredible. For example, when I first wanted to create a new governance standard for all of our industries, my lawyer said, "I'm sorry, Chairman; you can't do that. You have to issue it under each of the different pieces of legislation, and some of them don't even give you the power to do that." So the ability to create a harmonized approach was severely handicapped by the law. Now, the UK went another way of doing it -- was they created their omnibus act. It was very painful, but the outcome was very strong.

So, legal elements are important. I would encourage you if you go this route to get the legislation running ahead of the agency if you can -- get the legal side sorted out so that the agency has the powers to do what it needs to do.

Last comment -- your question about was it a good move -- Our prime minister in Australia and our treasurer are out crowing around the world about how great our system has been. If you wound the clock back two years ago, they were still grumbling that that system belonged to their predecessors, who were of a different party. The story has change enormously.

SEN. LIEBERMAN: That's powerful testimony. Thank you.

Senator Collins.

SEN. COLLINS: Thank you, Mr. Chairman.

Mr. Carmichael, let me take up where the chairman left off. Your "four peaks" or "twin peaks" approach has a lot of appeal to me, but I'm wondering, as someone who spent five years overseeing financial regulation in the state of Maine, how it works for the regulatory community. If you have separate regulators, do you also have separate compliance audits? In other words, in Maine, when we would send out our bank auditors to review the state-chartered banks for compliance, they did the entire audit because it was only that one agency, plus there was a federal agency involved as well. But if you have separate regulators for prudential regulation, competition -- are you having multiple audits?

MR. CARMICHAEL: The answer is yes, but multiple is a very small number in that our prudential regulator has the primary responsibility for onsite inspections. And I should say we are much more of a principles-based than a rules-based country, so we don't do anything like as many audits and onsite inspections as would be common under the U.S. approach.

Our conduct regulator, which is the pillar that's looking at mis- selling, mispricing of product and so on -- they work on the basis of responding to complaints. So they are not out there auditing compliance as such. They will hear a complaint, and they're really looking for misconduct of a type. Then they will do an investigation. So it's very targeted. It's not a regular onsite audit of that style. So in the sense of overlap, it's really quite minimal.

SEN. COLLINS: I also recall when I was head of the financial department that we would have regulated entities say, "Well, we're going to consider becoming federally chartered unless you do 'x.'" So there is a real problem in our country with shopping for the easiest regulator and playing the states off against the federal regulators and vice versa. And because that's an income stream to the department, to the regulator, those threats matter to state governments, particularly state governments that are strapped for funds. So I think that's an issue as well.

Mr. Nason, in the United States we now recognize that a large shadow banking sector can threaten the entire financial sector, and I for one believe that it's not enough to monitor just the safety and soundness of traditional banks, but we need to extend safety and soundness regulation to investment banks, for example, to subsidiaries of companies like AIG. Bear Stearns I'm told had an astonishing leverage ratio of 30 to one when it failed. Do you think that we should be extending some system of capital requirements across the financial sector?

MR. NASON: That's a great and very difficult question. If you go back to Bear Stearns, Bear Stearns was under a consolidated supervisory system that was administered by the SEC, so they did have liquidity and capital requirements that were different than the banking system, but they were under some type of conglomerate supervision.

I think generally if you are a systemically important institution, it's hard to argue that you shouldn't be under some type of systemic supervision to prevent the systemic risk becoming -- hurting the general economy. What gets harder is that -- where do you draw the line between which types of institutions get safety and soundness supervision and which don't. For example, a very easy case is -- some hedge funds are -- you can make an argument that they're systemically important because of their size or concentration on particular markets. They could probably be subjected to some type of supervision. The question is, should all hedge funds be subjected to that type of supervision? The case is harder the smaller they become. So I -- the way that we cut it in the blueprint is that institutions would all need to be licensed, chartered, and under the supervision of our systemic regulator, but that type of systemic regulation was different than traditional prudential safety and soundness regulation.

SEN. COLLINS: It of course gets very complicated very quickly because if you designate certain financial institutions as systemically important and thus make them subject to safety and soundness regulation, you're also sending a message that they're too big to fail -- a very bad message to send because then you're creating moral hazard.

So this is -- it's so complicated to figure out the right answer here, but I do think it's significant that the Canadian banks that bear higher capital requirements and the ability to hold lower- returned assets -- lower-risk assets, and the far lower leverage ratios compared to American banks -- were healthier. They didn't fail. So clearly there's got to be a lesson for us there.

Mr. Clark, I know we're running out of time, but I do want to talk to you further about the lending practices. I completely agree with my colleague from Missouri that part of the problem with the American mortgage system was that risk and responsibility were divorced, so you had a mortgage broker who was making the loan, gets his or her cut, then sells it to the bank which gets its cut, which then sells it to the secondary market. Everyone's getting a financial reward, but ultimately no one's responsible for the mortgage if it goes bad. There's just -- there's no skin in the game, which I think is a big problem that's so difficult to solve because of the liquidity issues that Mr. Nason raised.

But there are other key differences as well that you talked to me about when we were in my office, and they had to do with downpayment levels, mortgage insurance, deductibility of interest. Could you discuss some of the differences between Canadian and American mortgage lending?

MR. CLARK: As you just mentioned, one other feature that I haven't underscored but we found a tremendous difference on the two sides of the border is that in Canada, because we hold all the mortgages, modifying the mortgages is easy to do. We don't have to ask anyone's permission to modify the mortgage, and it's not the government coming to us and saying, "Would you start -- here's our modification program." We just were instantly modifying the mortgages.

Last year -- we represent about 20 percent of the mortgage market in Canada. We only foreclosed on 1,000 homes in a whole year, to give you a sort of order of magnitude, and every one of those thousand we regarded as a failure. And so the last thing we would ever want to do is actually foreclose on a good customer, and so we go out of our way to modify the mortgages, and that's just natural practice for us because I don't have to ask permission of some investor whether or not I want to do this or can I do it or what the rules are for governing it. So I do think that has turned out in this crisis to be a second feature that frankly none of us would have thought about until the current crisis.

So in terms of your specifics, we're required if we in fact lend more than 80 percent loan-to-value to actually insure the mortgage so that it represents a constraint. It wouldn't have represented a constraint until the kind of no-doc lending that was done in the United States because of the actual underwriting we're doing, but then again because we actually would be holding the mortgages, we tend to -- we in fact insisted on full documentation. There is not interest deductibility. I think there's no question that the feature of having interest deductibility in the United States is a major factor for leveraging up, and despite the fact that it's justified on the basis that it encourages homeownership, historically homeownership has actually been higher in Canada than it has been in the United States.

So there's no evidence that the two are linked at all. All it does is inflate housing prices because in fact people are looking at after- tax cost and computing the value in which there's a bid for the houses.

So those are the main features. We do use mortgage brokers, but they're originating mortgages which then we hold. We don't -- (inaudible) -- and I think that's the core feature.

SEN. COLLINS: And just to clarify, in most cases the home buyer is putting down 20 percent? Is that correct?

MR. CLARK: Yes, although when I started my first house I bought the insurance. I hadn't put down less than 20 percent, but you can do it. But again, we wouldn't lend to that person unless we were sure they were going to pay us back because we have to -- we're responsible for the collections. We're responsible for managing that. And it's really our customer relationship, is how we regard it.

SEN. COLLINS: I think it's fascinating that homeownership levels are actually higher in Canada than in the United States because the justification for all these policies that encouraged the subprime mortgage market was to increase homeownership, and in fact it's caused a lot of people to lose homes that they could not afford in the first place. And the Canadian experience is very instructive.

Mr. Green, last question to you: In Canada what are the lending policies? Are they more similar to -- Canada, I'm sorry -- in the United Kingdom, are they more similar to the Canadian practices or to the American practices?

MR. GREEN: A mixture. There is also no interest deductibility in the UK, though that hasn't stopped a boom in house prices. There I think has been no regulation of the terms of lending, and one of the issues that has arisen in the review which the FSA has undertaken of what went wrong and what might need to change, which I commend to you -- their very, very detailed review covering very many of the issues we've talked about today -- the question has been raised as to whether there should be some kind of mandatory loan-to-value ratios, loan-to- income ratios. So they weren't in place, but that's seriously being considered.

What has now been agreed at the European level is that there will be skin in the game and that the originator in securitization will have to maintain 5 percent. And I think I'm right in saying that has now been legislated across the EU because of the rather widespread perception that this was a problem that needed fixing. Five percent you may say is only symbolic, but of course it will concentrate the minds of the management to all the issues that Dr. Clark has mentioned.

SEN. COLLINS: Thank you. Thank you, Mr. Chairman.

SEN. LIEBERMAN: Thanks very much, Senator Collins.

Thanks to our four witnesses. Thanks for the trouble you took to come here, for the time you spent with us, and most of all for sharing your experiences and opinions. I found this to be a very helpful hearing -- even you, Mr. Nason, that didn't come that far. (Laughter.) We appreciate your testimony. And at the risk of simplifying, it really is -- I think in various ways your testimony has shown us that structure matters -- obviously regulation does, too -- and that you need a healthy combination of both, and that none is a cure-all, that you can't assume that a good regulatory structure will solve all the problems. But it will solve some of them and it will prevent others from occurring or make it harder for others to occur. And I think you've helped clarify opinions up here. So we thank you very much.

It's our normal course to keep the record of the hearing open for 15 days for any additional questions or statements. If you have any second thoughts you want to add to the printed record or your prepared statements, which were excellent, will be printed in the record in full. It may be that some members of the committee -- those that were here and those that weren't -- would file some questions with you, and if you have the chance it would be appreciated if you'd answer them for the record. But -- (inaudible) -- our thanks, and I hope you'll both watch with interest as we proceed to attempt to reform, and say a prayer for us as well. (Laughter.)

The hearing is adjourned. Thank you.

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