Hearing of the House Financial Services Committee - Systemic Risk and the Financial Markets

REP. FRANK: The hearing will begin. We have an overflow room, I believe. Is that true? Okay, so there is the overflow room for people who can't find seats.

We have gotten the agreement of the chairman and the secretary -- these are preliminary to any opening statements -- to stay till 1:00. We will probably have some votes. We will maximize our time.

Let me remind the members, Chairman Bernanke will be before this committee next week for the Humphrey-Hawkins hearings on the economy. Members are obviously free to raise anything they want. It is my hope that we would focus today on these very important questions of the financial regulations.

I know there are members who want to review what happened with Bear Stearns and what we do going forward. I personally believe the best use of the committee's time would be to focus on those structural questions and regulatory questions today. We will have the chairman before us for a few more hours next week to talk about the economy and Humphrey-Hawkins. And again, I would urge members to do that.

All members are free, as we know, to bring up whatever they want, but that would be our hope, because I did note some of the committees had asked previously for a hearing to look into what happened with Bear Stearns, and I said at the time that I thought that was very important. I believe that it's best to do that in this broader context. Members are certainly encouraged if that's what they want to get into, because the experience regarding Bear Stearns is clearly the context in which much of this hearing is and much of what we will be talking about is what happens if that should recur. So those are the parameters.

Given the importance of this and given the interest in members in speaking, we are going to hold pretty firmly to the five-minute rule. And obviously we're not going to (bang it ?) totally at five minutes, but no question can be put after the five minutes. We'll allow the answers to conclude, but I'm going to have to restrain myself and others from putting any questions after the five minutes.

Under the rules that apply when we have Cabinet and Cabinet-level officials, there are two opening statements on each side, the chairs and ranking members of the appropriate subcommittees. In this case it seems to be clear that it is the Financial Institutions Subcommittee that is the relevant subcommittee, so that is where we will -- that is how we will proceed.

And the official part of the hearing will now begin, and I will recognize myself for five minutes, and a fairly strict five minutes.

When I was about to become chairman of this committee in 2006, I was told by a wide range of people that our agenda should be that of further deregulating. I was told that the excess regulation in America from Sarbanes-Oxley and other factors was putting American investment companies and financial institutions at a competitive disadvantage and that people much preferred the softer touch of the financial services authority to the harshness of the American regulatory structure.

Things have changed. Where there was a strong argument as recently as November of 2006 that we had been overregulating the financial system, I believe the evidence is now clear that we are in one of the most serious economic troubles that we have seen recently because, in part, of inadequacy of regulation. Clearly that has been the case with regard to the subprime mortgages. But what's been striking is not simply that we had the problems with the subprime mortgages but that those problems infected so much of the financial system, including, I must say, many in Europe.

One of the things, though, that I do take away from that set of conversations, and it's a fairly clear one, is that what we do -- and I believe there is a consensus now among people in the administration, among many of us in Congress, among people in the financial industry, that an increase in regulation is required. It must be done sensibly. It must be market-sensitive. But I believe we have seen a significant shift from the notion that the most important issue was to deregulate further to one recognizing the need for more sensible regulation, but more regulation.

It is clear that this needs to be done in the context of international cooperation. And I am encouraged to (believe ?) -- and the first trip this committee took when I became chairman was to Belgium and London to meet with people from the European Union and Great Britain in terms of their financial regulation. This needs to be done with international cooperation. And I think the prospects of that are very good. I think there is a broad international recognition that some form of increased regulation is necessary.

The form that we are talking about is regulation of risk-taking outside the very narrowly defined commercial banking. Innovation is very important. An innovation that has brought a great deal of benefit the last few decades is securitization. Securitization replaces the lender-borrower relationship and the discipline that you got in the lender-borrower relationship.

And a very large part of our problem is that we have not yet found sufficient replacements for the discipline of a lender not lending to a borrower unless the lender is sure that the borrower will be able to repay. Something that simple caused problems elsewhere. We have had too many loans made without sufficient attention to whether or not the loans could be repaid. And what we now have is a contagion, because people having bought loans in various forms that they shouldn't have bought, they are now resistant to buying things that they should buy.

That is why I believe regulation, properly done, regulation of risk that is too unconstrained today because of various risk management techniques that were supposed to replace the lender- borrower relationship, have not been successful. Diversification and quantitative models for the rating agencies, we have not yet replaced them.

Some form of regulatory authority is necessary. Done right, a market-sensitive regulatory authority not only prevents some of the problems but is pro-market, because we have investors now who are unwilling to invest even in things they should. Many of our non- profit institutions and our state and local governments have been the victims of this.

So our job, I believe, is -- and I congratulate the officials of this administration for having done a good job in the current legal context of dealing with these problems -- our job is to look at what happened, look at what is now going on, and to decide what should be done to provide a better statutory framework for the increase in regulation that I believe people agree should happen.

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REP. FRANK: Thank you.

Let me begin Mr. Secretary because I was pleased to in your statement that you understand that the regulator at OFHEO of Fannie Mae and Freddie Mac believe that they are now adequately capitalized, they are important institutions and I think there was a, I'm pleased that you made that statement. I think that's important for people to understand.

I said before that we are talking about more regulation done since obviously there are still areas as the secretary indicated where we could improve by simplifying regulation, that doesn't mean that it needs more regulation everywhere.

But there's, there does seem to me to be emerging a consensus that we need a regulator concerned with threats to the systemic stability of the economy that come from unconstrained risk taking in a group of financial institutions outside the commercial banking system. And I was pleased Mr. Secretary that you mentioned hedge funds and investment banks, I think it would be a great mistake to talk about type of institutions that would -- (inaudible) -- said to change their hats when you're talking about the impact of the activity. And we are talking I think and a consensus appears to be emerging that it's going to be the Federal Reserve.

And I got to say there are people who say well, either you create a brand new regulator it seems to me, which would be I think a mistake, or you give it to the Federal Reserve. And I agree with both of you.

To do that, the Federal Reserve needs more power.

A situation in which the Federal Reserve is available and is under pressure to provide funding but does not have the ability to act well before that time to diminish the need for that and to impose conditions, that's unacceptable. And we are talking -- what we should be clear about -- an increase in regulatory power.

And let me say, you know, there was a time when the notion of requiring hedge funds to register was very controversial. It does seem to me we've clearly gone beyond that. We are talking about giving the Federal Reserve the power to not just get information but to deal with various things which could include capital requirements and other factors.

Now, those are very important issues. I think, as I said, there was a consensus emerging that it should be the Federal Reserve. And I have to say, when people say, "Well" -- they'll have this or that question about whether the Federal Reserve should do it -- I invoke, as people have heard me do, the wisdom of a great 20th century philosopher, Henny Youngman. And the maxim was, "How's your wife?" "Compared to what?" And the Federal Reserve compared to what? I don't see any alternative to the Federal Reserve.

But my question is this. We agree that this is a -- I think it's an important task, and there's a great deal of agreement that we should be moving to empower the Federal Reserve to have regulatory authority over a wide range of financial institutions in recognition, in part, of the fact that they have a systemic impact and that the current situation puts too much -- it puts the Fed in an untenable position of being given a set of expectations to respond when it doesn't have the full panoply of tools to respond with.

But here's the question: How soon? Now, we are where we are. It's July of an election year. This is a very complex subject. We don't want to do anything that would interfere with our wonderful financial. And I mean our wonderful financial system, which has been so productive. We want to curb abuses without interfering with the productive functions.

Mr. Secretary, you said that they don't now have the authority, and we all agree with that. Isn't there the sense that we move now -- my sense is this. And I applaud the signing of the memorandum of understanding between the SEC and the Fed. That kind of cooperation has been useful. The cooperation between your two entities has been useful.

Are we in a situation -- I guess there are two options. One is, if we have to try and legislate something now -- and let me say, we should distinguish. Mr. Secretary, you had a broader set of recommendations involving thrift institutions, credit unions and a whole lot of things that no one in this institution is eager to deal with. So nobody's in any hurry on those.

But we have, I think, taken out of that -- and you elaborated on it with the resolution issue -- the question of giving -- of a macro- stability regulator, of the Federal Reserve being given powers to deal with the problems that could come to a system from someone too big or too (much ?) connected to fail.

That one -- here's the question. Working together as we have within existing authorities -- with yourselves; with, I hope, cooperation with -- (inaudible) -- and cooperation with us -- can we get by till the end of the year? We obviously will start working on this.

Is it the view of either of you that immediate legislation is necessary? Or are we able to get by, given the cooperation we've had, given the kind of support we try to give you, as much as possible, and begin working immediately together so that early next year, one of the first items on the congressional agenda will be the legislation you talk about? Let me ask each of you to respond.

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REP. SPEIER: Mr. Chairman, I would like to just point out that there probably is some action that we should take as a committee, sooner than later, as it relates to the authority of the Fed over investment banking institutions, because another Bear Stearns can happen; it could happen in the course of six months while we're campaigning for re-election.

And, if it's important as you say it is to get some authority in place -- so it's very clear, I would think that would be one priority --

REP. FRANK: Would the gentlewoman yield?

I would disagree with her. And I think, frankly, it's a disservice to suggest that they don't have the authority. They had it under Bear Stearns. And I don't think we should be suggesting -- in fact, I think there was agreement here that they do have the authority -- it's not as perfect, in many ways, as they want to be, but they did go through Bear Stearns.

And, look, nobody's -- I've talked to the agencies -- people talk about this. I haven't seen anybody draft anything. There's a whole lot of people ready to write that they're in favor of, apparently, of somebody else drafting this legislation. Anybody is free, of course, to be able to do what they want. But I do think it's a disservice to suggest that there's a shortfall in authority now.

I believe that with the memorandum, and with the work we've got together, and with the support that they would get from us -- so that no one would think they could end-run things, that we are capable of getting through this. And if someone thinks he or she can write a bill that we can pass that quickly, obviously everybody has that right.

I am very skeptical, and I think beginning a process, and getting it bogged down in the Senate or elsewhere, is more likely to cause uncertainty than saying, look, we have gotten this far, we'll continue to work this way together. Other members are free, if they want to write up something and try and offer it. The departments are free to do it. The Fed is free to do it. I think the fact that no one's done it is a -- is a recognition of reality.

REP. SPEIER: Well, Mr. Chairman, I recognize that I have very little expertise in this area at this point. But I do sense from our two speakers that there is a sense of urgency, that we need to act. And I just want to make sure that we're not in a situation in a few months where there's a need to act --

REP. FRANK: Well, I want to -- I want to respond. I very much disagree with the gentlewoman's statement. As we made clear at the beginning -- I don't know if the gentlewoman was here for the whole hearing --

REP. SPEIER: I was.

REP. FRANK: -- but we addressed -- we addressed that early on. And they said -- and I don't think that should be undercut, that the authority that we've had so far is still there. I think it is a mistake to suggest that there is a lack of authority.

And, yes, we all agree that there is an urgency. The Treasury has not, the Federal Reserve have not asked us specifically to do something. And I think that is in recognition that it is best for everybody out there to understand that we're going to continue as we have been, pending this situation, until when we can -- we can do new legislation.

And the likelihood of being able to do this very complicated subject -- well, and I would say this, doing it and then redoing it would be, I think, a very bad idea. I think the instability that would be there would be a mistake. So, as I listen to our two witnesses, their view is that, in an ideal world, we would have more authority, but that we are able to continue working together as we have been, with the SEC, with them and with us. And, as I said, I think it's a great mistake to suggest that there is going to be some crisis we can't handle. We did handle Bear Stearns and I think we'll be able to deal with others.

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Ben, I'm just curious: Do you believe -- do you agree or disagree that you currently have the authority, if you chose to use it, to put very clear, very concise conditions -- not regulations -- but conditions on the loan that hopefully would lead us and my colleagues to know where you might want to go if we gave you the authority -- which I would be happy to do -- if we gave you the authority to have those regulations before they got to the window?

MR. BERNANKE: Congressman, there are two classes of firms that are borrowing from us. There's the commercial banks, which already have a well-established regulatory structure and a set of regulators. And we are, of course, along with our federal regulators working hard to make sure that they have adequate capital and they are taking all the steps necessary.

The investment banks has been a more ad hoc relationship, because we've been working with the SEC, as you know. But as I've mentioned, between us we have made strong demands on the firms. We've insisted that they raise their liquidity holding in particular, because that turned out to be the major point of vulnerability for Bear Stearns. But we've also asked them to raise their capital, improve their practice of risk management and so on.

So we are doing very much the same kinds of things between the Fed and SEC and the investment banks that we and other regulators already do in the commercial banks. So there is a quid pro quo that if we're going to lend to you, you have to take steps --

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REP. FRANK: -- because the secretary referred to some, I thought, questionable things in the article. Nothing in that, as you described it, Mr. Chairman, to allow either set to be done -- for instance, to waive any part of Sarbanes-Oxley or any other -- any other regulation. I don't think that was clear in the article. So is that correct?

SEC. PAULSON: I don't think I cast disparagements on the article. I'm just saying I read the article quickly.

REP. FRANK: It's okay to cast disparagements on articles. Free speech -- free speech works both ways.

SEC. PAULSON: And again, as I look at accounting, we have by industry different accounting standards. We have different accounting standards for different financial institutions. It's hard to say there is one --

REP. FRANK: Well, yeah, but that decision about mutual recognition would not --

SEC. PAULSON: No.

REP. FRANK: -- relax any other regulatory standard.

SEC. PAULSON: No. It's not --

REP. : Let me just say, Mr. Chairman, if I might: I actually have the article. And I would suggest it didn't imply anything. Again, it's an article, but it's an article from a reputable source.

It says very clearly -- and again, it's an article. That's why I caveat it right up front. I haven't had a chance to talk to the SEC about it. But it says it would permit American companies to shift to international rules, which are set by foreign organizations and give companies greater latitude in reporting earnings.

Now, that alone right there -- greater latitude in reporting earnings, after our Enron mess and other messes we have right now -- if that doesn't raise hackles on the back of your neck, I don't know what does. After all the work that you have done to try to stabilize the books and stabilize -- and again, I'm not saying the article is right. I'm simply saying, if that is correct, enable you to -- it goes on to say that it would enable companies, for example, to provide fewer details about mortgage-backed securities.

Now, if that's correct -- I don't know yet -- I hope that raises concern. If it's correct. If it's not correct, so be it. Again, I agree with the chairman. I don't necessarily accept anything wholehearted, even -- no matter how good the source. But those lines just in and of themselves in a relatively short article, raise major questions in my mind that with all the problems you have with mortgage-backed securities right now to then go into a regime now -- I'm not saying we shouldn't do it over time, thoughtfully, one step at a time. As you stabilize things, you can head towards convergence, I'm all for it. But if this is correct and they do it like this, I will tell you that I for one will have some major concerns, because I want you two to finish what you're doing to get us on more stable ground so that we can then look and continue to progress in our economic status.

SEC. PAULSON: You should definitely talk to Chairman Cox about this.

But the only thing I will say is that there are different accounting regimes that have different standards and different requirements. That doesn't make them worse then ours. We have had plenty of issues in our markets in our system with our accounting regime.

And so again, I think that the chairman's approach is to take other countries where they've got accounting systems or regimes, which he thinks have standards that are very similar to ours -- the highest standards -- and then allowing for this --

REP. FRANK: Let me say -- I'm going to wind this up. And I'm very appreciative of the time and you've stayed all the time and it's been helpful.

We have a hearing in two weeks with Chairman Cox and the president of the New York Federal Reserve, Mr. Geithner, to go over many of these same issues. And that, obviously, is something that we will expect Mr. Cox to be addressing.

I will just say for the purposes of members on the Democratic side and for staff or others who are listening, we will begin the questioning there with those who didn't get to ask a question today. As we will next week at Humphrey Hawkins -- we'll begin the questioning with those who didn't have a chance.

Two other substantive points I want to make. One, I disagree with the gentleman from California, Mr. Sherman. Obviously we have a different view here. I do not think that competitive bidding would have made any sense in the crisis atmosphere regarding Bear Stearns with BlackRock.

Secondly, I don't think that people thought this was the most desirable assignment ever set up. And three, to now disrupt what BlackRock is doing and put it out to -- I think would be very disruptive. So I think -- I would also add that the Government Operations Committee had requested some information about this, and the chairman of the Federal Reserve did respond very appropriately to their inquiry.

Secondly, I understand again the questions about urgency. Now, anyone -- I guess a lot of people believe in urgency in principle, but not on paper. And you can't be urgent in theory. You've got to be urgent with very specific legislation.

I do not believe it is even necessary or possible to deal with this complex set of issues with the appropriate degree of certainty or rest-assuredness and then to do it and then have to redo it or amend it a few months later I think would be a terrible idea.

So I think what we ought to -- but this is what I want to make very clear: No one should think that we here in the Congress are available for end runs. We have a situation where the SEC and the Federal Reserve and the Treasury and regulators will be putting together their various powers so that if crises arise, they can be met. I believe we have sufficient power now to get through the crisis. We don't have sufficient power, frankly, to avoid some of the crisis. And that, I think, is the distinction. We have the power to respond to different crises. What we are looking for are rules to make the crises less likely and I think that is a very high priority. We will begin working on this.

Were we to begin now -- frankly, if we were to decide to do it now, I don't think we can get it finished, just in terms of the complexity of the issues and the hearings and the bills in both houses. But we are going to start now. And I hope that early next year we will be able to complete it.

But I don't want anyone to think that there are somehow loopholes that they can run through and that they might get some cooperation here. I think we've all worked together very cooperatively when it comes to the crisis situation and I believe that we'll be able to continue to do that.

I thank the chairman and the secretary.

And the hearing is now adjourned.

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