Regulators Testify on Proposed Reforms

Bair, Dugan Offer Insights on Obama Plan A litany of legislators listened as federal banking regulators testified Friday on Capitol Hill over the proposed regulatory reforms for the financial services industry.

Testimony was heard from Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke, FDIC Chairman Sheila Bair, Comptroller of the Currency John Dugan, Office of Thrift Supervision acting Director John Bowman and Joseph Smith, North Carolina Commissioner of Banks. Here are excerpts from testimony given at the House Financial Services Committee hearing.

"The institutions who have this authority and have teams of dedicated, motivated people with that responsibility today -- they are not enthusiastic about giving up that authority. ... And I understand the obligation they feel. On the substance, though, these are very different types of responsibilities. Prudential supervision is different from consumer protection. ... Again, we've had a running national experiment ... and that did not turn out so well for us. So I think the basic point is -- I don't think there's a plausible defense of maintaining that current system in place today, although I understand why people who still preside over those authorities make the case to preserve them."

" The current financial crisis emerged after a long and remarkable period of growth and innovation. New instruments, such as over-the-counter (OTC) derivatives, allowed risks to be spread quickly and widely, enabling investors to diversify their portfolios in new ways and enabling banks and other companies to shed exposures that had once resided on their balance sheets.

"However, the OTC derivatives markets, which were thought to efficiently promote dispersion of risk to those most able to bear it, instead became a major channel of contagion through the financial sector in the crisis. When fear spread that any institution could fail, the markets for risk transfer and liquidity froze - making it difficult for all financial institutions to maintain daily operations.

"Two weeks ago, I testified at a joint hearing of this committee and the House Agriculture Committee on our comprehensive regulatory framework for the OTC derivatives markets. I outlined how our plan would provide strong regulation and transparency for all OTC derivatives regardless of whether the derivative is customized or standardized. In addition, I discussed how our plan will provide for strong supervision and regulation of all OTC derivative dealers and all other major participants in the OTC derivative markets."

"The notion of too big to fail creates a vicious circle that needs to be broken. Large firms are able to raise huge amounts of debt and equity and are given access to the credit markets at favorable terms without consideration of the firms' risk profile. Investors and creditors believe their exposure is minimal since they also believe the government will not allow these firms to fail. The large firms leverage these funds and become even larger, which makes investors and creditors more complacent and more likely to extend credit and funds without fear of losses. In some respects, investors, creditors, and the firms themselves are making a bet that they are immune from the risks of failure and loss because they have become too big, believing that regulators will avoid taking action for fear of the repercussions on the broader market and economy."

"The widespread economic damage that has occurred over the past two years has called into question the fundamental assumptions regarding financial institutions and their supervision that have directed our regulatory efforts for decades. The unprecedented size and complexity of many of today's financial institutions raise serious issues regarding whether they can be properly managed and effectively supervised through existing mechanisms and techniques. Our current system clearly failed in many instances to manage risk properly and to provide stability. Many of the systemically significant entities that have needed federal assistance were already subject to extensive federal supervision. For various reasons, these powers were not used effectively and, as a consequence, supervision was not sufficiently proactive.

"Insufficient attention was paid to the adequacy of complex institutions' risk management capabilities. Too much reliance was placed on mathematical models to drive risk management decisions. Notwithstanding the lessons from Enron, off-balance sheet-vehicles were permitted beyond the reach of prudential regulation, including holding company capital requirements. The failure to ensure that financial products were appropriate and sustainable for consumers caused significant problems not only for those consumers but for the safety and soundness of financial institutions. Lax lending standards employed by lightly regulated non-bank mortgage originators initiated a downward competitive spiral which led to pervasive issuance of unsustainable mortgages. Ratings agencies freely assigned AAA credit ratings to the senior tranches of mortgage securitizations without doing fundamental analysis of underlying loan quality. Trillions of dollars in complex derivative instruments were written to hedge risks associated with mortgage backed securities and other exposures. This market was, by and large, excluded from federal regulation by statute."

"Many of the current problems affecting the safety and soundness of the financial system were caused by a lack of strong, comprehensive rules against abusive lending practices applying to both banks and non-banks, and lack of a meaningful examination and enforcement presence in the non-bank sector. Products and practices that strip individual and family wealth undermine the foundation of the economy. As the current crisis demonstrates, increasingly complex financial products combined with frequently opaque marketing and disclosure practices result in problems, not just for consumers, but for institutions and investors as well. As the ultimate insurer of over $6 trillion in deposits, the FDIC has both the responsibility and vital need to ensure that consumer compliance and safety and soundness are appropriately integrated.

"To protect consumers from potentially harmful financial products, the Administration has proposed to establish a single primary federal consumer-products regulator, the Consumer Financial Protection Agency (CFPA). The CFPA would regulate providers of consumer credit, savings, payment and other financial products and services. Under the proposal, the agency would be the sole rule-making authority for consumer financial protection statutes and would have supervisory and enforcement authority over all providers of consumer credit. It would set a floor on consumer regulation and supervision and would guarantee the ability of states to adopt and enforce stricter laws for institutions of all types, regardless of charter.

"The proposal would eliminate regulatory gaps between insured depository institutions and non-bank providers of financial products and services by establishing strong, consistent consumer protection standards across the board. It also would address another gap by giving the CFPA authority to examine non-bank financial service providers that are not currently examined by the federal banking agencies. In addition, the Administration's proposal would eliminate the potential for regulatory arbitrage that exists because of federal preemption of certain State laws. By creating a floor for consumer protection and by allowing more protective State consumer laws to apply to all providers of financial products and services operating within a State, the CFPA should significantly improve consumer protection."

"Establishment of a Financial Stability Oversight Council. This council would consist of the Secretary of the Treasury and all of the federal financial regulators, and would be supported by a permanent staff. Its general role would be to identify and monitor systemic risk, and it would have strong authority to gather the information necessary for that mission, including from any entity that might pose systemic risk. We believe that having a centralized and formalized mechanism for gathering and sharing systemically significant information, and making recommendations to individual regulators, makes good sense.

"Enhanced authority to resolve systemically significant financial firms. The Federal Deposit Insurance Corporation (FDIC) currently has broad authority to resolve a distressed systemically significant depository institution in an orderly manner. No comparable resolution authority exists for large bank holding companies, or for systemically significant financial companies that are not banks, as we learned painfully with the problems of such large financial companies as Bear Stearns, Lehman Brothers, and AIG. The Proposal would extend resolution authority like the FDIC's to such nonbanking companies, while preserving the flexibility to use the FDIC or another regulator as the receiver or conservator, depending on the circumstances. This is a sound approach that would help maximize orderly resolutions of systemically significant firms."

About the Author

Linda McGlasson

Linda McGlasson

Managing Editor

Linda McGlasson is a seasoned writer and editor with 20 years of experience in writing for corporations, business publications and newspapers. She has worked in the Financial Services industry for more than 12 years. Most recently Linda headed information security awareness and training and the Computer Incident Response Team for Securities Industry Automation Corporation (SIAC), a subsidiary of the NYSE Group (NYX). As part of her role she developed infosec policy, developed new awareness testing and led the company's incident response team. In the last two years she's been involved with the Financial Services Information Sharing Analysis Center (FS-ISAC), editing its quarterly member newsletter and identifying speakers for member meetings.

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