Statement of
Sheila C. Bair Chairman,
Federal Deposit Insurance Corporation
On
Establishing a Framework for Systemic Risk Regulation
before the
Committee on Banking, Housing and Urban Affairs,
U.S. Senate; Room 534,
Dirksen Senate Office Building
July 23, 2009
Chairman Dodd, Ranking Member Shelby and members of the Committee, I appreciate
the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC)
on the importance of reforming our financial regulatory system. The issues under
discussion today rival in importance those before the Congress in the wake of the Great
Depression.
The proposals put forth by the Administration regarding the structure of the financial
system, the supervision of financial entities, the protection of consumers, and the
resolution of organizations that pose a systemic risk to the economy provide a useful
framework for discussion of areas in vital need of reform. However, these are complex
issues that can be addressed in a number of different ways. We all agree that we must
get this right and enact regulatory reforms that address the fundamental causes of the
current crisis within a carefully constructed framework that guards against future crises.
It is clear that one of these causes was the presence of significant regulatory gaps
within the financial system. Differences in the regulation of capital, leverage, complex
financial instruments, and consumer protection provided an environment in which
regulatory arbitrage became rampant. Reforms are urgently needed to close these
regulatory gaps.
At the same time, we must recognize that much of the risk in recent years was built up,
within and around, financial firms that were already subject to extensive regulation and
prudential supervision. One of the lessons of the past several years is that regulation
and prudential supervision alone are not sufficient to control risk-taking within a dynamic
and complex financial system. Robust and credible mechanisms to ensure that market
participants will actively monitor and control risk-taking must be in place.
We must find ways to impose greater market discipline on systemically important
institutions. In a properly functioning market economy there will be winners and losers,
and when firms -- through their own mismanagement and excessive risk taking – are no
longer viable, they should fail. Actions that prevent firms from failing ultimately distort
market mechanisms, including the market's incentive to monitor the actions of similarly
situated firms. Unfortunately, the actions taken during the past year have reinforced the
idea that some financial organizations are too big to fail. The solution must involve a
Sheila C. Bair Chairman,
Federal Deposit Insurance Corporation
On
Establishing a Framework for Systemic Risk Regulation
before the
Committee on Banking, Housing and Urban Affairs,
U.S. Senate; Room 534,
Dirksen Senate Office Building
July 23, 2009
Chairman Dodd, Ranking Member Shelby and members of the Committee, I appreciate
the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC)
on the importance of reforming our financial regulatory system. The issues under
discussion today rival in importance those before the Congress in the wake of the Great
Depression.
The proposals put forth by the Administration regarding the structure of the financial
system, the supervision of financial entities, the protection of consumers, and the
resolution of organizations that pose a systemic risk to the economy provide a useful
framework for discussion of areas in vital need of reform. However, these are complex
issues that can be addressed in a number of different ways. We all agree that we must
get this right and enact regulatory reforms that address the fundamental causes of the
current crisis within a carefully constructed framework that guards against future crises.
It is clear that one of these causes was the presence of significant regulatory gaps
within the financial system. Differences in the regulation of capital, leverage, complex
financial instruments, and consumer protection provided an environment in which
regulatory arbitrage became rampant. Reforms are urgently needed to close these
regulatory gaps.
At the same time, we must recognize that much of the risk in recent years was built up,
within and around, financial firms that were already subject to extensive regulation and
prudential supervision. One of the lessons of the past several years is that regulation
and prudential supervision alone are not sufficient to control risk-taking within a dynamic
and complex financial system. Robust and credible mechanisms to ensure that market
participants will actively monitor and control risk-taking must be in place.
We must find ways to impose greater market discipline on systemically important
institutions. In a properly functioning market economy there will be winners and losers,
and when firms -- through their own mismanagement and excessive risk taking – are no
longer viable, they should fail. Actions that prevent firms from failing ultimately distort
market mechanisms, including the market's incentive to monitor the actions of similarly
situated firms. Unfortunately, the actions taken during the past year have reinforced the
idea that some financial organizations are too big to fail. The solution must involve a
practical, effective and highly credible mechanism for the orderly resolution of these
institutions similar to that which exists for FDIC-insured banks. In short, we need an end
to too big to fail.
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.
If anything is to be learned from this financial crisis, it is that market discipline must be
more than a philosophy to ward off appropriate regulation during good times. It must be
enforced during difficult times. Given this, we need to develop a resolution regime that
provides for the orderly wind-down of large, systemically important financial firms,
without imposing large costs to the taxpayers. In contrast to the current situation, this
new regime would not focus on propping up the current firm and its management.
Instead, under the proposed authority, the resolution would concentrate on maintaining
the liquidity and key activities of the organization so that the entity can be resolved in an
orderly fashion without disrupting the functioning of the financial system. Losses would
be borne by the stockholders and bondholders of the holding company, and senior
management would be replaced. Without a new comprehensive resolution regime, we
will be forced to repeat the costly, ad hoc responses of the last year.
My testimony discusses ways to address and improve the supervision of systemically
important institutions and the identification of issues that pose risks to the financial
system. The new structure should address such issues as the industry's excessive
leverage, inadequate capital and over-reliance on short-term funding. In addition, the
regulatory structure should ensure real corporate separateness and the separation of
the bank's management, employees and systems from those affiliates. Risky activities,
such as proprietary and hedge fund trading, should be kept outside of insured banks
and subject to enhanced capital requirements.
Although regulatory gaps clearly need to be addressed, supervisory changes alone are
not enough to address these problems. Accordingly, policymakers should focus on the
elements necessary to create a credible resolution regime that can effectively address
the resolution of financial institutions regardless of their size or complexity and assure
that shareholders and creditors absorb losses before the government. This mechanism
is at the heart of our proposals -- a bank and bank holding company resolution facility
that will impose losses on shareholders and unsecured debt investors, while
maintaining financial market stability and minimizing systemic consequences for the
national and international economy. The credibility of this resolution mechanism would
institutions similar to that which exists for FDIC-insured banks. In short, we need an end
to too big to fail.
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.
If anything is to be learned from this financial crisis, it is that market discipline must be
more than a philosophy to ward off appropriate regulation during good times. It must be
enforced during difficult times. Given this, we need to develop a resolution regime that
provides for the orderly wind-down of large, systemically important financial firms,
without imposing large costs to the taxpayers. In contrast to the current situation, this
new regime would not focus on propping up the current firm and its management.
Instead, under the proposed authority, the resolution would concentrate on maintaining
the liquidity and key activities of the organization so that the entity can be resolved in an
orderly fashion without disrupting the functioning of the financial system. Losses would
be borne by the stockholders and bondholders of the holding company, and senior
management would be replaced. Without a new comprehensive resolution regime, we
will be forced to repeat the costly, ad hoc responses of the last year.
My testimony discusses ways to address and improve the supervision of systemically
important institutions and the identification of issues that pose risks to the financial
system. The new structure should address such issues as the industry's excessive
leverage, inadequate capital and over-reliance on short-term funding. In addition, the
regulatory structure should ensure real corporate separateness and the separation of
the bank's management, employees and systems from those affiliates. Risky activities,
such as proprietary and hedge fund trading, should be kept outside of insured banks
and subject to enhanced capital requirements.
Although regulatory gaps clearly need to be addressed, supervisory changes alone are
not enough to address these problems. Accordingly, policymakers should focus on the
elements necessary to create a credible resolution regime that can effectively address
the resolution of financial institutions regardless of their size or complexity and assure
that shareholders and creditors absorb losses before the government. This mechanism
is at the heart of our proposals -- a bank and bank holding company resolution facility
that will impose losses on shareholders and unsecured debt investors, while
maintaining financial market stability and minimizing systemic consequences for the
national and international economy. The credibility of this resolution mechanism would