Statement of
Sheila C. Bair, Chairman,
Federal Deposit Insurance Corporation On FDIC Oversight
Examining and Evaluating the Role
of the
Regulator during the Financial Crisis
and
Today before the House Subcommittee
On
Financial Institutions and Consumer Credit
2128 Rayburn House Office Building
May 26, 2011
Chairman Capito, thank you for the opportunity to testify today on the state of the
banking industry and the Federal Deposit Insurance Corporation, and on future
challenges to economic and financial stability.
Shortly after taking the oath as FDIC Chairman almost five years ago, I came to realize
that we would face significant challenges in a number of areas. Although the FDIC was
still in the midst of a two-and-a-half year period without a failed institution, the longest
such period in our history, there were signs that not all was well with the banking
industry. Predatory lending practices and unsuitable mortgage products, which were
already an area of focus for me at the Treasury Department when I served as Assistant
Secretary for Financial Institutions in 2001 and 2002, became even more prevalent as
the decade progressed. Rising concentration in the banking industry was leading to the
emergence of large, complex organizations that encompassed bank subsidiaries,
special-purpose vehicles, and nonbank affiliates, while a greater share of financial
activity was migrating to nonbank financial companies. Not only did these non- bank
affiliates and financial companies exist largely outside of the prudential supervision and
capital requirements that apply to federally insured depository institutions in the U.S.,
but they were also not subject to the FDIC's process for resolving failed insured financial
institutions through receivership. Meanwhile, many small and mid-sized banking
institutions had, over time, accumulated large concentrations of loans backed by
commercial real estate and construction projects that were vulnerable to a weakening of
U.S. real estate markets following a record boom in home prices.
Despite the warning signs, few at the time foresaw the extent of the emerging threat to
our financial stability-a threat that was realized in the fall of 2008 when we experienced
the worst financial crisis since the 1930s. While the emergency policy measures that
were put in place in late 2008 and early 2009 helped to prevent an even larger
catastrophe, the macroeconomic consequences of the financial crisis have been
enormous. Even as the danger to the banking industry begins to recede, we are faced
with the twin tasks of rebuilding our financial infrastructure on more solid ground and
implementing safeguards that will help to prevent a costly recurrence of this disaster.
Sheila C. Bair, Chairman,
Federal Deposit Insurance Corporation On FDIC Oversight
Examining and Evaluating the Role
of the
Regulator during the Financial Crisis
and
Today before the House Subcommittee
On
Financial Institutions and Consumer Credit
2128 Rayburn House Office Building
May 26, 2011
Chairman Capito, thank you for the opportunity to testify today on the state of the
banking industry and the Federal Deposit Insurance Corporation, and on future
challenges to economic and financial stability.
Shortly after taking the oath as FDIC Chairman almost five years ago, I came to realize
that we would face significant challenges in a number of areas. Although the FDIC was
still in the midst of a two-and-a-half year period without a failed institution, the longest
such period in our history, there were signs that not all was well with the banking
industry. Predatory lending practices and unsuitable mortgage products, which were
already an area of focus for me at the Treasury Department when I served as Assistant
Secretary for Financial Institutions in 2001 and 2002, became even more prevalent as
the decade progressed. Rising concentration in the banking industry was leading to the
emergence of large, complex organizations that encompassed bank subsidiaries,
special-purpose vehicles, and nonbank affiliates, while a greater share of financial
activity was migrating to nonbank financial companies. Not only did these non- bank
affiliates and financial companies exist largely outside of the prudential supervision and
capital requirements that apply to federally insured depository institutions in the U.S.,
but they were also not subject to the FDIC's process for resolving failed insured financial
institutions through receivership. Meanwhile, many small and mid-sized banking
institutions had, over time, accumulated large concentrations of loans backed by
commercial real estate and construction projects that were vulnerable to a weakening of
U.S. real estate markets following a record boom in home prices.
Despite the warning signs, few at the time foresaw the extent of the emerging threat to
our financial stability-a threat that was realized in the fall of 2008 when we experienced
the worst financial crisis since the 1930s. While the emergency policy measures that
were put in place in late 2008 and early 2009 helped to prevent an even larger
catastrophe, the macroeconomic consequences of the financial crisis have been
enormous. Even as the danger to the banking industry begins to recede, we are faced
with the twin tasks of rebuilding our financial infrastructure on more solid ground and
implementing safeguards that will help to prevent a costly recurrence of this disaster.
Today, as I prepare to wrap up my term as FDIC Chairman, I am pleased to have the
opportunity to discuss with you what I see as some of the most important causes of the
crisis, the steps that the FDIC took to deal with the problem, the reforms we are putting
in place to make our system less vulnerable to costly instability in the future, and some
of the broader policy challenges we must address to secure our economic future.
The Roots of the Financial Crisis
Much has been said and written about the causes of the financial crisis. In previous
testimony, I have described in some detail the combination of factors that led to the
crisis of 2008 and motivated the legislative reforms that are now being put in place.
Today, I would like to summarize these causes under four broad themes.
Excessive Reliance on Debt and Financial Leverage
A healthy system of credit intermediation, where the surplus of savings is channeled
toward its highest and best use by household and business borrowers, is critically
important to the modern economy. A starting point for understanding the causes of the
crisis and the changes that need to be made in our economic policies is recognition that
the U.S. economy has long depended too much on debt and financial leverage to
finance all types of economic activity.
In principle, debt and equity are substitute forms of financing for any type of economic
activity. However, owing to the inherently riskier distribution of investment returns facing
equity holders, equity is generally seen as a higher-cost form of financing. This
perceived cost advantage for debt financing is further enhanced by the standard tax
treatment of payments to debt holders, which are generally tax deductible, and equity
holders, which are not. In light of these considerations, there is a tendency in good
times for practically every economic constituency - from mortgage borrowers, to large
corporations, to startup companies and the financial institutions that lend to all of them -
to seek higher leverage in pursuit of lower funding costs and higher rates of return on
capital. What is frequently lost when calculating the cost of debt financing are the
external costs that are incurred when problems arise and borrowers cannot service the
debt. Credit defaults, which tend to occur with high frequency in economic downturns,
frequently lead to severe adjustments-including foreclosure, repossession, and
distressed asset sales-that impose very high costs on economic growth and our
financial system.
Thus, as demonstrated in the recent financial crisis, the social costs of debt financing
are significantly higher than the private costs. In good economic times, when few
borrowers are forced to default on their obligations, more economic activity can take
place at a lower cost of capital when debt is substituted for equity. However, the built-in
private incentives for debt finance have long been observed to result in periods of
excess leverage that contribute to a financial crisis. As Carmen Reinhart and Kenneth
Rogoff describe in their 2009 book This Time It's Different:
opportunity to discuss with you what I see as some of the most important causes of the
crisis, the steps that the FDIC took to deal with the problem, the reforms we are putting
in place to make our system less vulnerable to costly instability in the future, and some
of the broader policy challenges we must address to secure our economic future.
The Roots of the Financial Crisis
Much has been said and written about the causes of the financial crisis. In previous
testimony, I have described in some detail the combination of factors that led to the
crisis of 2008 and motivated the legislative reforms that are now being put in place.
Today, I would like to summarize these causes under four broad themes.
Excessive Reliance on Debt and Financial Leverage
A healthy system of credit intermediation, where the surplus of savings is channeled
toward its highest and best use by household and business borrowers, is critically
important to the modern economy. A starting point for understanding the causes of the
crisis and the changes that need to be made in our economic policies is recognition that
the U.S. economy has long depended too much on debt and financial leverage to
finance all types of economic activity.
In principle, debt and equity are substitute forms of financing for any type of economic
activity. However, owing to the inherently riskier distribution of investment returns facing
equity holders, equity is generally seen as a higher-cost form of financing. This
perceived cost advantage for debt financing is further enhanced by the standard tax
treatment of payments to debt holders, which are generally tax deductible, and equity
holders, which are not. In light of these considerations, there is a tendency in good
times for practically every economic constituency - from mortgage borrowers, to large
corporations, to startup companies and the financial institutions that lend to all of them -
to seek higher leverage in pursuit of lower funding costs and higher rates of return on
capital. What is frequently lost when calculating the cost of debt financing are the
external costs that are incurred when problems arise and borrowers cannot service the
debt. Credit defaults, which tend to occur with high frequency in economic downturns,
frequently lead to severe adjustments-including foreclosure, repossession, and
distressed asset sales-that impose very high costs on economic growth and our
financial system.
Thus, as demonstrated in the recent financial crisis, the social costs of debt financing
are significantly higher than the private costs. In good economic times, when few
borrowers are forced to default on their obligations, more economic activity can take
place at a lower cost of capital when debt is substituted for equity. However, the built-in
private incentives for debt finance have long been observed to result in periods of
excess leverage that contribute to a financial crisis. As Carmen Reinhart and Kenneth
Rogoff describe in their 2009 book This Time It's Different: