Statement of Sheila C. Bair, Chairman,
Federal Deposit Insurance Corporation
on the Causes and Current State of the Financial Crisis
before the
Financial Crisis Inquiry Commission;
Room 1100, Longworth House Office Building
January 14, 2010
Chairman Angelides, Vice Chairman Thomas and Commissioners, I appreciate the
opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on
the causes and current state of the financial crisis—the most severe financial crisis and
the longest and deepest economic recession since the Great Depression.
The last major financial crisis—the thrift and banking crisis of the 1980s—resulted in
enactment of two laws designed to improve the financial regulatory system: The
Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and
the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).
Combined, FIRREA and FDICIA significantly strengthened bank regulation, and
provided banks strong incentives to operate at higher capital levels with less risk, but
these regulations have also created incentives for financial services to grow outside of
the regulated sector.
In the 20 years following FIRREA and FDICIA, the shadow banking system grew much
more quickly than the traditional banking system, and at the onset of the crisis, it's been
estimated that half of all financial services were conducted in institutions that were not
subject to prudential regulation and supervision. Products and practices that originated
within the shadow banking system have proven particularly troublesome in this crisis. In
particular, the crisis has shown that many of the institutions in this sector grew to be too
large and complex to resolve under existing bankruptcy law and currently they cannot
be wound down under the FDIC's receivership authorities.
We are now poised to undertake far-reaching changes that will affect the regulation of
our entire financial system, including the shadow banking sector. Our reforms must
address the causes of the crisis, if we are to reduce as far as possible the chance that it
will recur. The financial crisis calls into question the fundamental assumptions regarding
financial supervision, credit availability, and market discipline that have informed our
regulatory efforts for decades. We must reassess whether financial institutions can be
properly managed and effectively supervised through existing mechanisms and
techniques.
Our approach must be holistic, giving regulators the tools to address risk throughout the
system, not just in those insured banks where we have long recognized that heightened
prudential supervision is necessary. To be sure, there can be improvements in the
oversight of insured institutions. And some banks themselves exploited the opportunity
for arbitrage by funding higher risk activity through third parties or in more lightly
regulated affiliates. As a consequence, if the thrust of reform is to simply layer more
Federal Deposit Insurance Corporation
on the Causes and Current State of the Financial Crisis
before the
Financial Crisis Inquiry Commission;
Room 1100, Longworth House Office Building
January 14, 2010
Chairman Angelides, Vice Chairman Thomas and Commissioners, I appreciate the
opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on
the causes and current state of the financial crisis—the most severe financial crisis and
the longest and deepest economic recession since the Great Depression.
The last major financial crisis—the thrift and banking crisis of the 1980s—resulted in
enactment of two laws designed to improve the financial regulatory system: The
Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and
the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).
Combined, FIRREA and FDICIA significantly strengthened bank regulation, and
provided banks strong incentives to operate at higher capital levels with less risk, but
these regulations have also created incentives for financial services to grow outside of
the regulated sector.
In the 20 years following FIRREA and FDICIA, the shadow banking system grew much
more quickly than the traditional banking system, and at the onset of the crisis, it's been
estimated that half of all financial services were conducted in institutions that were not
subject to prudential regulation and supervision. Products and practices that originated
within the shadow banking system have proven particularly troublesome in this crisis. In
particular, the crisis has shown that many of the institutions in this sector grew to be too
large and complex to resolve under existing bankruptcy law and currently they cannot
be wound down under the FDIC's receivership authorities.
We are now poised to undertake far-reaching changes that will affect the regulation of
our entire financial system, including the shadow banking sector. Our reforms must
address the causes of the crisis, if we are to reduce as far as possible the chance that it
will recur. The financial crisis calls into question the fundamental assumptions regarding
financial supervision, credit availability, and market discipline that have informed our
regulatory efforts for decades. We must reassess whether financial institutions can be
properly managed and effectively supervised through existing mechanisms and
techniques.
Our approach must be holistic, giving regulators the tools to address risk throughout the
system, not just in those insured banks where we have long recognized that heightened
prudential supervision is necessary. To be sure, there can be improvements in the
oversight of insured institutions. And some banks themselves exploited the opportunity
for arbitrage by funding higher risk activity through third parties or in more lightly
regulated affiliates. As a consequence, if the thrust of reform is to simply layer more
regulation upon insured banks, we will simply provide more incentives for financial
activity to be conducted in less-regulated venues and exacerbate the regulatory
arbitrage that fed this crisis. Reform efforts will once again be circumvented, as they
were in the decades following FIRREA and FDICIA.
My testimony will focus on the failure of market discipline and regulation, provide a
detailed chronology of events that led to the crisis and suggest reforms to prevent a
recurrence.
The Failure of Market Discipline and Regulation
Numerous problems in our financial markets and regulatory system have been identified
since the onset of the crisis. Most importantly, these include stimulative monetary
policies, significant growth of financial activities outside the traditional banking system,
the failure of market discipline to control such growth, and weak consumer protections.
Low interest rates encouraged consumer borrowing and excessive leverage in the
shadow banking sector. The limited reach of prudential supervision allowed these
activities to grow unchecked. Laws that protected consumers from abusive lending
practices were weak. Many did not extend to institutions outside of the regulated
banking sector.
Similarly, the FDIC's authorities for the orderly wind down of a failed bank did not apply
to activity outside of the insured depository. Financial firms grew in both size and
complexity to the point that, when the weaker institutions became distressed, there was
no legal means to wind them down in an orderly manner without creating systemic risks
for the broader system. As a result of their too-big-to-fail status, these firms were funded
by the markets at rates that did not reflect the risks these firms were taking.
This growth in risk manifested itself in many ways. Overall, financial institutions were
only too eager to originate mortgage loans and securitize them using complex
structured debt securities. Investors purchased these securities without a proper risk
evaluation, as they outsourced their due diligence obligation to the credit rating
agencies. Consumers refinanced their mortgages, drawing ever more equity out of their
homes as residential real estate prices grew beyond sustainable levels. These
developments were made possible by a set of misaligned incentives among and
between all of the parties to the securitization process—including borrowers, loan
originators, credit rating agencies, loan securitizers, and investors.
The size and complexity of the capital-market activities that fueled the credit boom
meant that only the largest financial firms could package and sell the securities. In
addition to the misaligned incentives in securitizations, differences in the regulation of
capital, leverage, and consumer protection between institutions in the shadow banking
system and the traditional banking sector, and the almost complete lack of regulation of
over-the-counter derivatives, allowed rampant regulatory arbitrage to take hold.
Many of the products and services of the non-bank financial institutions that comprised
the shadow banking system competed directly with those provided in the traditional
activity to be conducted in less-regulated venues and exacerbate the regulatory
arbitrage that fed this crisis. Reform efforts will once again be circumvented, as they
were in the decades following FIRREA and FDICIA.
My testimony will focus on the failure of market discipline and regulation, provide a
detailed chronology of events that led to the crisis and suggest reforms to prevent a
recurrence.
The Failure of Market Discipline and Regulation
Numerous problems in our financial markets and regulatory system have been identified
since the onset of the crisis. Most importantly, these include stimulative monetary
policies, significant growth of financial activities outside the traditional banking system,
the failure of market discipline to control such growth, and weak consumer protections.
Low interest rates encouraged consumer borrowing and excessive leverage in the
shadow banking sector. The limited reach of prudential supervision allowed these
activities to grow unchecked. Laws that protected consumers from abusive lending
practices were weak. Many did not extend to institutions outside of the regulated
banking sector.
Similarly, the FDIC's authorities for the orderly wind down of a failed bank did not apply
to activity outside of the insured depository. Financial firms grew in both size and
complexity to the point that, when the weaker institutions became distressed, there was
no legal means to wind them down in an orderly manner without creating systemic risks
for the broader system. As a result of their too-big-to-fail status, these firms were funded
by the markets at rates that did not reflect the risks these firms were taking.
This growth in risk manifested itself in many ways. Overall, financial institutions were
only too eager to originate mortgage loans and securitize them using complex
structured debt securities. Investors purchased these securities without a proper risk
evaluation, as they outsourced their due diligence obligation to the credit rating
agencies. Consumers refinanced their mortgages, drawing ever more equity out of their
homes as residential real estate prices grew beyond sustainable levels. These
developments were made possible by a set of misaligned incentives among and
between all of the parties to the securitization process—including borrowers, loan
originators, credit rating agencies, loan securitizers, and investors.
The size and complexity of the capital-market activities that fueled the credit boom
meant that only the largest financial firms could package and sell the securities. In
addition to the misaligned incentives in securitizations, differences in the regulation of
capital, leverage, and consumer protection between institutions in the shadow banking
system and the traditional banking sector, and the almost complete lack of regulation of
over-the-counter derivatives, allowed rampant regulatory arbitrage to take hold.
Many of the products and services of the non-bank financial institutions that comprised
the shadow banking system competed directly with those provided in the traditional