Today, the Joint Economic Committee held a hearing entitled “Unregulated Markets: How Regulatory Reform Will Shine A Light in the Financial Sector.” The hearing examined how the financial sectors referred to as the “dark market,” the unregulated over-the-counter market, and lightly regulated mortgage markets contributed to the financial crisis.
Testifying before the Committee were the following individuals:
Brooksley Born, former Chair of the Commodity Futures Trading Commission
Robert Litan, Senior Fellow in Economic Studies, Brookings Institution, Vice President of Research and Policy at the Ewing Marion Kauffman Foundation, and member of the Task Force on Financial Reform
James Carr, Chief Operating Officer, National Community Reinvestment Coalition
Robert K. Steel, former Under Secretary for Domestic Finance, United States Treasury, chairman of the board of The Aspen Institute and a member of the Task Force on Financial Reform.
In her opening remarks Committee Chairwoman Carolyn Maloney (D-NY) asserted that the financial crisis was triggered in part by the highly unregulated over-the-counter derivatives (“OTC derivatives”) and credit default swap (“CDS”) market that, in the absence of regulation, created an “illusion that the assets [underlying such products] were risk-free.” She also noted that “[a]t its peak, this unregulated market was tied to $680 trillion in assets,” an amount equal to 50 times the U.S. GDP, placing the financial stability of the United States and the global economy at risk, and emphasized the need to adopt “common-sense regulation of the financial services industry to insure stability and safety of the system.”
Ms. Born stated that certain regulatory gaps, including a failure to regulate OTC derivatives, played a significant role in the financial crisis. She stated that, from the perspective of a former regulator, the lack of transparency and price discovery, excessive leverage, undue speculation, inadequate capital and prudential controls made the market “extremely dangerous.” Ms. Born stressed that the CFTC and the SEC should be granted primary “regulatory responsibilities” for the trading of derivatives both on and off exchanges. In addition, she noted that, with respect to futures and options, “all standardized and standardizable derivatives contract[s] should be traded on regulated derivatives exchanges and cleared through regulated derivatives clearing operations” with no exceptions.
Dr. Litan and Mr. Steel, both members of bipartisan Financial Reform Task Force, offered five principles that should be addressed in any comprehensive legislative reform:
- implement an early warning systemic risk system to prevent “inappropriate and dangerous financial practices from harming the economy”;
- adopt appropriate capital, liquidity and leverage requirements so that no financial institution going forward becomes “too big to fail”;
- put in place a single prudential regulator;
- strengthen present OTC derivatives markets and market discipline; and
- provide greater protection for consumers from financial abuses.
Mr. Steel further noted “that all financial institutions should be free to fail, but free to fail in [a] manner that will not destabilize the financial system.” Specifically the Task Force recommends that regulators require institutions above a certain size to submit “for approval a ‘funeral plan’ or ‘living will’” that will describe in detail how the financial institution, if it were to fail “could be wound-down, with reduced impact on the overall economy.” Mr. Carr focused mainly on the need for enhanced consumer protection, and spoke about the benefits of the Consumer Financial Protection Agency which he believes will increase the safety and soundness of the regulatory system.
Senator Sam Brownback (R-KS) stated that one of the key things that have come out of the crisis is recognition of the inability to handle financial institutions that are too big to fail and he asked the panelists to share their collective thoughts as to how best to restructure the regulatory system to better deal with potential future crises. With respect to OTC derivatives, Ms. Born stated that one of the problems was that such institutions are so interconnected that the failure of one would impact others. She stressed that bringing OTC derivative trading out of the preserve of big banks and onto exchanges and clearings houses would improve transparency and financial stability.
Congressman Elijah Cummings (D-MD) asked Ms. Born whether she felt the proposed House bill’s treatment of OTC derivatives went far enough. Ms. Born responded that the end user exemption from standardized contracts from exchange trading was unwise and stressed that all standardized contract should be required to be traded on exchanges. Congressman Kevin Brady (R-TX) asked the panel whether the CDS market posed a real problem to the stability of the financial markets. The panelist generally agreed that the CDS market played an important role in destabilizing the financial system due their speculative nature but that with appropriate regulation such risks could be minimized.
Congressman Maurice Hinchey (D-NY) asked the panelists what final recommendations they would make to Congress with respect to the proposed legislative reforms. Dr. Lutin emphasized that Congress should not oversell any legislative reforms since crises are frequent and cannot be prevented. At best he stated that passage of such legislation would reduce the frequency and severity of future crises. Mr. Carr stressed that, despite recent improvements in the financial system, lawmakers still need to remain focused on institution reforms to improve the financial regulatory framework.