Yesterday, the U.S. Senate Committee on Homeland Security and Governmental Affairs held a hearing entitled “Where Were the Watchdogs? Systemic Risk and Breakdown in Financial Governance.” Testifying before the Committee were the following witnesses:

  • Robert E. Litan, Vice President for Research and Policy, Ewing Marion Kauffman Foundation and Senior Fellow at the Brookings Institution
  • Damon A. Silvers, Deputy Chair, Congressional Oversight Panel and Associate General Counsel, The American Federation of Labor – Congress of Industrial Organizations (AFL-CIO)
  • Robert C. Pozen, Chairman, MFS Investment Management (and former Chair of the SEC's Advisory Committee on Improvements to Financial Reporting)

The hearing focused on “ways to reform the federal financial regulatory system to ensure that systemic risks would be identified and addressed before they cause severe damage to the economy.” This hearing was the second in a series set to examine the framework of the nation’s financial and regulatory system. In particular the witnesses’ testimonies “focused on the current system’s inability to identify and manage risks that occur across different types of institutions, markets, and activities and that broadly threaten the financial system.” With respect to the present financial crisis, Committee Chairman Joe Lieberman (IND-CT) stated that the U.S. financial regulatory system needs “a watchdog with a universal perspective, a complete picture of the variety of institutions and activities that pose the greatest risks to our economy.” Ranking Member Susan Collins (R-ME) said that “[o]versight gaps in our existing financial regulatory system, risky financial instruments with little or no regulatory oversight, and a lack of attention to systemic risk have undermined confidence in our financial markets.” She further noted that “[w]hile there are many regulators in our current system, not one of them has the ability to evaluate risk across the entire system.” She also emphasized that “[t]he drastic and expensive bailouts financed by the American taxpayer might not have occurred had there been a monitor charged with evaluating risk to the financial system as a whole.”

One witness defined systemic risk “as the risk of a broad-based breakdown in the financial system.” The witnesses generally agreed that a failure to monitor systemic risk contributed to the present crisis. While the witnesses all agreed that there was a clear need for monitoring and responding to systemic risk, there was much disagreement as to whether creating a framework to regulate systemic risk was best accomplished by expanding the mandate of one or more pre-existing regulatory bodis or by establishing a new agency. Mr. Silvers strongly advocated that several key regulators should address systemic risk and not just one institution. He noted that creating the framework of an inter-agency regulatory system would enable the free flow of information and expertise.

Mr. Pozen stated that the United States should have one federal agency to regulate systemic risk and that this role should be granted to the Federal Reserve, mainly because it is responsible for providing liquidity support to struggling financial institutions and “has a substantial portion of the resources and expertise necessary to monitor risks” in the financial system. However, Mr. Pozen cautioned that the Federal Reserve should not serve as the primary regulator of large hedge funds or other non-banking institutions. He also recommended that the Federal Reserve, in its capacity as a systemic risk regulator, monitor the following five areas that are sources of systemic risk: “inflated prices of real estate, institutions with high levels of leverage, new products falling into regulatory gaps, rapid growth in an asset class or intermediary and mismatches of assets and liabilities.” Mr. Litan agreed that the Federal Reserve should be tasked with the primary responsibility of regulating systemic risk, while acknowledging that there are challenges in tasking an agency with the “responsibility of reducing systemic risk.” However, he emphasized that there must be a designated arm of the government to oversee systemic risk.

Chairman Lieberman indicated that “the Committee would eventually make recommendations to the Senate Banking Committee as to the most effective organizational structure for regulation and oversight of the nation’s financial system.”