On Thursday, the Financial Crisis Inquiry Commission (FCIC) held the second of a two-day hearing entitled “Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis.” Testifying before the FCIC were the following witnesses:  

Session 1: The Federal Reserve

Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System

 Session 2: Federal Deposit Insurance Corporation

Shelia C. Bair, Chairman, Federal Deposit Insurance Corporation

FCIC Chairman Phil Angelides opened the hearing by explaining the need to examine institutions deemed “too big, too important and too systemic to fail.” Chairman Bernanke provided an overview of the factors underlying the financial crisis, the obstacles to public officials’ management of the crisis, and monetary policy actions during the period leading up to the crisis. He acknowledged his failure to recognize the impact of the subprime mortgage crisis, noting that “what I did not recognize was the extent to which the system had flaws and weaknesses in it that were going to amplify the shock from subprime and make it into a much bigger crisis.” While maintaining that the Federal Reserve had not fostered the housing bubble by preserving low interest rates in 2002 through 2004, he conceded that the housing crisis was like the E. coli bacteria. “E-coli got into the food system, and it created a much bigger problem.... There was an awful lot of dependence on short-term, unstable funding, which is analogous to the deposits in banks before the period of deposit insurance.”  

When asked by Mr. Angelides if the Federal Reserve failed to use its existing authority earlier to regulate mortgage and lending practices, Mr. Bernanke replied “I think it was the most severe failure of the Fed in this particular episode.” Bernanke stressed that the biggest lesson of the crisis is that the too-big-to-fail issue must be resolved, noting the importance of tougher rules and market pressures to encourage large institutions to reduce their size. In order to achieve sustained economic growth as well as stability, Bernanke cited the need for “a framework which promotes the appropriate mix of prudence, risk-taking and innovation in our financial system.” Bernanke then addressed the failure of Lehman Brothers, stating that “it was with great reluctance and sadness that I conceded there was no other option.” Asked how the Lehman failure differed from that of AIG, which received $182 billion in taxpayer aid, Mr. Bernanke noted that while AIG had valuable assets to serve as collateral for the government loan ensuring that the Federal Reserve “will absolutely be paid back,” Lehman Brothers lacked the collateral to secure a similar loan.  

Chairman Bair addressed the panel next, echoing Mr. Bernanke’s emphasis on the importance of ending “too-big-to fail.” She noted that the FDIC is creating an interim rule to assist large financial institutions faced with failure, noting that under the new legislation regulators have the ability to break up financial firms if they fail to perform during times of crises. Ms. Bair also stressed the need to adopt increased capital requirements and encouraged the Basel Committee on Banking Supervision to adopt tougher standards. Ms. Bair told the panel that the “stakes are high” for regulators to exercise their new powers under Dodd-Frank. If regulators fail to use these regulatory tools, she said that “we will have forfeited this historic chance to put our financial system on a sounder and safer path in the future.”