Yesterday, the Senate Committee on Banking, Housing, and Urban Affairs held a hearing entitled “Establishing a Framework for Systemic Risk Regulation.” Testifying before the Committee were:

Panel I

Panel II

Chairman Bair cautioned Committee members against taking action that may prevent non-viable firms from failing, stating that “the notion of too big to fail creates a vicious circle that needs to be broken.” Alternatively, Bair supported a “regime that provides for the orderly wind-down of large, systemically important financial firms without imposing large costs to the taxpayers.” She highlighted the need for a single entity in this regime that would ensure transparency, the minimization of costs and the maximization of recoveries, manage risk exposure, and allow continuation of operations that are deemed systemically significant. She suggested that Congress create “incentives that reduce the size and complexity of financial institutions,” and argued that systemically important firms should face higher capital and liquidity requirements. Bair generally supported the Administration’s proposal for an Financial Stability Oversight Council, but noted that the current proposal “lacks sufficient authority to address systemic risks.” She questioned the suggested role of the Secretary of the Treasury as Chairman of the Oversight Council, preferring a separate Presidential appointee that would be better insulated from political influence.

Chairman Schapiro noted the existence of two kinds of systemic risk: “the risk of sudden, near-term systemic seizures or cascading failures” and “the longer term risk that our system will unintentionally favor large systemically important institutions over smaller, more nimble competitors.” She also pointed to two types of systemic risk regulation: “the traditional oversight, regulation, market transparency and enforcement provided by primary regulators” and “macro-prudential regulation designed to identify and minimize systemic risk.” To best address both types of systemic risk, Schapiro supported closing gaps in regulation, improving transparency, strengthening enforcement, creating a “single Systemic Risk Regulator with clear authority and accountability," the creation of an Oversight Council. She echoed Chairman Bair in calling for a “credible resolution mechanism for unwinding systemically important institutions.” “Structured correctly, such a regime could force market participant to realize the full costs of their decisions and help reduce the too-big-to-fail dilemma.”

Mr. Tarullo identified five “key administrative and legislative elements” that should be included in Congress’ systemic risk agenda:

  1. Ensuring that systemically important institutions are adequately supervised;
  2. A macro-prudential outlook that considers the financial industry as a whole, in addition to individual institutions;
  3. More effective mechanisms for identifying, monitoring and addressing potential and emerging systemic risks;
  4. A new resolution process for the winding-down of non-bank financial institutions; and
  5. Consistent oversight and prudential standards for payment, clearing and settlement systems.

He noted that expanding the role of the Federal Reserve to ensure the overall health of the financial system is a natural extension of its existing powers, claiming that “there are some important synergies between systemic risk regulation and monetary policy, as insights garnered from each of those functions informs the performance of the other.” Tarullo also argued for an expanded role for existing agencies and departments, including the Treasury, SEC, CFTC and FDIC.

Ms. Rivlin argued that an effective system of risk prevention and management must be based on an understanding of the three primary roots of the financial crisis: the lack of a single entity tasked with identifying systemic risk, an expansive monetary policy and excessive leverage, and excessive risk-taking by systemically important institutions. She called for an agency with “specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures,” tasking the Federal Reserve with responsibility for “Macro System Stability,” and requiring the Federal Reserve to periodically report to Congress and a Financial Stability Oversight Council.

Prof. Meltzer noted that the Federal Reserve has never “acted in advance to head off a crisis or a series of banking or financial failures.” He also noted that the Federal Reserve has never officially announced a “lender of last resort policy.” He asked Committee members “whether bankers or regulators are more likely to know about the risks on a bank’s balance sheet,” and suggested that “reform should start by increasing a banker’s responsibility for losses.”

Mr. Reinhart called complexity “the bane of our financial system,” arguing that any framework for addressing systemic risk should center on simplicity. He argued for the consolidation of existing federal financial regulators and the assumption of state responsibilities. Reinhart also supported a comprehensive simplification of accounting rules and the tax code. He cautioned against an expanded role for the Federal Reserve, noting a history of failing to prevent and identify sources of risk. Absent “radical simplification,” he supported a scheme whereby supervision of financial stability “be delegated to a committee of existing financial supervisors,” including the Federal Reserve, the FDIC, the SEC, and the CFTC.

Mr. Stevens suggested that the creation of a systemic risk regulator is key, but said that any regulation establishing such an entity “should be crafted to avoid imposing undue constraints or inapposite forms of regulation on normally functioning elements of the financial system.” He criticized the Administration’s suggested role for the Federal Reserve, fearing that it “could jeopardize the Federal Reserve’s ability to conduct monetary policy with the requisite degree of independence.” Stevens also suggested that the creation of an Oversight Council should include members with a “broad base of expertise, including the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve, the Chairman of the SEC, the Chairman of the CFTC, the Comptroller of the Currency, the Chairman of the FDIC and the head of a potential future federal insurance regulator.