Today, the House Financial Services Committee held a hearing to gather insight from financial experts on the best means of managing systemic risk. In his introductory remarks framing the hearing, Committee Chairman Frank (D-MA), noted the "universal dislike" for the "too big to fail" doctrine, under which large, interconnected firms are protected from failure because of their size. He said he hoped those testifying would offer measures they thought could be taken to effectively respond when a systemically important entity was at risk.
Testifying before the Committee were the following witnesses:
- Paul Volcker, Former Chairman of the Board of Governors of the Federal Reserve System
- Arthur Levitt, Jr., Former Chairman of the United States Securities and Exchange Commission, Senior Advisor, The Carlyle Group
- Jeffrey A. Miron, Senior Lecturer and Director of Undergraduate Studies, Department of Economics, Harvard University
- Mark Zandi, Chief Economist, Moody’s Economy.com
- John H. Cochrane, AQR Capital Management Professor of Finance, The University of Chicago Booth School of Business
Mr. Volcker was generally critical of the Obama administration’s proposal to have firms designated as systemically important in advance, arguing that it could lead to additional bailouts by establishing an expectation of government intervention. He also said that the proposal would face criticism from the designated firms themselves: in poor economic conditions, firms would seek to be designated as systemically important, while in favorable conditions, they would complain about the additional oversight.
Instead, he advocated a "more traditional view" focusing on protection of commercial banks, which he described as "the indispensable backbone of the financial system[.]" It should be made clear, he said, that only traditional banks would have the support of the Federal Reserve "safety net." When asked by Rep. Watt (D-NC) how his proposal was different than the current system, Mr. Volcker responded, "I’m not recommending anything particularly different so far as banks are concerned. . . . What’s different is [that] . . . some of the benefits of the safety net have been extended outside of the banking system. That’s what I want to change."
Mr. Volcker expressed his support for new regulation of commercial banks since they would be the only entities eligible for taxpayer funds under his proposal. For example, he said that commercial banks should not be able to engage in riskier activities like ownership or sponsorship of hedge funds or private equity funds, and he also advocated limits on commercial banks’ proprietary trading activities.
Another theme of Mr. Volcker’s testimony was his support for the Federal Reserve as the appropriate entity to monitor systemic risk. He rejected suggestions that the Federal Reserve was taking on too many responsibilities, or that its monetary policy and bank supervisory functions should be separated. In his view, the two issues are interrelated, and "cross pollination" between these functions would benefit both. In his prepared remarks, he said that, "The Federal Reserve Board should not become an academic seminar debating in its marble palace various approaches toward monetary policy without the leavening experience of direct contact with, and responsibility for, the world of finance and the institutions through which monetary policy is effected."
With respect to the insolvencies of systemically important non-bank institutions, Mr. Volcker expressed his support for the Obama administration’s call for a new "resolution regime" under which a conservator would have emergency powers to take control. Mr. Volcker acknowledged that such a system would take the place of the bankruptcy system, but supported it nonetheless in "exceptional and particular circumstances of a systemic breakdown." Rep. Capito (R-WV) questioned if an "enhanced bankruptcy" proceeding proposed by Republican lawmakers would be a viable alternative to a "resolution regime." Mr. Volcker affirmed his support for the "resolution regime," citing the urgency needed in the case of a systemic emergency.
The other panelists were questioned as a group following a short recess by the Committee. Mr. Levitt cautioned against making the Federal Reserve the sole systemic risk regulator, arguing that under its current structure, inevitable conflicts would arise because of its monetary policy duties. Mr. Levitt also urged the Committee to focus on which entity would be responsible for winding down failed institutions as opposed to concentrating only on which entity would oversee systemic risk.
Among his remarks, Mr. Miron, a libertarian scholar, criticized proposed legislation that would grant the FDIC authority to resolve certain non-bank financial institutions, and stated his belief that the current bankruptcy system was capable of handling the insolvencies of systemically important institutions.
In contrast, Mr. Zandi, argued that the bankruptcy process "can be protracted and vary by jurisdiction . . . [and] thus is not suitable for resolving large, complex financial firms that get into trouble." Citing its experience overseeing insolvent depository institutions, Mr. Zandi proposed empowering the FDIC under the new "resolution regime."
Mr. Cochrane suggested a number of measures that might be taken to improve systemic risk management, including his preference for a "too big to exist" doctrine. Under such a regime, he said, the government would "think carefully about the minimal set of activities that cannot be allowed to fail and must be guaranteed . . . [and would] commit not to bail out the rest." He believes that such an approach would better incentivize private parties to prepare for, and work against, their own failure.