The House Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises held a hearing yesterday regarding perspectives on systemic risk in the financial system. Witnesses and prepared testimony at the hearing included:

  • Orice Williams, Director, Financial Markets and Community Investment, Government Accountability Office
  • Richard H. Baker, President and Chief Executive Officer, Managed Funds Association
  • Steve Bartlett, President and Chief Executive Officer, The Financial Services Roundtable
  • Therese Vaughan, Chief Executive Officer, National Association of Insurance Commissioners
  • Robert A. DiMuccio, President and Chief Executive Officer, Amica Mutual Group
  • T. Timothy Ryan, Jr., President and Chief Executive Officer, Securities Industry and Financial Markets Association and former Director, Office of Thrift Supervision

Congressman Paul E. Kanjorski (D-PA), Chairman of the Subcommittee, noted that the collapse of several actors in the financial industry, including Long-Term Capital Management, Bear Stearns, and Lehman Brothers, and the government assistance provided to American International Group (AIG) “are just a few examples of how the financial services industry can create systemic risk that endangers the broader economy and affects the daily lives of average Americans.” He continued by noting that “[m]any of our financial institutions have become too-big-to-fail or too-interconnected-to fail, and we need to protect the American economy from the whirlpool of risks that they pose by putting in place a systemic risk regulator with vigorous powers and a strong mandate[.]”

Ms. Williams’ testimony centered on a recent GAO report requested by the Financial Services Committee on credit default swaps (CDS) and their impact on the financial markets crisis. She noted that a majority of the products and entities involved with over-the-counter CDS are unregulated, but that the products interlink multiple entities, and multiple categories of entities, such that CDS failures impact the market as a whole. The interlinking of multiple parties across multiple industries, both regulated and unregulated, creates the need to have a system-wide regulator to accurately gauge the systemic risk inherent in CDS and similar products.

Mr. Baker, a former chairman of the Subcommittee and now representing the majority of the world’s largest hedge funds, noted that hedge funds provide liquidity and price-finding functions to the financial market. In order to be effective, Mr. Baker believes that systemic risk regulation should be embodied in a single regulator because a multiple-regulator system will create inefficient overlaps or gaps in coverage.

Mr. Bartlett noted that the vast majority of the current regulatory system is the product of patchwork legislation and regulation at the state and federal level. He suggested that the Federal Reserve should be empowered to work through the current state and federal prudential regulators to address systemic risk. He also advocated providing a federal insurance charter, with corresponding federal regulator, for those insurance companies providing products in multiple states in order to gather information on a uniform basis.

Dr. Vaughan noted that the current state-based regulatory system is a series of checks and balances that has operated effectively to date. She stated that enhanced systemic risk regulation should build on the current regulatory regime, and that state insurance regulators recognize the need for a federal systemic risk regulator, but should not be preempted by a federal insurance regulator.

Mr. DiMuccio defined the existence of systemic risk occurring when the federal government is required to step in to ameliorate the effects of the conduct or actions of one entity. “Too big to fail” means the degree to which one entity’s activities are significantly intertwined in the economy or a market. Mr. DiMuccio believes that authority to oversee systemic risk in the financial sector should be placed in the Federal Reserve as a separate function from its current oversight powers.

Mr. Ryan stated that systemic risk is at the heart of current financial crisis and that SIFMA has spent considerable time and resources to identify and mitigate systemic risk. He also expressed the view that there was consensus around the need for a financial market stability regulator with authority over all entities in the financial markets, regardless of functional regulator, charter, or current status as a regulated or unregulated entity.

Follow-up questions to the witnesses centered on what a systemic risk regulator would look like and whether an agency like the Federal Reserve could take on such a role. Most witnesses appeared to be comfortable with an entity like the Federal Reserve taking on a systemic risk oversight role, working through and with the current prudential regulators, and filling the “gaps” in the current framework, such as the regulatory oversight of CDS.

Other lines of inquiry dealt with the collapse of AIG and the question of whether companies should be limited in size so as to prevent entities that are “too big to fail.” Responses from the witnesses indicated that large, complex financial institutions are necessary to provide complex financial products to the market and that arbitrarily limiting their size would not be a tenable solution. The real problem, it was suggested, was that holding company regulators for these complex institutions only look at the unregulated subsidiaries when they perceive that the subsidiary poses a threat to the larger organization. Without regular examinations of unregulated subsidiaries, it is unlikely that regulators would be able to identify a threat before it manifests itself—likely already causing harm to the holding company. In this regard, then, it was proposed that a systemic regulator, working through the holding company regulator, would be able to review the entire structure of the complex institution and determine the level in which the institution’s activities pose a systemic risk and fill gaps in the current regulatory framework.