By W. Bernard Mason
We seem to be awash in media reports touting the return to health for the nation’s largest financial institutions. Another year of big profits and big bonuses is well underway for these firms. Much of this success can be attributed to the emergency programs implemented by the federal government within the past year. As The New York Times recently pointed out, “Many of the steps that policy makers took last year to stabilize the financial system – reducing interest rates to near zero, bolstering big banks with taxpayer money, guaranteeing billions of dollars of financial institutions’ debts “ helped bring about this robust return.
These same Washington policymakers now seem to be puzzled over the fact that, while the big banks are even bigger and stronger, there still seems to be a lack of available credit for “Main Street.” At virtually every Congressional hearing on the subject of banking reform, at least one lawmaker laments that his/her constituents continue to complain about the lack of consumer and small business lending activity.
Recalling what now seems ancient history, TARP was sold to Congress as a way to stabilize the markets and bring liquidity back to credit functions. We know what ultimately occurred: capital contributions to the largest institutions with little accountability for fund use to increase lending. With a couple of notable exceptions, we also know these funds have been repaid to the Treasury with interest. However, there was no significant increase in the availability of credit for consumers and small businesses as a result of this effort.
When a U.S. Senator most recently asked the now familiar question regarding lack of credit availability, FDIC Chairman Sheila Bair responded by noting that there had been “100% participation” in the TARP by the largest U.S. Banks, whereas only 9% of all other banks had received TARP funding. She stated that community banks are disproportionately the source of credit for small businesses and pointed out that lending by the largest banks had declined in the second quarter while lending by smaller institutions had actually increased. Her conclusion was that these smaller institutions are striving to make sound loans to “Main Street,” but are hindered in their capacity by a lack of capital and balance sheets already laden with devalued and non-earning assets. She said that funding costs for the largest institutions had declined, while these costs for smaller institutions had been increasing. Sitting alongside Ms. Bair at this particular hearing was North Carolina Banking Commissioner Joseph Smith, who fully concurred in this view and stated that smaller banks must be given a mechanism by which to cleanse their balance sheets of these weaker assets in order to restore robust lending activities.
Chairman Bair suggested that TARP should be restructured to make it more accessible for smaller institutions and those that may not now meet the stringent eligibility requirements. She said she had discussed with Treasury a plan, perhaps employing a “one-for-one” matching arrangement where private capital would be used alongside TARP money, to bolster the capital of smaller institutions, thus giving them the capital cushion necessary to dispose of weaker assets and allow for new lending. She believes it is critical that capital be made more available to these smaller institutions.
Other policymakers and critical observers have raised objection to the entire notion of TARP and more specifically any desire to continue its usage now that the large “systemically important” institutions have repaid their TARP funds. Many (including lawmakers on both sides of the aisle) were skeptical of the proposal at inception, and they believe their skepticism was validated by the subsequent decision to deploy taxpayer funds in ways not initially envisioned when the program was hastily approved. These observers believe the market should allow entities to succeed and fail without government intervention and without the subjective picking of winners and losers. They believe government intervention sends the message that taxpayers will step in to assist troubled entities when times are tough, furthering the problem of moral hazard. In their view, the economy will work itself out in due course, with credit and employment improving over some natural period of time.
Discussion Topic: Join the discussion in the Comment Box below.
Given these observations, should the federal government do more to assist smaller institutions in raising capital (either through direct capital infusions or through other mechanisms to improve balance sheets) as a means to more quickly bring credit to consumers and small businesses, or should government now remove itself from direct intervention in banking activities?
Wednesday, October 21, 2009
Friday, September 18, 2009
Compliance with 2006 Commercial Real Estate Regulatory Guidance
In 2006 the bank and thrift regulators issued industry guidance entitled Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. By now, institutions with significant exposure to commercial real estate lending activities should be well aware of the principles embodied in this document. While there is little debate with respect to the principles and concepts contained in the guidance, questions have arisen regarding supervisory expectations in assessing compliance with certain provisions.
More particularly, smaller community banks (arguably those that possess the greatest levels of individual exposure to CRE) are concerned that examiners may apply unreasonable standards when determining the adequacy of portfolio and credit risk management policies and practices. Banks are concerned that regulators may have unrealistic expectations regarding the level of risk management sophistication appropriate for community banks.
In recent discussions, banking agency senior staffs state that they do not apply a "one size fits all" approach in assessing individual bank compliance with the CRE guidance. Regulators understand the varying levels of risk management expertise and the budgetary constraints impacting institution operations. However, in individual conversations, representatives of each of the four banking agencies stand unified in their position that bank concentrations need to be properly managed and monitored. In essence, each regulator's position was: if an institution is sophisticated enough to create a concentration risk, it should be sophisticated enough to properly manage it.
Therefore, while regulators will accept varying levels of sophistication in applying the principles contained in the CRE guidance, the level of risk management in individual institutions must be adequate for the risks presented. The banking agencies have consistently held to their view that institutions with CRE concentrations, regardless of asset size, must meet all the provisions of the guidance. Institutions have the discretion to determine how best to do this. Regulators do not expect small institutions to employ sophisticated modeling in their ongoing risk analyses; simple Excel spreadsheet analysis and reporting may be sufficient. However, the goal of guidance compliance should not be simply to satisfy the regulators; the goal should be proper management of CRE concentration risk, including adequate reporting to the institution's board of directors.
Recently, regulators have expressed concern that a significant number of smaller institutions appear to have given little, if any, attention to the provisions contained in the CRE guidance. Some institutions have been subjected to formal enforcement actions regarding noncompliance. As CRE becomes a more significant concern in the current economy, regulators certainly will devote increased attention to the adequacy of CRE risk management programs and practices in individual institutions.
On September 21, 2009, at 2:00 PM EST, RMA will hold the first in a series of Regulatory and Legislative Update audio conferences. The primary discussion topic for this first audio conference will be compliance with the CRE guidance, and a senior bank regulatory official will present supervisory expectations, observed deficiencies and proposed courses of action regarding compliance. Adequate time will be allotted for participant questions and regulatory responses. RMA members are invited to register for this event and participate in the discussion of this timely and important topic.
Monday, August 10, 2009
FDIC Issues Financial Institution Letter on Immediate Applicability of Credit Card Act
By W. Bernard Mason
On August 6, 2009 the Federal Deposit Insurance Corporation issued Financial Institution Letter (FIL) 44-2009 advising its supervised institutions of certain aspects of The Credit Card Accountability Responsibility and Disclosure Act of 2009 that take effect on August 20, 2009. It advises institutions to take appropriate steps to ensure compliance with these new requirements.
The FIL advises that, with regard to all open-end consumer credit accounts, including credit cards and home equity lines of credit accessed by a credit card, creditors must mail or deliver periodic statements at least 21 days before the payment is due. Applicable to credit card accounts, creditors must give 45-days’ notice of increases in the Annual Percentage Rate (APR) or other significant changes in terms, including a notice of the right to cancel the account. Both of these provisions become effective on August 20, 2009.
Further, all increases in the APR of a credit card account after January 1, 2009 must be reviewed beginning in August 2010 for a possible reduction in the APR based upon the same factors used to justify the increase. This mandatory “look-back” review will occur at least once every six months and will require creditors to use “reasonable methodology” in making assessments regarding possible rate decreases.
The Federal Reserve Board is required to issue final rules within nine months after enactment of the new law to implement these provisions. The FDIC is advising its supervised institutions to demonstrate regular meaningful progress in preparing for full compliance with these new restrictions and requirements, including adoption of reasonable methodologies for determining rate changes as well as adequate procedures to review accounts.
The Federal Reserve’s interim final rule, adopted on July 15, 2009 and applicable to all insured institutions, is available at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090715a1.pdf - PDF
On August 6, 2009 the Federal Deposit Insurance Corporation issued Financial Institution Letter (FIL) 44-2009 advising its supervised institutions of certain aspects of The Credit Card Accountability Responsibility and Disclosure Act of 2009 that take effect on August 20, 2009. It advises institutions to take appropriate steps to ensure compliance with these new requirements.
The FIL advises that, with regard to all open-end consumer credit accounts, including credit cards and home equity lines of credit accessed by a credit card, creditors must mail or deliver periodic statements at least 21 days before the payment is due. Applicable to credit card accounts, creditors must give 45-days’ notice of increases in the Annual Percentage Rate (APR) or other significant changes in terms, including a notice of the right to cancel the account. Both of these provisions become effective on August 20, 2009.
Further, all increases in the APR of a credit card account after January 1, 2009 must be reviewed beginning in August 2010 for a possible reduction in the APR based upon the same factors used to justify the increase. This mandatory “look-back” review will occur at least once every six months and will require creditors to use “reasonable methodology” in making assessments regarding possible rate decreases.
The Federal Reserve Board is required to issue final rules within nine months after enactment of the new law to implement these provisions. The FDIC is advising its supervised institutions to demonstrate regular meaningful progress in preparing for full compliance with these new restrictions and requirements, including adoption of reasonable methodologies for determining rate changes as well as adequate procedures to review accounts.
The Federal Reserve’s interim final rule, adopted on July 15, 2009 and applicable to all insured institutions, is available at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090715a1.pdf - PDF
Friday, August 7, 2009
Senate Hears Testimony on Credit Rating Agencies
By W. Bernard Mason
On August 5, 2009 the Senate Committee on Banking, Housing and Urban Affairs held a hearing entitled “Examining Proposals to Enhance the Regulation of Credit Rating Agencies”. The Committee heard from two witness panels. The sole witness on the first panel was Michael Barr, Assistant Treasury Secretary for Financial Institutions. The second panel consisted of: John Coffee, Professor of Law, Columbia University; Lawrence White, Professor of Economics, New York University; Stephen Joynt, President and CEO, Fitch Ratings; James Gellert, President and CEO, Rapid Ratings; and, Mark Froeba, Principal, PF2 Securities Evaluations, Inc.
Committee Chairman Christopher Dodd (D – CT) opened the hearing by pointing out two areas that he felt were primary problems causing the current crisis: the first was the marketing of unacceptable loan products that mortgage originators knew would never be repaid at fully indexed rates and the subsequent securitization and sale of these products and the receipt of substantial compensation for doing so; and, the failure of the credit rating agencies to properly evaluate and rate these products for the use and benefit of investors. He said instead of helping investors understand risk, these organizations were “hiding” risks. He wondered if the credit rating agencies were even needed in today’s environment.
Ranking Member Shelby pointed out The Credit Rating Reform Act, passed in 2006, was intended to address the perceived weaknesses in the credit rating agency system and in the Nationally Recognized Statistical Rating Organization (NRSRO) process administered by the SEC. He said this legislation was not enacted until 2007, too late to deal with the problems already existing in the system. He remarked that in considering new measures, “every option should be on the table”. He stated that he believes the rating agencies played a “pivotal role” in the collapse of our financial markets.
Senator Dodd began his questioning of Secretary Barr by stating his amazement to discover that the rating agencies, in many cases, do not verify the underlying information presented to them before assigning ratings and asked if it would not be appropriate to require such verification. Mr. Barr said he believed it would be inappropriate for the government to design a particular methodology; he said the primary issue is disclosure and transparency so that, if no independent verification has been performed, potential investors clearly understand that situation.
Senator Shelby asked what could be done to bring back investor confidence, since the NRSROs have failed so badly. He said the SEC had given considerable confidence to these rating agency firms, so what should be done now that that confidence was misplaced? Secretary Barr said there should be greater competition, with more entrants into this activity and more diversity of approach. Mr. Barr said the Administration wants to reduce regulatory agency reliance on these agencies by removing regulatory requirements that require NRSRO ratings.
Senator Bob Corker (R – TN) observed that we have just witnessed the worst regulatory failure in 30-40 years and regulators outsourced oversight of the securitization market. He marveled that the Administration wants to specifically dictate consumer financial products but only seeks transparency with respect to credit rating agencies. Mr. Barr first clarified that the Administration was not proposing that the government dictate specific products, only that a standard, easily understood product be part of a financial institution’s array of product offerings. He said in dealing with these consumer issues, we are assuming unsophisticated customers who need more specific protection. With respect to the securitization market, investors are more sophisticated and this market would benefit more from clear and complete disclosure. Senator Corker then asked where the Administration stands with respect to the question of who pays for the services of the NRSROs. Mr. Barr said he believes it makes sense to have different payment models. He said the goal is to reduce reliance on these credit ratings, but it will take time to develop alternatives. Senator Corker then asked if it would be wise to require the NRSROs to have “skin in the game” with respect to the performance of the securities they rate. Secretary Barr said he believes that would be beneficial.
Senator Mark Warner (D – VA) asked if it would not be important to translate the NRSRO ratings into something more meaningful that would provide a sense of the actual chance of default and of the magnitude of loss given default. Secretary Barr said such a system would be very beneficial. Senator Dodd took specific note of this issue and said it was deserving of further attention.
Senator Mike Johanns (R – NE) asked if the “little guy” wouldn’t end up paying the costs of any plan implemented to improve the current system. Secretary Barr said that everyone is now paying for the effects of a broken system and we need to get these problems under control. He said “the trade-offs are not even close”.
Senator Jeff Merkley (D – OR) observed that the Administration’s proposal to ban credit agency consulting fees and introduce better disclosure of payments still may not eliminate the perception of a conflict of interest on the part of the NRSROs. He asked if other approaches had been considered. Secretary Barr said that banning consulting fees, requiring better disclosures, closing the personnel “revolving door”, and creating a strong SEC compliance office would go a long way in addressing these concerns. He said the Administration had looked at different pay models (issuer, user, etc.) and all had particular deficiencies. Senator Merkley then asked if some security instruments simply weren’t too complicated to understand and properly rate, and if the better approach wouldn’t be to simply ban them. Secretary Barr said that was an option, but he believed there were ways to deal with these problems without an outright ban.
Senator Jim Bunning (R – KY) said everyone agrees the current system has failed. He said we must break the hold of the top three NRSROs and asked if all regulatory requirements for the use of these ratings shouldn’t be eliminated. Secretary Barr said this should be pursued, but he felt each requirement needed to be analyzed individually. Senator Bunning obtained agreement from Secretary Barr that there are basic conflicts existing in the current system.
Senator Charles Schumer (D – NY) said he had hoped with the passage of the 2006 legislation that the ratings agencies would be one of the cornerstones of a sound credit market; instead the credit rating agencies turned out to be one of the weakest links and this needs to be fixed. One of the weaknesses was that issuers “went shopping for ratings just like they were shopping for used cars”. He said because the revenues of the NRSROs increased with the increase in the securitization market, the agencies had every incentive to help issuers structure the products to get the ratings they wanted. The result was that ratings agencies rubber-stamped as” investment-grade” complex products they didn’t understand, and their flawed models didn’t factor in such adverse assumptions as escalating mortgage defaults. He wondered if the message was getting through to the NRSROs that change was necessary. He then cited a recent example of a questionable issuance that had just been highly rated by Moody’s. He put forth a suggestion that the SEC randomly select particular security issuances (he suggested one out of every ten rated products) for a secondary review by another rating agency as a means of encouraging proper conduct by the primary NRSRO on the selected issuance. Secretary Barr said he shared the conceptual goal to have more than one NRSRO rate particular issues, particularly in the case of structured finance products. Mr. Barr said the Administration suggests having the selected agency provide all information on their particular issuance to all the other rating agencies so that they can do their own analysis and “demonstrate their prowess” in assigning ratings as a means of competitive control over ratings quality.
In commencing questioning of the second panel, Senator Shelby asked Professor White if the government wasn’t sending a confusing message to regulated entities by instructing them to invest only in products possessing an acceptable NRSRO rating, while the NRSRO’s rating disclosure informs that no investment reliance should be placed on the assigned ratings. Professor White said he didn’t know “whether to laugh or cry” over this situation, and said this was one reason he advocated removing such reliance on the NRSROs. He said the burden should be on the investment manager to justify the investment, and that could be done through independent research either directly or by an independent third party (who could be an NRSRO or some other expert). Professor White said we should recognize that these complex products are not being purchased by unsophisticated investors, and investment managers should have the responsibility to either research the product or find someone to do it for them.
Senator Shelby then asked how we can bring confidence and trust back to the securitization market. Professor Coffee said we had a very good securitization market In the 1990s, but it got corrupted through the creation of more complex products that no one could completely understand. He said a good rule would be – if a product is too opaque to explain and understand, it should not be issued. He foresees simpler forms of asset-backed securities in the future, because the market will insist upon it.
Senator Corker said it was obvious that Committee Members were shocked to discover that no due diligence had been performed by the NRSROs as part of their process for assigning ratings. He asked Mr. Joynt what value the credit rating agencies were providing the public, given this lack of due diligence. Mr. Joynt said he believed there was enough public information available such that independent due diligence reviews were unnecessary. He viewed the NRSRO’s service to be the analysis of that public information and the projection of future performance based upon that public information. Senator Corker said he understood this concept as it relates to corporate issuances, but he fails to see what real assurance an NRSRO rating provides when considering an asset-back product, not backed by a corporate issuer but by mortgages, and the rating agency does not actually research and analyze the underlying mortgages. He said he failed to see any value being offered in this situation. Mr. Joynt said the NRSROs look to the issuing entity, the servicer, the accounting firm that signed off on the financial statements and then make a determination.
Senator Bunning stated that, during the housing boom, the rating agencies issued ratings without reviewing any information regarding the underlying mortgages. If they had, perhaps they would have detected some of the fraud and bad underwriting practices. Professor Coffee agreed with the assessment and pointed to information indicating that the percentage of “liar loans” expanded from approximately 28 percent in 2001 to 51 percent in 2006. Senator Bunning then asked if information on existing “toxic” securities should be shared with all the rating agencies so a better picture could be developed regarding the true condition of these products. Mr. Gellert said he believed this was the most important first step in getting the securities market moving again. Senator Bunning then asked if rating agencies should be subject to suit for errors in their ratings. Professor Coffee said he did not think there should be a cause of action simply for negligence. Misjudgments should not produce litigation; instead, it should be in instances where there is recklessness. In his view, giving ratings with no facts is “reckless”.
The hearing was adjourned with the understanding that this subject will be further explored following the August recess.
On August 5, 2009 the Senate Committee on Banking, Housing and Urban Affairs held a hearing entitled “Examining Proposals to Enhance the Regulation of Credit Rating Agencies”. The Committee heard from two witness panels. The sole witness on the first panel was Michael Barr, Assistant Treasury Secretary for Financial Institutions. The second panel consisted of: John Coffee, Professor of Law, Columbia University; Lawrence White, Professor of Economics, New York University; Stephen Joynt, President and CEO, Fitch Ratings; James Gellert, President and CEO, Rapid Ratings; and, Mark Froeba, Principal, PF2 Securities Evaluations, Inc.
Committee Chairman Christopher Dodd (D – CT) opened the hearing by pointing out two areas that he felt were primary problems causing the current crisis: the first was the marketing of unacceptable loan products that mortgage originators knew would never be repaid at fully indexed rates and the subsequent securitization and sale of these products and the receipt of substantial compensation for doing so; and, the failure of the credit rating agencies to properly evaluate and rate these products for the use and benefit of investors. He said instead of helping investors understand risk, these organizations were “hiding” risks. He wondered if the credit rating agencies were even needed in today’s environment.
Ranking Member Shelby pointed out The Credit Rating Reform Act, passed in 2006, was intended to address the perceived weaknesses in the credit rating agency system and in the Nationally Recognized Statistical Rating Organization (NRSRO) process administered by the SEC. He said this legislation was not enacted until 2007, too late to deal with the problems already existing in the system. He remarked that in considering new measures, “every option should be on the table”. He stated that he believes the rating agencies played a “pivotal role” in the collapse of our financial markets.
Senator Dodd began his questioning of Secretary Barr by stating his amazement to discover that the rating agencies, in many cases, do not verify the underlying information presented to them before assigning ratings and asked if it would not be appropriate to require such verification. Mr. Barr said he believed it would be inappropriate for the government to design a particular methodology; he said the primary issue is disclosure and transparency so that, if no independent verification has been performed, potential investors clearly understand that situation.
Senator Shelby asked what could be done to bring back investor confidence, since the NRSROs have failed so badly. He said the SEC had given considerable confidence to these rating agency firms, so what should be done now that that confidence was misplaced? Secretary Barr said there should be greater competition, with more entrants into this activity and more diversity of approach. Mr. Barr said the Administration wants to reduce regulatory agency reliance on these agencies by removing regulatory requirements that require NRSRO ratings.
Senator Bob Corker (R – TN) observed that we have just witnessed the worst regulatory failure in 30-40 years and regulators outsourced oversight of the securitization market. He marveled that the Administration wants to specifically dictate consumer financial products but only seeks transparency with respect to credit rating agencies. Mr. Barr first clarified that the Administration was not proposing that the government dictate specific products, only that a standard, easily understood product be part of a financial institution’s array of product offerings. He said in dealing with these consumer issues, we are assuming unsophisticated customers who need more specific protection. With respect to the securitization market, investors are more sophisticated and this market would benefit more from clear and complete disclosure. Senator Corker then asked where the Administration stands with respect to the question of who pays for the services of the NRSROs. Mr. Barr said he believes it makes sense to have different payment models. He said the goal is to reduce reliance on these credit ratings, but it will take time to develop alternatives. Senator Corker then asked if it would be wise to require the NRSROs to have “skin in the game” with respect to the performance of the securities they rate. Secretary Barr said he believes that would be beneficial.
Senator Mark Warner (D – VA) asked if it would not be important to translate the NRSRO ratings into something more meaningful that would provide a sense of the actual chance of default and of the magnitude of loss given default. Secretary Barr said such a system would be very beneficial. Senator Dodd took specific note of this issue and said it was deserving of further attention.
Senator Mike Johanns (R – NE) asked if the “little guy” wouldn’t end up paying the costs of any plan implemented to improve the current system. Secretary Barr said that everyone is now paying for the effects of a broken system and we need to get these problems under control. He said “the trade-offs are not even close”.
Senator Jeff Merkley (D – OR) observed that the Administration’s proposal to ban credit agency consulting fees and introduce better disclosure of payments still may not eliminate the perception of a conflict of interest on the part of the NRSROs. He asked if other approaches had been considered. Secretary Barr said that banning consulting fees, requiring better disclosures, closing the personnel “revolving door”, and creating a strong SEC compliance office would go a long way in addressing these concerns. He said the Administration had looked at different pay models (issuer, user, etc.) and all had particular deficiencies. Senator Merkley then asked if some security instruments simply weren’t too complicated to understand and properly rate, and if the better approach wouldn’t be to simply ban them. Secretary Barr said that was an option, but he believed there were ways to deal with these problems without an outright ban.
Senator Jim Bunning (R – KY) said everyone agrees the current system has failed. He said we must break the hold of the top three NRSROs and asked if all regulatory requirements for the use of these ratings shouldn’t be eliminated. Secretary Barr said this should be pursued, but he felt each requirement needed to be analyzed individually. Senator Bunning obtained agreement from Secretary Barr that there are basic conflicts existing in the current system.
Senator Charles Schumer (D – NY) said he had hoped with the passage of the 2006 legislation that the ratings agencies would be one of the cornerstones of a sound credit market; instead the credit rating agencies turned out to be one of the weakest links and this needs to be fixed. One of the weaknesses was that issuers “went shopping for ratings just like they were shopping for used cars”. He said because the revenues of the NRSROs increased with the increase in the securitization market, the agencies had every incentive to help issuers structure the products to get the ratings they wanted. The result was that ratings agencies rubber-stamped as” investment-grade” complex products they didn’t understand, and their flawed models didn’t factor in such adverse assumptions as escalating mortgage defaults. He wondered if the message was getting through to the NRSROs that change was necessary. He then cited a recent example of a questionable issuance that had just been highly rated by Moody’s. He put forth a suggestion that the SEC randomly select particular security issuances (he suggested one out of every ten rated products) for a secondary review by another rating agency as a means of encouraging proper conduct by the primary NRSRO on the selected issuance. Secretary Barr said he shared the conceptual goal to have more than one NRSRO rate particular issues, particularly in the case of structured finance products. Mr. Barr said the Administration suggests having the selected agency provide all information on their particular issuance to all the other rating agencies so that they can do their own analysis and “demonstrate their prowess” in assigning ratings as a means of competitive control over ratings quality.
In commencing questioning of the second panel, Senator Shelby asked Professor White if the government wasn’t sending a confusing message to regulated entities by instructing them to invest only in products possessing an acceptable NRSRO rating, while the NRSRO’s rating disclosure informs that no investment reliance should be placed on the assigned ratings. Professor White said he didn’t know “whether to laugh or cry” over this situation, and said this was one reason he advocated removing such reliance on the NRSROs. He said the burden should be on the investment manager to justify the investment, and that could be done through independent research either directly or by an independent third party (who could be an NRSRO or some other expert). Professor White said we should recognize that these complex products are not being purchased by unsophisticated investors, and investment managers should have the responsibility to either research the product or find someone to do it for them.
Senator Shelby then asked how we can bring confidence and trust back to the securitization market. Professor Coffee said we had a very good securitization market In the 1990s, but it got corrupted through the creation of more complex products that no one could completely understand. He said a good rule would be – if a product is too opaque to explain and understand, it should not be issued. He foresees simpler forms of asset-backed securities in the future, because the market will insist upon it.
Senator Corker said it was obvious that Committee Members were shocked to discover that no due diligence had been performed by the NRSROs as part of their process for assigning ratings. He asked Mr. Joynt what value the credit rating agencies were providing the public, given this lack of due diligence. Mr. Joynt said he believed there was enough public information available such that independent due diligence reviews were unnecessary. He viewed the NRSRO’s service to be the analysis of that public information and the projection of future performance based upon that public information. Senator Corker said he understood this concept as it relates to corporate issuances, but he fails to see what real assurance an NRSRO rating provides when considering an asset-back product, not backed by a corporate issuer but by mortgages, and the rating agency does not actually research and analyze the underlying mortgages. He said he failed to see any value being offered in this situation. Mr. Joynt said the NRSROs look to the issuing entity, the servicer, the accounting firm that signed off on the financial statements and then make a determination.
Senator Bunning stated that, during the housing boom, the rating agencies issued ratings without reviewing any information regarding the underlying mortgages. If they had, perhaps they would have detected some of the fraud and bad underwriting practices. Professor Coffee agreed with the assessment and pointed to information indicating that the percentage of “liar loans” expanded from approximately 28 percent in 2001 to 51 percent in 2006. Senator Bunning then asked if information on existing “toxic” securities should be shared with all the rating agencies so a better picture could be developed regarding the true condition of these products. Mr. Gellert said he believed this was the most important first step in getting the securities market moving again. Senator Bunning then asked if rating agencies should be subject to suit for errors in their ratings. Professor Coffee said he did not think there should be a cause of action simply for negligence. Misjudgments should not produce litigation; instead, it should be in instances where there is recklessness. In his view, giving ratings with no facts is “reckless”.
The hearing was adjourned with the understanding that this subject will be further explored following the August recess.
Wednesday, August 5, 2009
Senate Hearing on Strengthening and Streamlining Prudential Bank Supervision
By W. Bernard Mason
On August, 4, 2009 the Senate Committee on Banking, Housing and Urban Affairs heard testimony from the heads of the four federal banking agencies on the subject of bank regulatory restructuring. In their opening statements, each of the panelists stated their positions regarding the major elements of the Administration’s reform proposal. There was general agreement among the witnesses that creation of a new Consumer Financial Protection Agency would be a positive move (although Federal Reserve Governor Tarullo indicated the Federal Reserve Board had not taken an official position on this point). They also agreed that some form of systemic risk oversight was called for, but disagreed on how this could best be accomplished. FDIC Chairman Sheila Bair argued that a council of regulators would be the best approach, while Comptroller John Dugan and Governor Tarullo argued that the Federal Reserve was well-situated to assume this role. None of the panelists argued strongly for further consolidation of the agencies beyond the Administration’s announced proposal to merge the OTS and the OCC (OTS Acting Director John Bowman expressed no view). Each witness also expressed support for the creation of a resolution mechanism for large, systemically important financial firms.
Committee Chairman Christopher Dodd (D – CT) commenced the questioning by asking the panel why it would not make sense to merge all prudential supervision functions under one agency. Ms. Bair stated that creation of one agency would not address the causes of the current crisis, that other countries that had such arrangements faired no better than the U.S., and multiple regulators actually strengthens the financial system by allowing for different regulatory points of view. Governor Tarullo added that it would weaken the regulatory system if the Federal Reserve and the FDIC did not play an active role in day-to-day supervisory activities because they would lose touch with banking operational issues.
Ranking Member Richard Shelby (R – AL) stated that, in terms of regulatory failure, “all roads lead to the Federal Reserve”. He then asked what steps should be taken to reduce “moral hazard” – do we need to just let big firms fail? Ms. Bair said we need a clear resolution authority for these firms. Mr. Dugan added that while we need more orderly resolution processes, we also need up-front supervision that sets strong capital and liquidity requirements, with flexibility for the government to intervene if necessary. Mr. Tarullo said we need more transparency and disclosure and alternative capital structures such as convertible debt. In response to Sen. Shelby’s Federal Reserve observation, Governor Tarullo pointed out that Bear Stearns, AIG, Fannie, and Freddie were not regulated by the Federal Reserve. Sen. Shelby answered by stating that the Federal Reserve was the supervisor for the large banking organizations that received government funding in the current crisis.
Senator Bob Corker (R – TN) stated his understanding that the Administration had originally contemplated having the new National Bank Supervisor (the consolidated OTS/OCC) structured as an independent agency, and asked Comptroller Dugan why this was changed in the final proposal. Mr. Dugan said he pushed for the change, because he believed it would be more cumbersome to have another banking agency with yet another board of directors populated by individuals simultaneously serving on other regulatory boards (FDIC and the new consumer agency). He believes the present structure, with the national bank supervisor as an independent bureau within the Treasury Department, is the best approach. Chairman Bair disagreed, stating it would be best if this regulatory body were completely independent of the Administration.
Senator Robert Menendez (D – NJ) asked the panel members if consolidating the agencies wouldn’t eliminate the opportunity for regulatory arbitrage? Governor Tarullo said the agencies had already addressed this potential through an interagency agreement prohibiting charter changes for institutions undergoing enforcement or other supervisory actions. Chairman Bair and Comptroller Dugan supported making this prohibition statutory to eliminate future discretion or flexibility. The panelists uniformly stated that “regulator shopping” among the closely regulated was not a problem; instead, it was the lack of regulatory oversight regarding the “shadow banking industry” that was the problem and attention should be focused on closing those regulatory gaps.
Senator David Vitter (R – LA) asked for the regulators’ views on FASB’s effort to move off- balance sheet activities clearly onto the books of insured financial institutions. Chairman Bair said banks need to follow the dictates of Generally Accepted Accounting Principles. She said the capital rules need to be reviewed, and she was particularly concerned about the timing of this effort because she believed it could be damaging when efforts are underway to get the securitization market functional again. Senator Vitter asked if regulators had any flexibility on this. Comptroller Dugan said there may be some regulatory flexibility, but the issue is timing. He said regulators were discussing how this issue affects capital, and interagency guidance and rulemaking may be forthcoming.
Senator Mel Martinez (R – FL) asked the panelists if interstate branching contributed to the current crisis. None of the panelists felt this was a problem, and Comptroller Dugan said it would not be a good idea to attempt to restrict interstate activities at this time. Governor Tarullo agreed. Senator Martinez then asked about the Administration’s proposal to designate certain firms as “Tier 1 Financial Holding Companies”. Ms. Bair said this was a bad idea, since identifying these firms would create moral hazard under the assumption they would be too big to fail.
Senator Robert Bennett (R – UT) stated his objection to the Administration’s proposal to prohibit industrial loan companies, arguing that these firms played no role in the current crisis. He then offered his observation that the primary problem in the current crisis was not “too big to fail” but the lack of a systemic supervisor to recognize the system-wide risk created by the poor lending and resulting inferior securitization process where no player had any risk of loss in the process. Governor Tarullo agreed with this assessment.
Senator Mark Warner (D – VA) stated his view that there should be one consolidated bank regulator, with the FDIC maintaining its back-up supervisory role enabling it to participate in selected examinations. He said his concern was the non-bank sector – do we need prudential oversight of that business segment? Ms. Bair said the new consumer protection agency would adequately address this; that the federal government did not need to get into the safety and soundness operations of uninsured entities. Comptroller Dugan said prudential supervision of these entities would be a daunting challenge, but he was concerned that some of the weak underwriting that caused the current problems may not be addressed if we approach them from strictly a “consumer” point of view. Governor Tarullo said there should be some government body looking at such practices beyond simply the consumer aspect.
Senator Charles Schumer (D – NY) observed that there was clearly a turf battle going on among the agencies, which he characterized as understandable. He said there are good reasons for one, strong prudential regulator: (1) prevents charter-shopping; (2) removes regulator conflict and burden; (3) allows for closer oversight of the entire industry; and, (4) eliminates regulatory arbitrage. He asked the panelists if they disagreed with this view. Governor Tarullo said he agreed with each point, but said there are “cons” to be considered: the Federal Reserve would lose insight into how banks are functioning, eliminating a valuable perspective for the Central Bank. Comptroller Dugan said he agreed with Sen. Schumer’s points. Chairman Bair said that, while she agreed with the points, there is no evidence that a single-regulator model works any better. She said competition among regulators is a good thing.
Senator Schumer said he has always been puzzled as to why the Federal Reserve and the FDIC have supervisory responsibility for state-chartered banks, and why should they keep such responsibility? Chairman Bair said the FDIC finds it extremely helpful to be “on the ground” on a continuous basis as a regulator, and believes its resolution process and abilities would suffer if it lost its examination and supervision responsibilities. Governor Tarullo added that state chartered institutions have always been hesitant to have the national bank charterer and supervisor also serve as their federal supervisor.
A second witness panel, consisting of independent experts and industry observers, was scheduled to testify but was postponed due to Senate scheduling issues. This witness panel will be heard at a later time.
On August, 4, 2009 the Senate Committee on Banking, Housing and Urban Affairs heard testimony from the heads of the four federal banking agencies on the subject of bank regulatory restructuring. In their opening statements, each of the panelists stated their positions regarding the major elements of the Administration’s reform proposal. There was general agreement among the witnesses that creation of a new Consumer Financial Protection Agency would be a positive move (although Federal Reserve Governor Tarullo indicated the Federal Reserve Board had not taken an official position on this point). They also agreed that some form of systemic risk oversight was called for, but disagreed on how this could best be accomplished. FDIC Chairman Sheila Bair argued that a council of regulators would be the best approach, while Comptroller John Dugan and Governor Tarullo argued that the Federal Reserve was well-situated to assume this role. None of the panelists argued strongly for further consolidation of the agencies beyond the Administration’s announced proposal to merge the OTS and the OCC (OTS Acting Director John Bowman expressed no view). Each witness also expressed support for the creation of a resolution mechanism for large, systemically important financial firms.
Committee Chairman Christopher Dodd (D – CT) commenced the questioning by asking the panel why it would not make sense to merge all prudential supervision functions under one agency. Ms. Bair stated that creation of one agency would not address the causes of the current crisis, that other countries that had such arrangements faired no better than the U.S., and multiple regulators actually strengthens the financial system by allowing for different regulatory points of view. Governor Tarullo added that it would weaken the regulatory system if the Federal Reserve and the FDIC did not play an active role in day-to-day supervisory activities because they would lose touch with banking operational issues.
Ranking Member Richard Shelby (R – AL) stated that, in terms of regulatory failure, “all roads lead to the Federal Reserve”. He then asked what steps should be taken to reduce “moral hazard” – do we need to just let big firms fail? Ms. Bair said we need a clear resolution authority for these firms. Mr. Dugan added that while we need more orderly resolution processes, we also need up-front supervision that sets strong capital and liquidity requirements, with flexibility for the government to intervene if necessary. Mr. Tarullo said we need more transparency and disclosure and alternative capital structures such as convertible debt. In response to Sen. Shelby’s Federal Reserve observation, Governor Tarullo pointed out that Bear Stearns, AIG, Fannie, and Freddie were not regulated by the Federal Reserve. Sen. Shelby answered by stating that the Federal Reserve was the supervisor for the large banking organizations that received government funding in the current crisis.
Senator Bob Corker (R – TN) stated his understanding that the Administration had originally contemplated having the new National Bank Supervisor (the consolidated OTS/OCC) structured as an independent agency, and asked Comptroller Dugan why this was changed in the final proposal. Mr. Dugan said he pushed for the change, because he believed it would be more cumbersome to have another banking agency with yet another board of directors populated by individuals simultaneously serving on other regulatory boards (FDIC and the new consumer agency). He believes the present structure, with the national bank supervisor as an independent bureau within the Treasury Department, is the best approach. Chairman Bair disagreed, stating it would be best if this regulatory body were completely independent of the Administration.
Senator Robert Menendez (D – NJ) asked the panel members if consolidating the agencies wouldn’t eliminate the opportunity for regulatory arbitrage? Governor Tarullo said the agencies had already addressed this potential through an interagency agreement prohibiting charter changes for institutions undergoing enforcement or other supervisory actions. Chairman Bair and Comptroller Dugan supported making this prohibition statutory to eliminate future discretion or flexibility. The panelists uniformly stated that “regulator shopping” among the closely regulated was not a problem; instead, it was the lack of regulatory oversight regarding the “shadow banking industry” that was the problem and attention should be focused on closing those regulatory gaps.
Senator David Vitter (R – LA) asked for the regulators’ views on FASB’s effort to move off- balance sheet activities clearly onto the books of insured financial institutions. Chairman Bair said banks need to follow the dictates of Generally Accepted Accounting Principles. She said the capital rules need to be reviewed, and she was particularly concerned about the timing of this effort because she believed it could be damaging when efforts are underway to get the securitization market functional again. Senator Vitter asked if regulators had any flexibility on this. Comptroller Dugan said there may be some regulatory flexibility, but the issue is timing. He said regulators were discussing how this issue affects capital, and interagency guidance and rulemaking may be forthcoming.
Senator Mel Martinez (R – FL) asked the panelists if interstate branching contributed to the current crisis. None of the panelists felt this was a problem, and Comptroller Dugan said it would not be a good idea to attempt to restrict interstate activities at this time. Governor Tarullo agreed. Senator Martinez then asked about the Administration’s proposal to designate certain firms as “Tier 1 Financial Holding Companies”. Ms. Bair said this was a bad idea, since identifying these firms would create moral hazard under the assumption they would be too big to fail.
Senator Robert Bennett (R – UT) stated his objection to the Administration’s proposal to prohibit industrial loan companies, arguing that these firms played no role in the current crisis. He then offered his observation that the primary problem in the current crisis was not “too big to fail” but the lack of a systemic supervisor to recognize the system-wide risk created by the poor lending and resulting inferior securitization process where no player had any risk of loss in the process. Governor Tarullo agreed with this assessment.
Senator Mark Warner (D – VA) stated his view that there should be one consolidated bank regulator, with the FDIC maintaining its back-up supervisory role enabling it to participate in selected examinations. He said his concern was the non-bank sector – do we need prudential oversight of that business segment? Ms. Bair said the new consumer protection agency would adequately address this; that the federal government did not need to get into the safety and soundness operations of uninsured entities. Comptroller Dugan said prudential supervision of these entities would be a daunting challenge, but he was concerned that some of the weak underwriting that caused the current problems may not be addressed if we approach them from strictly a “consumer” point of view. Governor Tarullo said there should be some government body looking at such practices beyond simply the consumer aspect.
Senator Charles Schumer (D – NY) observed that there was clearly a turf battle going on among the agencies, which he characterized as understandable. He said there are good reasons for one, strong prudential regulator: (1) prevents charter-shopping; (2) removes regulator conflict and burden; (3) allows for closer oversight of the entire industry; and, (4) eliminates regulatory arbitrage. He asked the panelists if they disagreed with this view. Governor Tarullo said he agreed with each point, but said there are “cons” to be considered: the Federal Reserve would lose insight into how banks are functioning, eliminating a valuable perspective for the Central Bank. Comptroller Dugan said he agreed with Sen. Schumer’s points. Chairman Bair said that, while she agreed with the points, there is no evidence that a single-regulator model works any better. She said competition among regulators is a good thing.
Senator Schumer said he has always been puzzled as to why the Federal Reserve and the FDIC have supervisory responsibility for state-chartered banks, and why should they keep such responsibility? Chairman Bair said the FDIC finds it extremely helpful to be “on the ground” on a continuous basis as a regulator, and believes its resolution process and abilities would suffer if it lost its examination and supervision responsibilities. Governor Tarullo added that state chartered institutions have always been hesitant to have the national bank charterer and supervisor also serve as their federal supervisor.
A second witness panel, consisting of independent experts and industry observers, was scheduled to testify but was postponed due to Senate scheduling issues. This witness panel will be heard at a later time.
Tuesday, August 4, 2009
FDIC Legacy Loans Program Gets a Test
By W. Bernard Mason
On July 31, 2009 the Federal Deposit Insurance Corporation announced commencement of the first test of the Legacy Loans Program funding mechanism. Using this funding process, the FDIC will transfer a receivership portfolio of residential mortgage loans (servicing released) to a limited liability company (LLC) in exchange for an ownership interest in the LLC. The LLC will also sell an equity interest to an approved investor, who will manage the loan portfolio. Other investors will be offered equity interests in the LLC under two options: (1) an all cash basis, with an equity split of 80 percent (FDIC) and 20 percent (investor); or, (2) a sale with leverage, under which the equity split will be 50/50.
Under the funding mechanism, financing will be offered by the receivership to the LLC using an amortizing note guaranteed by the FDIC. The FDIC will be protected against losses on the guarantee by leverage limits (both a maximum ratio and a dollar amount), the mortgages collateralizing the guarantee, and a guarantee fee.
The FDIC will analyze the results of this sale to determine how the Legacy Loans Program can best further the removal of troubled assets from bank balance sheets. The FDIC said this announcement was for informational purposes only, and not an offer for the sale of securities. A formal offering will be made to accredited investors in accordance with applicable securities laws.
On July 31, 2009 the Federal Deposit Insurance Corporation announced commencement of the first test of the Legacy Loans Program funding mechanism. Using this funding process, the FDIC will transfer a receivership portfolio of residential mortgage loans (servicing released) to a limited liability company (LLC) in exchange for an ownership interest in the LLC. The LLC will also sell an equity interest to an approved investor, who will manage the loan portfolio. Other investors will be offered equity interests in the LLC under two options: (1) an all cash basis, with an equity split of 80 percent (FDIC) and 20 percent (investor); or, (2) a sale with leverage, under which the equity split will be 50/50.
Under the funding mechanism, financing will be offered by the receivership to the LLC using an amortizing note guaranteed by the FDIC. The FDIC will be protected against losses on the guarantee by leverage limits (both a maximum ratio and a dollar amount), the mortgages collateralizing the guarantee, and a guarantee fee.
The FDIC will analyze the results of this sale to determine how the Legacy Loans Program can best further the removal of troubled assets from bank balance sheets. The FDIC said this announcement was for informational purposes only, and not an offer for the sale of securities. A formal offering will be made to accredited investors in accordance with applicable securities laws.
House Passes Compensation Legislation
By W. Bernard Mason
On July 31, 2009 the House of Representatives, by a vote of 237 to 185, approved H.R. 3269, the Corporate and Financial Institution Compensation Fairness Act of 2009. Republican opposition centered primarily on Section 4 of the bill that requires financial institutions to file reports with their appropriate federal regulator regarding any incentive compensation plans and authorizes federal regulators to intervene in any instance where such a program could threaten the safety or soundness of the institution or have serious adverse effects on economic stability. Republicans also objected to the concept of an annual, non-binding shareholder vote on compensation, arguing instead for such a vote once every three years. Republicans argued that the provisions of H.R. 3269 should apply exclusively to TARP recipients and other beneficiaries of taxpayer funds.
Rep. Scott Garrett (R – NJ) said the odd thing about the legislation is that it “gives with one hand, and takes with the other”. It allows shareholders to vote on pay, but it permits the government to later say the shareholders made an incorrect decision and allows some bureaucrat to make the final decision. He said the bill will create unintended consequences and may worsen undesirable aspects of compensation arrangements. He also said he has seen no factual proof that the underlying cause of the current crisis was excessive pay.
Rep. Mel Watt (D – NC) stated that the House debate “is a commentary on how out of whack our whole system has become”. He said this was a modest bill, providing for a nonbinding shareholder vote on executive compensation plans. He said the opposition is arguing that the owners of a company should not have the right to express their opinions on compensation to the officers of the company. He said this was not the government taking over corporate decision-making, not even with respect to the financial industry.
On July 31, 2009 the House of Representatives, by a vote of 237 to 185, approved H.R. 3269, the Corporate and Financial Institution Compensation Fairness Act of 2009. Republican opposition centered primarily on Section 4 of the bill that requires financial institutions to file reports with their appropriate federal regulator regarding any incentive compensation plans and authorizes federal regulators to intervene in any instance where such a program could threaten the safety or soundness of the institution or have serious adverse effects on economic stability. Republicans also objected to the concept of an annual, non-binding shareholder vote on compensation, arguing instead for such a vote once every three years. Republicans argued that the provisions of H.R. 3269 should apply exclusively to TARP recipients and other beneficiaries of taxpayer funds.
Rep. Scott Garrett (R – NJ) said the odd thing about the legislation is that it “gives with one hand, and takes with the other”. It allows shareholders to vote on pay, but it permits the government to later say the shareholders made an incorrect decision and allows some bureaucrat to make the final decision. He said the bill will create unintended consequences and may worsen undesirable aspects of compensation arrangements. He also said he has seen no factual proof that the underlying cause of the current crisis was excessive pay.
Rep. Mel Watt (D – NC) stated that the House debate “is a commentary on how out of whack our whole system has become”. He said this was a modest bill, providing for a nonbinding shareholder vote on executive compensation plans. He said the opposition is arguing that the owners of a company should not have the right to express their opinions on compensation to the officers of the company. He said this was not the government taking over corporate decision-making, not even with respect to the financial industry.
Friday, July 24, 2009
Adminstration Delivers Systemic Risk Legislation to Capital Hill
By W. Bernard Mason
On July 22, 2009 the Administration issued its proposed legislation regarding the establishment of a systemic risk oversight regime. The legislation fleshes out the points on systemic risk contained in the Administration’s original regulatory reform announcement on June 17th.
The legislation proposes creation of a Financial Services Oversight Council to facilitate coordination of financial regulatory policy and resolution of disputes, and to identify emerging risks in financial markets. The Council would be chaired by the Treasury Secretary and its members would include each of the principal federal prudential regulators and operate with a permanent, full-time staff within the Treasury Department.
The legislation further proposes that all financial firms found to pose a threat to economic financial stability (based upon size, leverage, and interconnectedness) will be subjected to strong, consolidated supervision and regulation by the Federal Reserve, whether or not they own insured depository institutions. The firms so identified will be subjected to higher standards on capital, liquidity and risk management and also be subjected to a prompt corrective action regime that mirrors the current provisions contained in the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The proposed legislation would also require these firms to maintain a credible plan for rapid resolution of the firm in the case of severe financial distress.
The proposed legislation would also raise capital and management requirements for all financial holding companies, and would close loopholes and gaps such that all companies controlling an insured financial institution would receive consolidated supervision by the Federal Reserve. It would also tighten restrictions on bank transactions with affiliates. The legislation additionally would require federal banking regulators to coordinate assessment of fees for examinations of institutions above $10 billion in assets.
The legislation would also require securitizers to retain a 5 percent interest in the credit risk of underlying assets and would require loan-level disclosure, in a standard format, for asset-backed securities. This legislation would also provide the Federal Reserve authority to oversee systemically important payment, clearing, and settlement activities and systems.
The proposed legislation would establish the Office of National Insurance to monitor all aspects of the insurance industry, including identifying gaps in the regulation of insurers that could contribute to a systemic crisis. Finally, the proposed legislation would require prior written approval of the Treasury Secretary for lending by the Federal Reserve under its emergency lending authority (Section 13 of the Federal Reserve Act).
On July 22, 2009 the Administration issued its proposed legislation regarding the establishment of a systemic risk oversight regime. The legislation fleshes out the points on systemic risk contained in the Administration’s original regulatory reform announcement on June 17th.
The legislation proposes creation of a Financial Services Oversight Council to facilitate coordination of financial regulatory policy and resolution of disputes, and to identify emerging risks in financial markets. The Council would be chaired by the Treasury Secretary and its members would include each of the principal federal prudential regulators and operate with a permanent, full-time staff within the Treasury Department.
The legislation further proposes that all financial firms found to pose a threat to economic financial stability (based upon size, leverage, and interconnectedness) will be subjected to strong, consolidated supervision and regulation by the Federal Reserve, whether or not they own insured depository institutions. The firms so identified will be subjected to higher standards on capital, liquidity and risk management and also be subjected to a prompt corrective action regime that mirrors the current provisions contained in the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The proposed legislation would also require these firms to maintain a credible plan for rapid resolution of the firm in the case of severe financial distress.
The proposed legislation would also raise capital and management requirements for all financial holding companies, and would close loopholes and gaps such that all companies controlling an insured financial institution would receive consolidated supervision by the Federal Reserve. It would also tighten restrictions on bank transactions with affiliates. The legislation additionally would require federal banking regulators to coordinate assessment of fees for examinations of institutions above $10 billion in assets.
The legislation would also require securitizers to retain a 5 percent interest in the credit risk of underlying assets and would require loan-level disclosure, in a standard format, for asset-backed securities. This legislation would also provide the Federal Reserve authority to oversee systemically important payment, clearing, and settlement activities and systems.
The proposed legislation would establish the Office of National Insurance to monitor all aspects of the insurance industry, including identifying gaps in the regulation of insurers that could contribute to a systemic crisis. Finally, the proposed legislation would require prior written approval of the Treasury Secretary for lending by the Federal Reserve under its emergency lending authority (Section 13 of the Federal Reserve Act).
Wednesday, July 22, 2009
House Holds Hearing on Systemic Risk
By W. Bernard Mason
On July 21, 2009 the House Financial Services Committee heard testimony on systemic risk and issues surrounding the concept of “too big to fail”. Appearing as witnesses were: Alice Rivlin, Senior Fellow, Brookings Institution; Peter Wallison, Fellow, American Enterprise Institute; Simon Johnson, Professor, Massachusetts Institute of Technology; Mark Zandi, Chief Economist, Moody’s Economy.com, and Paul Mahoney, Dean, University of Virginia School of Law.
Committee Chairman Barney Frank opened the hearing by stating that he believes no one favors the concept of “too big to fail”, but there seems to be no consensus on what to do about it. He observed that it seemed to be much more easily denounced than dismantled. He said this hearing was not meant as a step toward structuring an approach for government “bail outs”, but instead is part of an effort to avoid the situation faced by the Bush Administration that had no alternative beyond providing government funding to large entities whose failures posed a risk to our financial system.
Ms. Rivlin began her prepared remarks by observing there is no permanent fix to this problem. She said we need some government entity charged with looking continuously at the regulatory system and markets and at whatever perverse incentives may have crept into the system, because whatever rules are adopted will become obsolete as financial innovation progresses and market participants find their way around the rules. She pointed out that the Administration makes a case for such an institution and places the responsibility with a new oversight council. She said this seems to be a cumbersome mechanism and she believes this type of responsibility should be given to the Federal Reserve. She believes this would actually enhance the Fed’s effectiveness as the central bank. Conversely, she believes designating the Federal Reserve as the consolidated regulator for systemic risk would be a mistake. She believes designating systemically important entities and giving them their own regulator would institutionalize “too big to fail” and create a new GSE-like class of institutions. Higher capital requirements and stricter regulation for these entities makes sense, but without granting them their own regulator.
Mr. Wallison stated that, if there is an entity that is "too big to fail", it can only be a large commercial bank. He said in order to be "too big to fail", its collapse must have a major adverse effect on the entire economy – not simply a mere disruption. In his view, only the failure of a large commercial bank could cause this kind of systemic breakdown. He said it would be difficult to see how a large, non-bank institution (bank holding company, securities firm, finance company, hedge fund, etc.,) can cause systemic risk and thus, be too big to fail. He pointed out that these entities do not hold deposits, and if they fail, their creditors do not suffer any immediate cash losses that would make it difficult to pay their bills. No household or business operating funds are placed with these companies. Further, he believes the freeze in lending that followed the Lehman Brothers collapse has led some to believe that Lehman caused that event. In his view, Lehman’s failure did not cause this systemic problem – it caused what he termed a “common shock” where a market freezes up because new information has come to light. This new information was the fact that the government was not going to rescue every firm larger than Bear Stearns. In this new light, every market participant had to re-evaluate the risks of lending to everyone else. He said it is no wonder lending ground to a halt. He said the government’s focus should be on keeping commercial banks sound and healthy; all other entities should be viewed as risk-takers and should be allowed to fail. He recommends that capital requirements for large banks be increased as the banks get larger. Higher capital requirements will cause banks to reconsider whether growth for its own sake really makes sense. He said regulators should develop indicators of risk-taking that banks should be required to publish regularly. Also, Congress should establish a “systemic risk council” consisting of all the bank supervisors and other financial regulators, and it should be charged with spotting conditions in the banking industry (like the acquisition of “toxic” assets) that might make all major banks weak or unstable. He said if we keep our banks stable, we will keep our financial system stable. He concluded by saying that, as a member of the Financial Crisis Inquiry Commission, he would urge Congress to wait until the Commission has delivered its report before adopting legislation.
Mr. Johnson said the issue before us is simple: we must avoid the situation where a large entity comes before the government and says "either you bail us out, or the system will collapse". He believes there are two ways to address this problem: (1) change the regulatory and bankruptcy system; and (2) reduce the size of the institutions. He does not believe the first approach will solve the fundamental problem. He said the banking system has been very persuasive in convincing itself and others (investors, regulators, Congress) that it knows how to manage risks. He pointed out that Alan Greenspan admits it was a mistake to believe that, because banks had a great deal to lose if things went bad, they understood these risks and would control and manage them – they didn’t. This was a failure of risk management, and Mr. Johnson said he sees no evidence either that the banks have improved their management of risk or that regulators have become better at spotting such a problem. He agrees that some sort of systemic risk oversight entity is desirable, but it seems we are a long way from achieving that. He believes the best approach is ratcheting up capital requirements and deposit insurance assessments as entities grow larger. He said the country has encountered massive costs in our efforts to forestall another depression, and the result has been concentration of more power and influence by these larger entities. He observed that, for this cost, we have bought nothing in terms of actually improving the financial system.
Mr. Zandi said, overall, the Administration’s plan is reasonable and well-designed. He believes the Federal Reserve is the right choice for systemic risk regulator. However, he doesn’t see the proposed new regulatory council as providing any value beyond what is already in place. He said the crisis has shown an uncomfortably large number of institutions are too big to fail. He understands the desire to break up these entities, but he believes such efforts would be futile. Breaking up large institutions would be too wrenching and would put U.S. institutions at a distinct disadvantage relative to their large, global competitors. He said large institutions are also needed to back-stop the rest of the financial system. He believes it is better to provide tighter regulation of these entities, with higher capital and liquidity requirements, greater disclosure requirements and higher deposit insurance premiums commensurate with the risks they take and present.
Mr. Mahoney described the Administration’s proposed systemic risk resolution structure as a "bail out" mechanism. He said there are two schools of thought on how to best prevent future financial crises leading to wide-scale bailouts. The first says it was wrong to bail out creditors of failed institutions so that they avoided losses they otherwise would have realized in a normal bankruptcy proceeding and the policy going forward should not be repeated. The second concedes that the government will ordinarily bail out large, systemically important entities. Under this approach, Congress should seek to limit the risks those institutions can take in order to minimize the likelihood that they will become financially distressed, because failure would result in a bail out as a matter of course. This is the Administration’s approach. Mr. Mahoney believes the first approach will produce a healthier financial services industry that will make fewer claims on taxpayers in the future. It is based on a sounder premise – that the best way to reduce moral hazard is to ensure that economic agents bear the costs of their own mistakes. He said the Administration’s plan suggests that regulatory oversight will compensate for misaligned incentives. This position is based on the premise that some institutions are too big to fail. Mr. Mahoney says it is not clear that the magnitude of this problem justifies the scale of the government intervention that we have seen in the past year. He believes bankruptcy is a more appropriate mechanism to deal with these failures, although he admits that the bankruptcy system may need to be refined and enhanced. The other approach furthers moral hazard that impacts the industry continuously, not just in times of crisis. He said that is because perceived systemically important firms ultimately do not pay a sufficient price for taking risks. The result is a dangerous feedback loop: large banks have access to cheap capital, which causes them to grow even larger and more systemically important while taking excessive risks. This all results in the higher probability of a crisis, thus a bailout regime leads to more frequent crises. He disagrees with the Administration’s premise that the higher requirements and regulatory scrutiny proposed for Tier 1 Financial Holding Companies reduces a firm’s desire to be so designated. He believes that the implicit "too big to fail" designation will cause firms to desire inclusion within such a designation. He believes that the Administration’s conclusion that the imposition of higher capital and liquidity requirements on these firms will increase their cost of capital is "wildly optimistic". Firms with an implicit government guarantee will have a valuable commodity to sell, he stated. They will have a powerful incentive to find financial products, off-balance sheet devices, and any other means to evade any limits on the risks they can purchase from others in the financial system.
Chairman Frank made it clear that there will be no official designation of any entities as Tier 1 Financial Holding Companies or any hard and fast rules or criteria for otherwise identifying systemically important firms. He said each case will be unique and will have to be judged independently. There will be no official list of systemically important entities. He said he believes the Administration now sees the weakness in the originally-announced approach. Chairman Frank asked Mr. Johnson if it would be feasible to adjust deposit insurance premiums to account for the higher risks posed by these types of entities. Mr. Johnson said this would be a workable concept and would have the effect of discouraging excessive risk-taking by insured institutions.
In response to a question, Mr. Wallison observed that no one can yet agree on what systemic risk really is; therefore, we need to concentrate on ensuring the banking industry is safe and sound and not worry about extending regulation to firms outside the banking industry.
Rep. Paul Kanjorski (D – PA) asked Ms. Rivlin to clarify whether she believes the Federal Reserve should be the systemic risk regulator. She responded that she did not hold that view for two reasons: first, she does not think there should be such a separately designated regulator; and, if there were, the Fed would not “be very good at it”. Rep. Kanjorski said he agreed with that assessment. He next asked Mr. Wallison how he could possibly believe that only banks present systemic risk, when he had just witnessed what had occurred with regard to the auto industry and the ripple effect failures of those firms would have caused. Mr. Wallison said this is an example of his observation that we don’t have a firm grasp on what systemic risk really is. He viewed the auto industry situation as a “disruption”, not a crisis.
Ranking Member Spencer Bachus (R – AL) observed that several witnesses have essentially concluded that the government’s actions in the recent crisis have increased systemic risk and created a more dangerous environment. Mr. Wallison agreed. He said every time we bail out one institution, we create the belief that others will be bailed out, creating risk and moral hazard. Mr. Bachus said he believed some firms have become bigger and more politically powerful as a result of the crisis – the competition has been eliminated. He said they have no incentive to bring down the level of risk they pose. Mr. Johnson agreed with that assessment. In response to another question from Rep. Bachus, Mr. Johnson responded that the best way to deal with large firms would be to add a new chapter to the bankruptcy code that would set forth more defined procedures for unwinding a failure. Mr. Zandi disagreed, saying he didn’t think bankruptcy courts would operate quickly enough to deal with such large failures. Public confidence would be a major issue in a situation such as this.
Chairman Frank next attacked a statement in Mr. Johnson’s prepared remarks referring to the short-term measures particularly undertaken by the Obama Administration. Mr. Frank wanted to clarify that every activity now being characterized as a "bail out" was initiated by the Bush Administration (AIG, Bear Stearns, Merrill Lynch/Bank of America, General Motors, and Chrysler). He said the first proposal for a bail out that came before the Obama Administration was CIT, and they said "no".
Rep. Scott Garrett (R – NJ) noted Mr. Zandi’s statement that he would place systemic risk regulation with the Federal Reserve, and asked "why them"? Mr. Garrett pointed out the failures of the Fed in previous situations (the tech and real estate bubbles) where he noted Alan Greenspan later had said "maybe I missed that one". Mr. Garrett said if you review the minutes of the Federal Reserve meetings, there was no acknowledgement of a “bubble”; instead the Fed was viewing this as an increase in productivity. Rep. Garrett also noted the Fed’s “wrong” approach on Basel II. Further, he said the Fed had authority to raise capital requirements for Citibank and others, and did nothing. He then asked Mr. Zandi how he could possibly think the Fed was the best choice to assume this new responsibility. Mr. Zandi’s response was that the Fed was the best of a group of bad choices.
Rep. Kenny Marchant (R – TX) asked Mr. Wallison if it was true that he believed AIG was not too big to fail, and that AIG had not defaulted on its obligations. Mr. Wallison said that was true. He said AIG’s credit default swaps did not cause any losses to counterparties; the counterparties merely lost the “insurance” protection they had purchased. Mr. Wallison said, in his view, there is a lot of misinformation regarding the nature of credit default swaps suggesting that they are very dangerous. He believes they are not, and there was no need for the government to take action such as it did with AIG. He said Goldman Sachs, AIG’s largest CDS counterparty, was fully protected from loss by collateral and other measures, but he said due to AIG’s size and interconnectedness, the government mistakenly believed intervention was necessary. In response to another question from Rep. Marchant, Mr. Zandi offered his opinion that the primary cause of the crisis was the fact that the securitization process was “fundamentally broken”. He said no one in the securitization chain had a clear understanding of all the risks. He further said the securitization process has economic value and makes sense under certain circumstances, but the process got abused. Mr. Zandi then said he disagreed with Mr. Wallison regarding AIG and said it is very clear that, if AIG had failed, there would have been substantive risk to the entire system. He said “too big to fail” may refer to relationships such as counterparties, but it also relates to confidence, and had AIG failed, many other entities would have failed and the whole financial system might have collapsed.
Chairman Frank then asked if any of the panel members favored an outright limitation on the growth and size of institutions. Mr. Johnson was the only witness to favor a cap on growth.
Rep. Brad Sherman (D – CA) noted that in his view, the Administration’s systemic resolution proposal represents “permanent, unlimited TARP”. “Wall Street will love the money, government will love the power”. He said this proposal has no chance of passing in the House on a straight up-or-down vote.
In closing the hearing Chairman Frank indicated that there appeared to be consensus regarding the need to correct the problems caused by the credit rating agencies and he stated that, as part of this legislative process, any and all existing statutory mandates to rely upon the credit rating agencies will be repealed, and the Congress will instruct the regulatory agencies to examine theirs.
On July 21, 2009 the House Financial Services Committee heard testimony on systemic risk and issues surrounding the concept of “too big to fail”. Appearing as witnesses were: Alice Rivlin, Senior Fellow, Brookings Institution; Peter Wallison, Fellow, American Enterprise Institute; Simon Johnson, Professor, Massachusetts Institute of Technology; Mark Zandi, Chief Economist, Moody’s Economy.com, and Paul Mahoney, Dean, University of Virginia School of Law.
Committee Chairman Barney Frank opened the hearing by stating that he believes no one favors the concept of “too big to fail”, but there seems to be no consensus on what to do about it. He observed that it seemed to be much more easily denounced than dismantled. He said this hearing was not meant as a step toward structuring an approach for government “bail outs”, but instead is part of an effort to avoid the situation faced by the Bush Administration that had no alternative beyond providing government funding to large entities whose failures posed a risk to our financial system.
Ms. Rivlin began her prepared remarks by observing there is no permanent fix to this problem. She said we need some government entity charged with looking continuously at the regulatory system and markets and at whatever perverse incentives may have crept into the system, because whatever rules are adopted will become obsolete as financial innovation progresses and market participants find their way around the rules. She pointed out that the Administration makes a case for such an institution and places the responsibility with a new oversight council. She said this seems to be a cumbersome mechanism and she believes this type of responsibility should be given to the Federal Reserve. She believes this would actually enhance the Fed’s effectiveness as the central bank. Conversely, she believes designating the Federal Reserve as the consolidated regulator for systemic risk would be a mistake. She believes designating systemically important entities and giving them their own regulator would institutionalize “too big to fail” and create a new GSE-like class of institutions. Higher capital requirements and stricter regulation for these entities makes sense, but without granting them their own regulator.
Mr. Wallison stated that, if there is an entity that is "too big to fail", it can only be a large commercial bank. He said in order to be "too big to fail", its collapse must have a major adverse effect on the entire economy – not simply a mere disruption. In his view, only the failure of a large commercial bank could cause this kind of systemic breakdown. He said it would be difficult to see how a large, non-bank institution (bank holding company, securities firm, finance company, hedge fund, etc.,) can cause systemic risk and thus, be too big to fail. He pointed out that these entities do not hold deposits, and if they fail, their creditors do not suffer any immediate cash losses that would make it difficult to pay their bills. No household or business operating funds are placed with these companies. Further, he believes the freeze in lending that followed the Lehman Brothers collapse has led some to believe that Lehman caused that event. In his view, Lehman’s failure did not cause this systemic problem – it caused what he termed a “common shock” where a market freezes up because new information has come to light. This new information was the fact that the government was not going to rescue every firm larger than Bear Stearns. In this new light, every market participant had to re-evaluate the risks of lending to everyone else. He said it is no wonder lending ground to a halt. He said the government’s focus should be on keeping commercial banks sound and healthy; all other entities should be viewed as risk-takers and should be allowed to fail. He recommends that capital requirements for large banks be increased as the banks get larger. Higher capital requirements will cause banks to reconsider whether growth for its own sake really makes sense. He said regulators should develop indicators of risk-taking that banks should be required to publish regularly. Also, Congress should establish a “systemic risk council” consisting of all the bank supervisors and other financial regulators, and it should be charged with spotting conditions in the banking industry (like the acquisition of “toxic” assets) that might make all major banks weak or unstable. He said if we keep our banks stable, we will keep our financial system stable. He concluded by saying that, as a member of the Financial Crisis Inquiry Commission, he would urge Congress to wait until the Commission has delivered its report before adopting legislation.
Mr. Johnson said the issue before us is simple: we must avoid the situation where a large entity comes before the government and says "either you bail us out, or the system will collapse". He believes there are two ways to address this problem: (1) change the regulatory and bankruptcy system; and (2) reduce the size of the institutions. He does not believe the first approach will solve the fundamental problem. He said the banking system has been very persuasive in convincing itself and others (investors, regulators, Congress) that it knows how to manage risks. He pointed out that Alan Greenspan admits it was a mistake to believe that, because banks had a great deal to lose if things went bad, they understood these risks and would control and manage them – they didn’t. This was a failure of risk management, and Mr. Johnson said he sees no evidence either that the banks have improved their management of risk or that regulators have become better at spotting such a problem. He agrees that some sort of systemic risk oversight entity is desirable, but it seems we are a long way from achieving that. He believes the best approach is ratcheting up capital requirements and deposit insurance assessments as entities grow larger. He said the country has encountered massive costs in our efforts to forestall another depression, and the result has been concentration of more power and influence by these larger entities. He observed that, for this cost, we have bought nothing in terms of actually improving the financial system.
Mr. Zandi said, overall, the Administration’s plan is reasonable and well-designed. He believes the Federal Reserve is the right choice for systemic risk regulator. However, he doesn’t see the proposed new regulatory council as providing any value beyond what is already in place. He said the crisis has shown an uncomfortably large number of institutions are too big to fail. He understands the desire to break up these entities, but he believes such efforts would be futile. Breaking up large institutions would be too wrenching and would put U.S. institutions at a distinct disadvantage relative to their large, global competitors. He said large institutions are also needed to back-stop the rest of the financial system. He believes it is better to provide tighter regulation of these entities, with higher capital and liquidity requirements, greater disclosure requirements and higher deposit insurance premiums commensurate with the risks they take and present.
Mr. Mahoney described the Administration’s proposed systemic risk resolution structure as a "bail out" mechanism. He said there are two schools of thought on how to best prevent future financial crises leading to wide-scale bailouts. The first says it was wrong to bail out creditors of failed institutions so that they avoided losses they otherwise would have realized in a normal bankruptcy proceeding and the policy going forward should not be repeated. The second concedes that the government will ordinarily bail out large, systemically important entities. Under this approach, Congress should seek to limit the risks those institutions can take in order to minimize the likelihood that they will become financially distressed, because failure would result in a bail out as a matter of course. This is the Administration’s approach. Mr. Mahoney believes the first approach will produce a healthier financial services industry that will make fewer claims on taxpayers in the future. It is based on a sounder premise – that the best way to reduce moral hazard is to ensure that economic agents bear the costs of their own mistakes. He said the Administration’s plan suggests that regulatory oversight will compensate for misaligned incentives. This position is based on the premise that some institutions are too big to fail. Mr. Mahoney says it is not clear that the magnitude of this problem justifies the scale of the government intervention that we have seen in the past year. He believes bankruptcy is a more appropriate mechanism to deal with these failures, although he admits that the bankruptcy system may need to be refined and enhanced. The other approach furthers moral hazard that impacts the industry continuously, not just in times of crisis. He said that is because perceived systemically important firms ultimately do not pay a sufficient price for taking risks. The result is a dangerous feedback loop: large banks have access to cheap capital, which causes them to grow even larger and more systemically important while taking excessive risks. This all results in the higher probability of a crisis, thus a bailout regime leads to more frequent crises. He disagrees with the Administration’s premise that the higher requirements and regulatory scrutiny proposed for Tier 1 Financial Holding Companies reduces a firm’s desire to be so designated. He believes that the implicit "too big to fail" designation will cause firms to desire inclusion within such a designation. He believes that the Administration’s conclusion that the imposition of higher capital and liquidity requirements on these firms will increase their cost of capital is "wildly optimistic". Firms with an implicit government guarantee will have a valuable commodity to sell, he stated. They will have a powerful incentive to find financial products, off-balance sheet devices, and any other means to evade any limits on the risks they can purchase from others in the financial system.
Chairman Frank made it clear that there will be no official designation of any entities as Tier 1 Financial Holding Companies or any hard and fast rules or criteria for otherwise identifying systemically important firms. He said each case will be unique and will have to be judged independently. There will be no official list of systemically important entities. He said he believes the Administration now sees the weakness in the originally-announced approach. Chairman Frank asked Mr. Johnson if it would be feasible to adjust deposit insurance premiums to account for the higher risks posed by these types of entities. Mr. Johnson said this would be a workable concept and would have the effect of discouraging excessive risk-taking by insured institutions.
In response to a question, Mr. Wallison observed that no one can yet agree on what systemic risk really is; therefore, we need to concentrate on ensuring the banking industry is safe and sound and not worry about extending regulation to firms outside the banking industry.
Rep. Paul Kanjorski (D – PA) asked Ms. Rivlin to clarify whether she believes the Federal Reserve should be the systemic risk regulator. She responded that she did not hold that view for two reasons: first, she does not think there should be such a separately designated regulator; and, if there were, the Fed would not “be very good at it”. Rep. Kanjorski said he agreed with that assessment. He next asked Mr. Wallison how he could possibly believe that only banks present systemic risk, when he had just witnessed what had occurred with regard to the auto industry and the ripple effect failures of those firms would have caused. Mr. Wallison said this is an example of his observation that we don’t have a firm grasp on what systemic risk really is. He viewed the auto industry situation as a “disruption”, not a crisis.
Ranking Member Spencer Bachus (R – AL) observed that several witnesses have essentially concluded that the government’s actions in the recent crisis have increased systemic risk and created a more dangerous environment. Mr. Wallison agreed. He said every time we bail out one institution, we create the belief that others will be bailed out, creating risk and moral hazard. Mr. Bachus said he believed some firms have become bigger and more politically powerful as a result of the crisis – the competition has been eliminated. He said they have no incentive to bring down the level of risk they pose. Mr. Johnson agreed with that assessment. In response to another question from Rep. Bachus, Mr. Johnson responded that the best way to deal with large firms would be to add a new chapter to the bankruptcy code that would set forth more defined procedures for unwinding a failure. Mr. Zandi disagreed, saying he didn’t think bankruptcy courts would operate quickly enough to deal with such large failures. Public confidence would be a major issue in a situation such as this.
Chairman Frank next attacked a statement in Mr. Johnson’s prepared remarks referring to the short-term measures particularly undertaken by the Obama Administration. Mr. Frank wanted to clarify that every activity now being characterized as a "bail out" was initiated by the Bush Administration (AIG, Bear Stearns, Merrill Lynch/Bank of America, General Motors, and Chrysler). He said the first proposal for a bail out that came before the Obama Administration was CIT, and they said "no".
Rep. Scott Garrett (R – NJ) noted Mr. Zandi’s statement that he would place systemic risk regulation with the Federal Reserve, and asked "why them"? Mr. Garrett pointed out the failures of the Fed in previous situations (the tech and real estate bubbles) where he noted Alan Greenspan later had said "maybe I missed that one". Mr. Garrett said if you review the minutes of the Federal Reserve meetings, there was no acknowledgement of a “bubble”; instead the Fed was viewing this as an increase in productivity. Rep. Garrett also noted the Fed’s “wrong” approach on Basel II. Further, he said the Fed had authority to raise capital requirements for Citibank and others, and did nothing. He then asked Mr. Zandi how he could possibly think the Fed was the best choice to assume this new responsibility. Mr. Zandi’s response was that the Fed was the best of a group of bad choices.
Rep. Kenny Marchant (R – TX) asked Mr. Wallison if it was true that he believed AIG was not too big to fail, and that AIG had not defaulted on its obligations. Mr. Wallison said that was true. He said AIG’s credit default swaps did not cause any losses to counterparties; the counterparties merely lost the “insurance” protection they had purchased. Mr. Wallison said, in his view, there is a lot of misinformation regarding the nature of credit default swaps suggesting that they are very dangerous. He believes they are not, and there was no need for the government to take action such as it did with AIG. He said Goldman Sachs, AIG’s largest CDS counterparty, was fully protected from loss by collateral and other measures, but he said due to AIG’s size and interconnectedness, the government mistakenly believed intervention was necessary. In response to another question from Rep. Marchant, Mr. Zandi offered his opinion that the primary cause of the crisis was the fact that the securitization process was “fundamentally broken”. He said no one in the securitization chain had a clear understanding of all the risks. He further said the securitization process has economic value and makes sense under certain circumstances, but the process got abused. Mr. Zandi then said he disagreed with Mr. Wallison regarding AIG and said it is very clear that, if AIG had failed, there would have been substantive risk to the entire system. He said “too big to fail” may refer to relationships such as counterparties, but it also relates to confidence, and had AIG failed, many other entities would have failed and the whole financial system might have collapsed.
Chairman Frank then asked if any of the panel members favored an outright limitation on the growth and size of institutions. Mr. Johnson was the only witness to favor a cap on growth.
Rep. Brad Sherman (D – CA) noted that in his view, the Administration’s systemic resolution proposal represents “permanent, unlimited TARP”. “Wall Street will love the money, government will love the power”. He said this proposal has no chance of passing in the House on a straight up-or-down vote.
In closing the hearing Chairman Frank indicated that there appeared to be consensus regarding the need to correct the problems caused by the credit rating agencies and he stated that, as part of this legislative process, any and all existing statutory mandates to rely upon the credit rating agencies will be repealed, and the Congress will instruct the regulatory agencies to examine theirs.
Monday, July 20, 2009
Securities Industry Perspectives on the Regulatory Reform Plan
By W. Bernard Mason
On July 17, 2009 the House Financial Services Committee heard from representatives of the securities industry regarding the issues raised by the Administration's regulatory reform plan. Appearing before the Committee were: Richard Baker, representing the Managed Funds Association; William Brodsky, representing the Chicago Board Options Exchange; Randy Snook, representing the Securities Industry and Financial Markets Association; Paul Stevens, representing the Investment Company Institute; Douglas Lowenstein, representing the Private Equity Council; Diahann Lassus, representing the Financial Planning Coalition; and Rob Nichols, representing the Financial Services Forum.
Rep. Paul Kanjorski (D -PA) chaired the Committee and began the hearing by mentioning a recent survey of investors that cited regulatory failure as the primary reason for their lack of confidence in the financial markets. He said he had advised SEC Chair Mary Shapiro earlier this week that the Commission must take bold and assertive action to strengthen enforcement. He said the Commission must also re-write the rules governing the industry to better protect investors. Additionally, he said Congress must update our security laws. He said Chairman Shapiro and the SEC's Inspector General have submitted legislative suggestions and the Administration's "white paper" and accompanying pieces of legislative language complement these suggestions, especially in the areas of hedge fund regulation and establishing a fiduciary duty for broker/dealers providing investment advice. Rep. Kanjorski said he is now developing legislation aimed at closing loopholes and stopping unscrupulous practices. Reform of credit rating agencies has a "top spot" on his agenda, as overly optimistic ratings played a significant role in the global crash.
Rep. Brad Sherman (D - CA), in his opening statement, indicated that he would be introducing legislation requiring the SEC to select the rating agency for a particular security issuance as an attempt to deal with the perceived conflict of interest created by issuer selection. Regarding custom, over-the-counter derivatives, he said these have been justified as a way to hedge legitimate risks, but he views the majority of these transactions as just "casino bets" where someone does not have a risk to hedge. He said this is a particular concern since Secretary Geithner told the Committee that he reserves the right to bail out derivatives issuers and their counterparties, so Mr. Sherman believes the federal government has an interest in restricting these instruments. Rep. Sherman says much higher capital requirements are needed for over-the-counter derivatives, and these instruments may be restricted to use only where a market instrument is not available. He said legislation should make clear that there will be no further government bailouts for these derivatives.
Rep. Randy Neugebaurer (R - TX) noted the witnesses' general agreement with the broad principles of the Administration's proposal on securities markets but he cautioned that the Congress must not take action that will put derivatives users at a competitive disadvantage and discourage businesses from properly hedging their risks. He warned that the government cannot micromanage markets to prevent future losses. Investors need to know that the responsibility rests with them and that government bailouts are not an option.
Mr. Baker, the first witness, provided a profile of the hedge fund industry by pointing out its total assets of $1.5 trillion under management make it significantly smaller than either the mutual fund industry or the banking industry and less likely to pose systemic risk. He further pointed out that many hedge funds use little or no leverage, further limiting their contribution to systemic risk. Nevertheless, he said his members have a shared interest in restoration of investor confidence and establishing a more stable and transparent marketplace. He believes this can be attained with a carefully constructed regulatory scheme and aided by adoption of industry "sound practices". He said this will require investors to do their own due diligence. He noted that SEC registration for fund advisors is a key regulatory reform. Mr. Baker said his organization supports efforts aimed at standardization and central clearing or exchange trading of OTC derivatives. However, he believes it is important for market participants to enter into customized contracts, assuming appropriate collateral is posted and adequately separated and protected. He said there should be a systemic risk regulator with key oversight of the system and with a clear mandate to protect the integrity of the financial system, not individual market participants.
Mr. Brodsky said he applauded the Administration's proposal on regulatory reform, and he believes the Congress should not squander the opportunity to design reforms that are long overdue. He believes the SEC/CFTC jurisdictional divide is dramatically antiquated. He said this bifurcation has had consistent negative consequences that we ignore at our peril. Consolidation of these two agencies is the only rational approach, he indicated. He said he applauded the Administration's proposal to create a regulatory council to oversee systemic risk.
Mr. Snook stated that establishment of a systemic risk regulator is the most important step in regulatory reform. He supports the Administration's proposal in this regard. He mirrored Mr. Baker's views with respect to regulatory oversight of derivative products.
Mr. Stevens said his organization fully supports the Administration's reform proposals, but has one concern regarding the plan to oversee systemic risk. He said his members have long subscribed to the notion of a council to oversee such issues and believes a diverse perspective is required. However, he is concerned that the council as proposed by the Administration would have only an advisory and consultative role. Vesting the authority with the Federal Reserve would strike the wrong balance. He would urge Congress to create a strong systemic risk council.
Mr Lowenstein said it is important for Congress to enact reforms, but speed should not be the goal. He stressed that private equity presents none of the factors listed in the Administration's proposal for identifying systemically important entities.
Ms. Lassus said her group was happy to see that the Administration's plan would hold broker/dealers to the same fiduciary standard as investment advisors. She said she further supported all the Administration's key principles for strengthening consumer protection.
Mr. Nichols said reform and modernization is needed and overdue. The current framework is outdated. In his view, the main deficiency with the current regulatory structure is its stovepipe structure that has led to two major problems that created the opportunity for and may have exacerbated the current crisis: gaps in the existing silos; and, no agency is responsible for systemic risks. He believes the cornerstone of reform is creation of a systemic risk supervisor. He said perhaps no factor is more regrettable than invoking the concept of "too big to fail", and it is important to establish an acceptable resolution mechanism to provide for failure of larger entities.
Rep. Kanjorski expressed his severe doubts regarding the appropriateness of designating the Federal Reserve as the systemic risk regulator. He is also concerned that "systemic risk" has not be adequately identified and defined. Mr. Stevens agreed that no one has clearly defined what "systemic risk" is. He said the Administration's criteria make specific application very uncertain.
Rep. Judy Biggert (R - IL) asked Mr. Baker his view on the proposal to establish a separate consumer agency. Mr. Baker said it is unclear to him how any such consumer agency or activity would relate to an entity regulated by either the SEC or the CFTC, and he would have to understand how that would work before he could take a position on the issue.
On July 17, 2009 the House Financial Services Committee heard from representatives of the securities industry regarding the issues raised by the Administration's regulatory reform plan. Appearing before the Committee were: Richard Baker, representing the Managed Funds Association; William Brodsky, representing the Chicago Board Options Exchange; Randy Snook, representing the Securities Industry and Financial Markets Association; Paul Stevens, representing the Investment Company Institute; Douglas Lowenstein, representing the Private Equity Council; Diahann Lassus, representing the Financial Planning Coalition; and Rob Nichols, representing the Financial Services Forum.
Rep. Paul Kanjorski (D -PA) chaired the Committee and began the hearing by mentioning a recent survey of investors that cited regulatory failure as the primary reason for their lack of confidence in the financial markets. He said he had advised SEC Chair Mary Shapiro earlier this week that the Commission must take bold and assertive action to strengthen enforcement. He said the Commission must also re-write the rules governing the industry to better protect investors. Additionally, he said Congress must update our security laws. He said Chairman Shapiro and the SEC's Inspector General have submitted legislative suggestions and the Administration's "white paper" and accompanying pieces of legislative language complement these suggestions, especially in the areas of hedge fund regulation and establishing a fiduciary duty for broker/dealers providing investment advice. Rep. Kanjorski said he is now developing legislation aimed at closing loopholes and stopping unscrupulous practices. Reform of credit rating agencies has a "top spot" on his agenda, as overly optimistic ratings played a significant role in the global crash.
Rep. Brad Sherman (D - CA), in his opening statement, indicated that he would be introducing legislation requiring the SEC to select the rating agency for a particular security issuance as an attempt to deal with the perceived conflict of interest created by issuer selection. Regarding custom, over-the-counter derivatives, he said these have been justified as a way to hedge legitimate risks, but he views the majority of these transactions as just "casino bets" where someone does not have a risk to hedge. He said this is a particular concern since Secretary Geithner told the Committee that he reserves the right to bail out derivatives issuers and their counterparties, so Mr. Sherman believes the federal government has an interest in restricting these instruments. Rep. Sherman says much higher capital requirements are needed for over-the-counter derivatives, and these instruments may be restricted to use only where a market instrument is not available. He said legislation should make clear that there will be no further government bailouts for these derivatives.
Rep. Randy Neugebaurer (R - TX) noted the witnesses' general agreement with the broad principles of the Administration's proposal on securities markets but he cautioned that the Congress must not take action that will put derivatives users at a competitive disadvantage and discourage businesses from properly hedging their risks. He warned that the government cannot micromanage markets to prevent future losses. Investors need to know that the responsibility rests with them and that government bailouts are not an option.
Mr. Baker, the first witness, provided a profile of the hedge fund industry by pointing out its total assets of $1.5 trillion under management make it significantly smaller than either the mutual fund industry or the banking industry and less likely to pose systemic risk. He further pointed out that many hedge funds use little or no leverage, further limiting their contribution to systemic risk. Nevertheless, he said his members have a shared interest in restoration of investor confidence and establishing a more stable and transparent marketplace. He believes this can be attained with a carefully constructed regulatory scheme and aided by adoption of industry "sound practices". He said this will require investors to do their own due diligence. He noted that SEC registration for fund advisors is a key regulatory reform. Mr. Baker said his organization supports efforts aimed at standardization and central clearing or exchange trading of OTC derivatives. However, he believes it is important for market participants to enter into customized contracts, assuming appropriate collateral is posted and adequately separated and protected. He said there should be a systemic risk regulator with key oversight of the system and with a clear mandate to protect the integrity of the financial system, not individual market participants.
Mr. Brodsky said he applauded the Administration's proposal on regulatory reform, and he believes the Congress should not squander the opportunity to design reforms that are long overdue. He believes the SEC/CFTC jurisdictional divide is dramatically antiquated. He said this bifurcation has had consistent negative consequences that we ignore at our peril. Consolidation of these two agencies is the only rational approach, he indicated. He said he applauded the Administration's proposal to create a regulatory council to oversee systemic risk.
Mr. Snook stated that establishment of a systemic risk regulator is the most important step in regulatory reform. He supports the Administration's proposal in this regard. He mirrored Mr. Baker's views with respect to regulatory oversight of derivative products.
Mr. Stevens said his organization fully supports the Administration's reform proposals, but has one concern regarding the plan to oversee systemic risk. He said his members have long subscribed to the notion of a council to oversee such issues and believes a diverse perspective is required. However, he is concerned that the council as proposed by the Administration would have only an advisory and consultative role. Vesting the authority with the Federal Reserve would strike the wrong balance. He would urge Congress to create a strong systemic risk council.
Mr Lowenstein said it is important for Congress to enact reforms, but speed should not be the goal. He stressed that private equity presents none of the factors listed in the Administration's proposal for identifying systemically important entities.
Ms. Lassus said her group was happy to see that the Administration's plan would hold broker/dealers to the same fiduciary standard as investment advisors. She said she further supported all the Administration's key principles for strengthening consumer protection.
Mr. Nichols said reform and modernization is needed and overdue. The current framework is outdated. In his view, the main deficiency with the current regulatory structure is its stovepipe structure that has led to two major problems that created the opportunity for and may have exacerbated the current crisis: gaps in the existing silos; and, no agency is responsible for systemic risks. He believes the cornerstone of reform is creation of a systemic risk supervisor. He said perhaps no factor is more regrettable than invoking the concept of "too big to fail", and it is important to establish an acceptable resolution mechanism to provide for failure of larger entities.
Rep. Kanjorski expressed his severe doubts regarding the appropriateness of designating the Federal Reserve as the systemic risk regulator. He is also concerned that "systemic risk" has not be adequately identified and defined. Mr. Stevens agreed that no one has clearly defined what "systemic risk" is. He said the Administration's criteria make specific application very uncertain.
Rep. Judy Biggert (R - IL) asked Mr. Baker his view on the proposal to establish a separate consumer agency. Mr. Baker said it is unclear to him how any such consumer agency or activity would relate to an entity regulated by either the SEC or the CFTC, and he would have to understand how that would work before he could take a position on the issue.
House Panel to Mark Up Legislation on Executive Compensation
By W. Bernard Mason
On July 17, 2009 House Financial Services Committee Chairman Barney Frank (D - RI) made public draft legislation that would require all U.S. banks, brokerages and other financial firms to disclose how they compensate top executive officers. It also would require nonbinding shareholder votes on compensation (say on pay) and require compensation committees to consist of independent directors.
More specifically, the legislation in its current form contains four components:
On July 17, 2009 House Financial Services Committee Chairman Barney Frank (D - RI) made public draft legislation that would require all U.S. banks, brokerages and other financial firms to disclose how they compensate top executive officers. It also would require nonbinding shareholder votes on compensation (say on pay) and require compensation committees to consist of independent directors.
More specifically, the legislation in its current form contains four components:
- Say on pay (similar to legislation passed by the House in 2007) that would apply to all public companies and would require annual nonbinding shareholder vote on compensation and golden parachutes.
- Independent compensation committee requirement that would apply to all public companies and a requirement that compensation consultants satisfy SEC-established criteria.
- Incentive-based compensation would require disclosure by all banks, bank holding companies, broker-dealers, credit unions, investment advisors and any others identified through joint rulemaking by federal financial regulators.
- Federal financial regulators would be required to establish compensation standards for financial institutions that would identify inappropriate or imprudently risky compensation practices as part of solvency regulation.
Rep. Frank released this draft bill on the heels of the Administration's submission of similar legislation to Congress the day before. Congressman Frank stated that he expects a mark-up of this bill to be completed by the end of this week.
House Hears Financial Industry Perspective on Reform Plan
By W. Bernard Mason
On July 15, 2009, the House Financial Services Committee held a hearing to obtain financial services industry representatives' perspectives on the Administration's regulatory reform plan. Testifying were: Steve Bartlett, representing the Financial Services Roundtable; John Courson, representing the Mortgage Bankers Association; Chris Stinebert, representing the American Financial Services Association; Steven Zeisel, representing the Consumer Bankers Association; Todd Zywicki, Professor of Law; Denise Leonard, representing the National Association of Mortgage Brokers; Edward Yingling, representing the American Bankers Association; and, Michael Menzies, representing the Independent Community Bankers Association.
Committee Chairman Barney Frank (D - RI) opened this hearing by indicating that he will be attempting to complete mark-ups on some pieces of the regulatory reform effort by the end of July, but other portions (he specifically mentioned issues dealing with systemic risk) will not be completed until September. He stated that he had scheduled a separate hearing for July 21 specifically to deal with the issue of "too big to fail". He stated that, while he felt the Administration's proposal had dealt with this matter in a reasonable way, he wanted to provide an opportunity to air all points of view on the issue.
Regarding matters relevant to the current hearing, he mentioned that his staff had compiled documentation regarding the many consumer complaints that he said had been received from Members on both sides of the aisle regarding the actions of credit card companies doing things in anticipation of the effective date of the recently signed legislation. He said that there had been agreement to hold off the effective date of the law as an accommodation to the industry, but he now questions to wisdom of the action because of moves taken by credit card lenders. He specifically cited a move by lenders to significantly increase minimum monthly payment requirements on existing balances, which he feels is particularly egregious, as it is "changing the rules after people have starting playing". He said had borrowers known their payments were going to be increased, they might have made other choices regarding their loan balances. He said credit card holders of one major lender had been told by bank personnel that the payment increases were mandated by federal law. He said these actions are the very types of things that strengthen the case for the creation of a Consumer Financial Protection agency. He said "We cannot pass a law every time there is a set of complaints." He said what we need are rules, and it has not been the case that existing regulators have used the statutory authority given to them. He said the complaints about credit card banks have become very significant.
Chairman Frank stated that the hearing's witnesses may object to the creation of a new consumer agency, but he made clear that no objection should be raised based upon a concern that this might cause a regulated institution to get conflicting messages from two regulators. He said he can guarantee that this law can be written to prevent that. He admits that, in his view, the Administration made a mistake in including CRA as a matter to fall under the purview of the new agency, as he believes this "is of a different order or activity". On another issue, he said that the concept of merging the OTS and the OCC would be a true "merger" of the two, not a take-over by the OCC, since Rep. Frank believes the thrift charter and function should be preserved and there will be no move to abolish the charter. He said the intention would be to narrow the focus of the charter so that it is "a thrift charter only" and not a license to engage in other activities.
Rep. Randy Neugebauer (R - TX), in his opening remarks, stated his concern that the entire process had been directed toward new legislation. He said the fact is there is already legislation on the books that addresses much of the problem areas; the problem is that regulators didn't do their jobs regarding proper enforcement.
The first witness, Mr. Bartlett, stated there were many factors that caused the problems that brought us to this point, but he believes the main one was a regulatory system in chaos that was just not functioning properly. He said the Financial Services Roundtable supports bold, comprehensive reform. He said the Roundtable strongly opposes creation of a new consumer protection agency and strongly supports the designation of the Federal Reserve as the systemic risk regulator. He believes the creation of a strong federal insurance regulator should be an essential part of this regulatory reform.
Mr. Courson seconded most of Mr. Bartlett's statements, emphasizing the need for uniform regulation of all mortgage service providers. Mr. Stinebert remarked that the proposed legislation has the potential to "roll back the clock 30 years", back to a time when consumers had no choice of products, and he believes this proposal will stifle industry innovation. He also pointed out that, under this proposal, institutions could "wind up with 50 different state requirements" and "that is not a formula for simplification." He also emphasized the importance of preserving the industrial bank charter, since it played no role in the current crisis and he believes they should be part of the solution.
Mr. Ziesel stated that safety and soundness and consumer protection are intimately related and the two functions should not be separated. He said there should be stronger supervision of non-bank lenders so there is consistent and competent oversight of mortgage lenders. He also cited the problem of subjecting retail banks to the consumer laws of 50 states, making nationwide lending a costly and complex undertaking. He indicated that this would limit the range of products and perhaps drive banks to avoid doing business in certain states. Even simple uniform disclosures, one of the goals of this legislation, would have to be supplemented to meet the requirements of each individual state, he stated. He believes the better approach is to maintain a uniform national standard. He further stated that the push for "plain vanilla" products makes it unclear that banks will be able to offer the range of products they now do. This is because the proposal discourages the offering of other products consumers may find useful by creating regulatory uncertainty regarding how these "non-vanilla" products must be described, how they can be advertised, and what disclosures will be required to accompany them. He said it is also unclear if institutions would be required to offer the same "plain vanilla" product to everyone regardless of whether they qualify.
Mr. Zywicki stated his view that there are three fatal problems with the proposal to create a new consumer agency: it is based on misguided paternalism; it misdiagnoses the underlying problems and could lead to unintended consequences; and, it creates an unworkable new government planning apparatus.
Ms. Leonard said her organization supports the general concept of a separate consumer agency. She said consumers would greatly benefit from a uniform disclosure requirement that clearly and simply explains critical loan terms. She also pointed out that the board structure of the new agency, as proposed, is flawed, since its board members would not be limited as to party affiliation. She said the five-person board should have no more than three members of any one political party.
Mr. Yingling said ABA believes there are three areas that should be the primary focus of regulatory reform: the creation of a systemic regulator; the creation of a new resolution mechanism; and, filling the gaps in regulation of the shadow banking industry. Regarding systemic regulation, Mr. Yingling said this should not be about focusing on specific entities or institutions, but about looking at information and trends on the economy and different sectors within the economy. Such problematic trends from the recent past would have included: the rapid appreciation of home prices; the proliferation of mortgages that ignored the long-term ability to repay; excess leverage in some Wall Street firms; the rapid growth and complexity of some mortgage-backed securities and how they were rated; and, the rapid growth of the credit default swap market. The new regulator should be focused and nimble; involving it in day-to-day regulation would be a distraction. He noted that, while most of the early focus had been on giving this systemic risk authority to the Federal Reserve, now the focus is on giving it to an independent council. He said this approach makes since, but it should not be a committee. The council should have its own dedicated staff, but it should not be a large bureaucracy. The council should have "carefully calibrated back-up authority" when systemic issues are not being properly addressed. He believes a board consisting of the primary regulators plus Treasury seems logical. He believes the systemic regulator should have authority over accounting rulemaking, due to the critical relationship of accounting rules to systemic risk. Regarding systemic resolution authority, Mr. Yingling said whatever is done on this front will set the parameters for "too big to fail". He said ABA is concerned that this issue is not adequately addressed in the Administration's proposal. ABA believes the goal should be to eliminate, as much as possible, moral hazard and unfairness. When an institution goes into this resolution process, its top management, board, and major stakeholders should be subject to clearly set out rules of accountability, change, and financial loss. He said no one should want to be considered "too big to fail". He said the ABA strongly supports maintaining the federal thrift charter.
Mr. Menzies said ICBA supports identifying specific institutions that may pose systemic risk and systemic danger, and subjecting them to stronger supervision, capital and liquidity requirements. He said the Administration's plan could be enhanced by imposing fees on systemically important holding companies for their supervisory costs and to fund, in advance, a new systemic risk fund. He said the plan should also implement procedures to downsize "too big to fail" institutions in an orderly way. He stated that ICBA urges continuation of both the state bank and the federal thrift charter. He said ICBA opposes the proposal for a new consumer protection agency, in its current form. ICBA urges the addition of an Assistant Secretary for Community Institutions within the Treasury Department to provide an internal voice for main street concerns.
Chairman Frank observed that most of the witnesses hold concerns regarding the extent to which the proposal would recognize state consumer protection authority. He said he assumes it is the position of the witnesses that any proposal should include federal preemption of such state authority. Except for Ms. Leonard, they all concurred that a national uniform standard was called for.
Rep. Neugebauer observed that, in his past experience as a banker, he was often called upon to tailor products to fit specific customer needs. He fears that the Administration's proposal is not a consumer protection bill, but a product regulation bill. He requested the panel's views on the federal government becoming very prescriptive in the types of products allowed to be offered. Mr. Bartlett said the government should regulate for safety and soundness and consumer protection but should not dictate products. The other panelists agreed with that observation.
Rep. Paul Kanjorski (D - PA) asked the panel if any of them believed either CRA or the activities of Fannie Mae and Freddie Mac had been contributing factors to the current crisis. None of the panelists felt that those factors were contributors to the crisis. Rep. Kanjorski then asked the panel if any of them recognized this problem building. Mr. Bartlett said the Roundtable saw troubling signs in 2006 but did not move quickly enough to deal with them. Mr. Yingling said that the failure to recognize the signs is clear evidence and support for the creation of a systemic risk authority.
Rep. Edward Royce (R - CA) stated his view that both Freddie and Fannie were driven by the misguided altruistic belief that the highest possible stretch for homeownership was to the benefit of consumers. He believes it would be very difficult to create a separate regulatory entity, charge it with consumer protection oversight, and then not expect it to come up with a similar, politically driven mandate. He believes these politically driven mandates caused the financial collapse. He asked the panel to comment on the prospect of the Consumer Financial Protection Agency being used for politically mandated purposes in the future. Mr. Courson said he is concerned that we are attempting an experiment that may ultimately cause safety and soundness concerns. Mr. Zywicki agreed.
Rep. Maxine Waters (D - CA) inquired as to why mortgage servicers cannot understand that we have a crisis and that we need to intensify the loan modification process to avoid massive foreclosures. Mr. Bartlett said Roundtable members are now modifying approximately 250,000 mortgages per month and he admitted this pace was woefully inadequate.
Rep. Frank Lucas (R - OK) asked Messrs. Yingling and Menzies to comment on the effect of the Administration's proposal on community banks and small businesses. Mr. Yingling said his main concern is the directive that products should be standardized, since loans in small communities are not "cookie-cutter", they are individually designed. Based upon the strong language in the Administration's proposal, community banks would be discouraged from making custom-designed loans due to the potential adverse consequences from the consumer agency. Mr. Menzies said community banks were the victims in this crisis due to the toxic products created by Wall Street and the mega-banks. He said the government should not take away his ability as a community banker to be creative in order to take care of the needs of his customers.
Rep. Mel Watt (D - NC) said he recognized the opportunity for conflict between two regulators working on the same turf, but he does not necessarily see the conflict between safety and soundness and consumer protection disciplines. He said there may be cases where the two overlap, but he says he is troubled by the notion that if the two are separated, there will be some sort of inherent conflict. He understood the resistance to change, but in his view the current structure "didn't work". He believes the industry's "conflict" argument is more a motivation to keep consumer protection subordinate to the other objectives. He said he is also puzzled about Mr. Bartlett's suggestion that the federal government set up a new insurance regulator, which will represent new costs, yet we shouldn't spend the money to set up a new agency whose sole responsibility is to deal with consumer issues. Mr. Bartlett said he is not advocating the status quo. He said important pieces of existing consumer protection legislation are not in the hands of the safety and soundness regulators, and they should be.
Rep. Judy Biggert (R - IL) asked how a federal standard would promote consistent regulation if it allowed the states to add on their various requirements. Mr. Courson said that is one of his concerns. In his view, if there had been a national standard, many of the current problems could have been avoided. He pointed out that state requirements would add more complexity, which is the opposite of the Administration's stated intention.
Rep. Gary Miller (R - CA) said he disagreed with many of his Republican colleagues that Fannie and Freddie should be phased out. He believes they perform an essential function, but need to be more strongly regulated. He then cited some consistent thoughts among the witnesses' testimony: concern about creating winners and losers; more government could be more confusion; more uniformity; need for systemic risk oversight; national standards; and inconsistent or inadequate enforcement. He asked the panel their views regarding an alternative outcome had the regulators enforced the rules already on the books, and if they believed the regulators already have most of the authority needed to accomplish the goals stated in the Administration's proposal. Mr. Zeisel stated that there are a lot of tools already available and some new ones that have just now been implemented that would permit the Administration's objectives to be achieved. Mr. Bartlett said the laws themselves may be adequate, but the allocation of responsibility for enforcement is inadequate and needs to be addressed by Congress. He said this does not mean that a new agency is justified; the existing agencies should be further empowered.
Rep. Dennis Moore (D - KS) asked about the costs of the Administration's proposals. Mr. Yingling said the cost of the new consumer agency is entirely unknown; however, it would be mandated to examine and administer enforcement actions with respect to the currently unregulated lending entities now operating, and that would require a significant budget. He stressed that the ABA wants this done, but the question is how to pay for it. He said if the budget is prepared "on the cheap", it cannot do what it is required to do and will end up discriminating by concentrating its enforcement actions on insured institutions. Mr. Courson says his organization has advocated for more regulation of the "shadow" banking industry, and has argued that these entities will have to share in the costs of running the agency. He said everyone recognizes there will be additional costs associated with more consumer regulation, whether it is housed within the existing safety and soundness regulator, or in a new agency.
Rep Jeb Hensarling (R - TX) asked if, under the proposed legislative language, a prepayment penalty included in a 30-year mortgage would be considered "fair". Mr. Yingling responded by stating that the regulatory discretion contained in the language of this legislation "changes everything". "There has been no law authorized by Congress in the consumer area, no regulation that isn't trumped by this." Rep. Hensarling observed that this legislation is aimed at consumers but, based upon Federal Reserve data, most small businesses use credit sources under an individual name and would thereby be brought under the legislation's purview. He inquired if this proposed legislation, and its potential to limit financing choices, could harm small businesses and job creation. Mr. Zeisel said small businesses definitely would be impacted by this.
Rep. Adam Putnam (R - FL) asked whether the crisis is far enough behind us for us to understand the causes and make the sweeping regulatory reforms that are being contemplated. Mr. Menzies said there are differing opinions as to whether the problem is fully behind us, and it also presupposes a need for legislation to deal with the problem. He said it is very important to focus on what caused the problem. "We can have all the product legislation in the world, we can do everything possible to protect the consumer, but the greatest damage to the consumer was the failure of the system because of concentrations and excesses across the board of the Wall Street vehicles that gathered together substandard, subprime, weird mortgages that community bankers didn't make, created a warehouse to slice and dice those entities, made huge profits selling off those items and had very little skin in the game, very little capital at risk." He emphasized that this is what deserves attention. He said "too big to fail" and "too big to regulate" are issues that must be dealt with. "And from the perspective of community banks, that is the crisis of the day, that's what destroyed the free market system", he concluded.
On July 15, 2009, the House Financial Services Committee held a hearing to obtain financial services industry representatives' perspectives on the Administration's regulatory reform plan. Testifying were: Steve Bartlett, representing the Financial Services Roundtable; John Courson, representing the Mortgage Bankers Association; Chris Stinebert, representing the American Financial Services Association; Steven Zeisel, representing the Consumer Bankers Association; Todd Zywicki, Professor of Law; Denise Leonard, representing the National Association of Mortgage Brokers; Edward Yingling, representing the American Bankers Association; and, Michael Menzies, representing the Independent Community Bankers Association.
Committee Chairman Barney Frank (D - RI) opened this hearing by indicating that he will be attempting to complete mark-ups on some pieces of the regulatory reform effort by the end of July, but other portions (he specifically mentioned issues dealing with systemic risk) will not be completed until September. He stated that he had scheduled a separate hearing for July 21 specifically to deal with the issue of "too big to fail". He stated that, while he felt the Administration's proposal had dealt with this matter in a reasonable way, he wanted to provide an opportunity to air all points of view on the issue.
Regarding matters relevant to the current hearing, he mentioned that his staff had compiled documentation regarding the many consumer complaints that he said had been received from Members on both sides of the aisle regarding the actions of credit card companies doing things in anticipation of the effective date of the recently signed legislation. He said that there had been agreement to hold off the effective date of the law as an accommodation to the industry, but he now questions to wisdom of the action because of moves taken by credit card lenders. He specifically cited a move by lenders to significantly increase minimum monthly payment requirements on existing balances, which he feels is particularly egregious, as it is "changing the rules after people have starting playing". He said had borrowers known their payments were going to be increased, they might have made other choices regarding their loan balances. He said credit card holders of one major lender had been told by bank personnel that the payment increases were mandated by federal law. He said these actions are the very types of things that strengthen the case for the creation of a Consumer Financial Protection agency. He said "We cannot pass a law every time there is a set of complaints." He said what we need are rules, and it has not been the case that existing regulators have used the statutory authority given to them. He said the complaints about credit card banks have become very significant.
Chairman Frank stated that the hearing's witnesses may object to the creation of a new consumer agency, but he made clear that no objection should be raised based upon a concern that this might cause a regulated institution to get conflicting messages from two regulators. He said he can guarantee that this law can be written to prevent that. He admits that, in his view, the Administration made a mistake in including CRA as a matter to fall under the purview of the new agency, as he believes this "is of a different order or activity". On another issue, he said that the concept of merging the OTS and the OCC would be a true "merger" of the two, not a take-over by the OCC, since Rep. Frank believes the thrift charter and function should be preserved and there will be no move to abolish the charter. He said the intention would be to narrow the focus of the charter so that it is "a thrift charter only" and not a license to engage in other activities.
Rep. Randy Neugebauer (R - TX), in his opening remarks, stated his concern that the entire process had been directed toward new legislation. He said the fact is there is already legislation on the books that addresses much of the problem areas; the problem is that regulators didn't do their jobs regarding proper enforcement.
The first witness, Mr. Bartlett, stated there were many factors that caused the problems that brought us to this point, but he believes the main one was a regulatory system in chaos that was just not functioning properly. He said the Financial Services Roundtable supports bold, comprehensive reform. He said the Roundtable strongly opposes creation of a new consumer protection agency and strongly supports the designation of the Federal Reserve as the systemic risk regulator. He believes the creation of a strong federal insurance regulator should be an essential part of this regulatory reform.
Mr. Courson seconded most of Mr. Bartlett's statements, emphasizing the need for uniform regulation of all mortgage service providers. Mr. Stinebert remarked that the proposed legislation has the potential to "roll back the clock 30 years", back to a time when consumers had no choice of products, and he believes this proposal will stifle industry innovation. He also pointed out that, under this proposal, institutions could "wind up with 50 different state requirements" and "that is not a formula for simplification." He also emphasized the importance of preserving the industrial bank charter, since it played no role in the current crisis and he believes they should be part of the solution.
Mr. Ziesel stated that safety and soundness and consumer protection are intimately related and the two functions should not be separated. He said there should be stronger supervision of non-bank lenders so there is consistent and competent oversight of mortgage lenders. He also cited the problem of subjecting retail banks to the consumer laws of 50 states, making nationwide lending a costly and complex undertaking. He indicated that this would limit the range of products and perhaps drive banks to avoid doing business in certain states. Even simple uniform disclosures, one of the goals of this legislation, would have to be supplemented to meet the requirements of each individual state, he stated. He believes the better approach is to maintain a uniform national standard. He further stated that the push for "plain vanilla" products makes it unclear that banks will be able to offer the range of products they now do. This is because the proposal discourages the offering of other products consumers may find useful by creating regulatory uncertainty regarding how these "non-vanilla" products must be described, how they can be advertised, and what disclosures will be required to accompany them. He said it is also unclear if institutions would be required to offer the same "plain vanilla" product to everyone regardless of whether they qualify.
Mr. Zywicki stated his view that there are three fatal problems with the proposal to create a new consumer agency: it is based on misguided paternalism; it misdiagnoses the underlying problems and could lead to unintended consequences; and, it creates an unworkable new government planning apparatus.
Ms. Leonard said her organization supports the general concept of a separate consumer agency. She said consumers would greatly benefit from a uniform disclosure requirement that clearly and simply explains critical loan terms. She also pointed out that the board structure of the new agency, as proposed, is flawed, since its board members would not be limited as to party affiliation. She said the five-person board should have no more than three members of any one political party.
Mr. Yingling said ABA believes there are three areas that should be the primary focus of regulatory reform: the creation of a systemic regulator; the creation of a new resolution mechanism; and, filling the gaps in regulation of the shadow banking industry. Regarding systemic regulation, Mr. Yingling said this should not be about focusing on specific entities or institutions, but about looking at information and trends on the economy and different sectors within the economy. Such problematic trends from the recent past would have included: the rapid appreciation of home prices; the proliferation of mortgages that ignored the long-term ability to repay; excess leverage in some Wall Street firms; the rapid growth and complexity of some mortgage-backed securities and how they were rated; and, the rapid growth of the credit default swap market. The new regulator should be focused and nimble; involving it in day-to-day regulation would be a distraction. He noted that, while most of the early focus had been on giving this systemic risk authority to the Federal Reserve, now the focus is on giving it to an independent council. He said this approach makes since, but it should not be a committee. The council should have its own dedicated staff, but it should not be a large bureaucracy. The council should have "carefully calibrated back-up authority" when systemic issues are not being properly addressed. He believes a board consisting of the primary regulators plus Treasury seems logical. He believes the systemic regulator should have authority over accounting rulemaking, due to the critical relationship of accounting rules to systemic risk. Regarding systemic resolution authority, Mr. Yingling said whatever is done on this front will set the parameters for "too big to fail". He said ABA is concerned that this issue is not adequately addressed in the Administration's proposal. ABA believes the goal should be to eliminate, as much as possible, moral hazard and unfairness. When an institution goes into this resolution process, its top management, board, and major stakeholders should be subject to clearly set out rules of accountability, change, and financial loss. He said no one should want to be considered "too big to fail". He said the ABA strongly supports maintaining the federal thrift charter.
Mr. Menzies said ICBA supports identifying specific institutions that may pose systemic risk and systemic danger, and subjecting them to stronger supervision, capital and liquidity requirements. He said the Administration's plan could be enhanced by imposing fees on systemically important holding companies for their supervisory costs and to fund, in advance, a new systemic risk fund. He said the plan should also implement procedures to downsize "too big to fail" institutions in an orderly way. He stated that ICBA urges continuation of both the state bank and the federal thrift charter. He said ICBA opposes the proposal for a new consumer protection agency, in its current form. ICBA urges the addition of an Assistant Secretary for Community Institutions within the Treasury Department to provide an internal voice for main street concerns.
Chairman Frank observed that most of the witnesses hold concerns regarding the extent to which the proposal would recognize state consumer protection authority. He said he assumes it is the position of the witnesses that any proposal should include federal preemption of such state authority. Except for Ms. Leonard, they all concurred that a national uniform standard was called for.
Rep. Neugebauer observed that, in his past experience as a banker, he was often called upon to tailor products to fit specific customer needs. He fears that the Administration's proposal is not a consumer protection bill, but a product regulation bill. He requested the panel's views on the federal government becoming very prescriptive in the types of products allowed to be offered. Mr. Bartlett said the government should regulate for safety and soundness and consumer protection but should not dictate products. The other panelists agreed with that observation.
Rep. Paul Kanjorski (D - PA) asked the panel if any of them believed either CRA or the activities of Fannie Mae and Freddie Mac had been contributing factors to the current crisis. None of the panelists felt that those factors were contributors to the crisis. Rep. Kanjorski then asked the panel if any of them recognized this problem building. Mr. Bartlett said the Roundtable saw troubling signs in 2006 but did not move quickly enough to deal with them. Mr. Yingling said that the failure to recognize the signs is clear evidence and support for the creation of a systemic risk authority.
Rep. Edward Royce (R - CA) stated his view that both Freddie and Fannie were driven by the misguided altruistic belief that the highest possible stretch for homeownership was to the benefit of consumers. He believes it would be very difficult to create a separate regulatory entity, charge it with consumer protection oversight, and then not expect it to come up with a similar, politically driven mandate. He believes these politically driven mandates caused the financial collapse. He asked the panel to comment on the prospect of the Consumer Financial Protection Agency being used for politically mandated purposes in the future. Mr. Courson said he is concerned that we are attempting an experiment that may ultimately cause safety and soundness concerns. Mr. Zywicki agreed.
Rep. Maxine Waters (D - CA) inquired as to why mortgage servicers cannot understand that we have a crisis and that we need to intensify the loan modification process to avoid massive foreclosures. Mr. Bartlett said Roundtable members are now modifying approximately 250,000 mortgages per month and he admitted this pace was woefully inadequate.
Rep. Frank Lucas (R - OK) asked Messrs. Yingling and Menzies to comment on the effect of the Administration's proposal on community banks and small businesses. Mr. Yingling said his main concern is the directive that products should be standardized, since loans in small communities are not "cookie-cutter", they are individually designed. Based upon the strong language in the Administration's proposal, community banks would be discouraged from making custom-designed loans due to the potential adverse consequences from the consumer agency. Mr. Menzies said community banks were the victims in this crisis due to the toxic products created by Wall Street and the mega-banks. He said the government should not take away his ability as a community banker to be creative in order to take care of the needs of his customers.
Rep. Mel Watt (D - NC) said he recognized the opportunity for conflict between two regulators working on the same turf, but he does not necessarily see the conflict between safety and soundness and consumer protection disciplines. He said there may be cases where the two overlap, but he says he is troubled by the notion that if the two are separated, there will be some sort of inherent conflict. He understood the resistance to change, but in his view the current structure "didn't work". He believes the industry's "conflict" argument is more a motivation to keep consumer protection subordinate to the other objectives. He said he is also puzzled about Mr. Bartlett's suggestion that the federal government set up a new insurance regulator, which will represent new costs, yet we shouldn't spend the money to set up a new agency whose sole responsibility is to deal with consumer issues. Mr. Bartlett said he is not advocating the status quo. He said important pieces of existing consumer protection legislation are not in the hands of the safety and soundness regulators, and they should be.
Rep. Judy Biggert (R - IL) asked how a federal standard would promote consistent regulation if it allowed the states to add on their various requirements. Mr. Courson said that is one of his concerns. In his view, if there had been a national standard, many of the current problems could have been avoided. He pointed out that state requirements would add more complexity, which is the opposite of the Administration's stated intention.
Rep. Gary Miller (R - CA) said he disagreed with many of his Republican colleagues that Fannie and Freddie should be phased out. He believes they perform an essential function, but need to be more strongly regulated. He then cited some consistent thoughts among the witnesses' testimony: concern about creating winners and losers; more government could be more confusion; more uniformity; need for systemic risk oversight; national standards; and inconsistent or inadequate enforcement. He asked the panel their views regarding an alternative outcome had the regulators enforced the rules already on the books, and if they believed the regulators already have most of the authority needed to accomplish the goals stated in the Administration's proposal. Mr. Zeisel stated that there are a lot of tools already available and some new ones that have just now been implemented that would permit the Administration's objectives to be achieved. Mr. Bartlett said the laws themselves may be adequate, but the allocation of responsibility for enforcement is inadequate and needs to be addressed by Congress. He said this does not mean that a new agency is justified; the existing agencies should be further empowered.
Rep. Dennis Moore (D - KS) asked about the costs of the Administration's proposals. Mr. Yingling said the cost of the new consumer agency is entirely unknown; however, it would be mandated to examine and administer enforcement actions with respect to the currently unregulated lending entities now operating, and that would require a significant budget. He stressed that the ABA wants this done, but the question is how to pay for it. He said if the budget is prepared "on the cheap", it cannot do what it is required to do and will end up discriminating by concentrating its enforcement actions on insured institutions. Mr. Courson says his organization has advocated for more regulation of the "shadow" banking industry, and has argued that these entities will have to share in the costs of running the agency. He said everyone recognizes there will be additional costs associated with more consumer regulation, whether it is housed within the existing safety and soundness regulator, or in a new agency.
Rep Jeb Hensarling (R - TX) asked if, under the proposed legislative language, a prepayment penalty included in a 30-year mortgage would be considered "fair". Mr. Yingling responded by stating that the regulatory discretion contained in the language of this legislation "changes everything". "There has been no law authorized by Congress in the consumer area, no regulation that isn't trumped by this." Rep. Hensarling observed that this legislation is aimed at consumers but, based upon Federal Reserve data, most small businesses use credit sources under an individual name and would thereby be brought under the legislation's purview. He inquired if this proposed legislation, and its potential to limit financing choices, could harm small businesses and job creation. Mr. Zeisel said small businesses definitely would be impacted by this.
Rep. Adam Putnam (R - FL) asked whether the crisis is far enough behind us for us to understand the causes and make the sweeping regulatory reforms that are being contemplated. Mr. Menzies said there are differing opinions as to whether the problem is fully behind us, and it also presupposes a need for legislation to deal with the problem. He said it is very important to focus on what caused the problem. "We can have all the product legislation in the world, we can do everything possible to protect the consumer, but the greatest damage to the consumer was the failure of the system because of concentrations and excesses across the board of the Wall Street vehicles that gathered together substandard, subprime, weird mortgages that community bankers didn't make, created a warehouse to slice and dice those entities, made huge profits selling off those items and had very little skin in the game, very little capital at risk." He emphasized that this is what deserves attention. He said "too big to fail" and "too big to regulate" are issues that must be dealt with. "And from the perspective of community banks, that is the crisis of the day, that's what destroyed the free market system", he concluded.
Monday, July 13, 2009
Senate Hears Testimony Regarding Effects of Economic Crisis on Community Banks and Credit Unions in Rural Communities
By W. Bernard Mason
On July 8, 2009 the Senate Financial Institutions Subcommittee held a hearing focused on the role smaller financial institutions play in the nation’s economy, particularly in rural communities. In opening the hearing, Subcommittee Chairman Tim Johnson (D – SD) stated: “Throughout our nation’s economic crisis there has often been too little distinction made between troubled banks and the many banks that have been responsible lenders.” He said that community banks and credit unions, for the most part, did not contribute to the current crisis, yet small lending institutions in rural communities and their customers are feeling the effects of the subprime mortgage crisis. “Jobs are disappearing, ag loans are being called, small businesses can’t get the lines of credit they need to continue operation, and homeowners are struggling to refinance.”
The Subcommittee heard from the following witness panel: Jack Hopkins, President and CEO of CorTrust Bank N.A., Sioux Falls, SD, testifying on behalf of the Independent Community Bankers of America; Frank Michael, President and CEO of Allied Credit Union, Stockton, CA, testifying on behalf of the Credit Union National Association; Arthur Johnson, Chairman and CEO of United Bank of Michigan, Grand Rapids, MI, testifying on behalf of the American Bankers Association; Ed Templeton, President and CEO of SRP Federal Credit Union, North Augusta, SC, testifying on behalf of the National Association of Federal Credit Unions; and, Peter Skillern, Executive Director of the Community Reinvestment Association of North Carolina.
Mr. Hopkins stated that “community banks played no part in causing the financial crisis and have watched as taxpayer dollars have been used to bail out Wall Street investment firms and our nation’s largest banks considered ‘too big to fail’”. “During this same time period, dozens of community banks have been allowed to fail while the largest and most interconnected banks have been spared the same fate due to government intervention”. He cited an ICBA study completed in March indicating that community banks are still lending and 40 percent have seen an increase in origination volumes in the last year, while 11 percent believe the financial crisis has “significantly curtailed” their lending ability. He said the survey indicated that some of the reduction in lending activity was a reaction to the mixed messages coming from the government. While banks are being told by policymakers to lend money, he said they also feel the agencies are dissuading them from lending by putting them through overzealous regulatory exams. He said that, while the largest banks saw a 3.23 percent decrease in lending in 2008, institutions will less than $1 billion in assets experienced a 5.53 percent increase.
Mr. Hopkins said bankers are concerned with the potential for their regulators to second-guess their desire to make additional loans and some bankers are under pressure from their regulators to decrease their loan-to-deposit ratios. He said bankers also stated regulators do not want them to use FHLBank advances for loan funding purposes, suggesting they are not as stable as core deposits. He commented that bankers believe the real issue is the FDIC does not want to have a secondary position behind the FHLB should there be widespread bank failures. Mr. Hopkins stated that FHLBank advances have become an important source of funding for community banks and that it must be allowed to continue.
Mr. Michael testified that credit unions are careful lenders and that their incentives are aligned in a way that ensures little or no harm is done to member-owners. He said toxic mortgages such as subprime loans were made by non-credit union lenders and were focused on maximizing loan originations even though many of these loans were not in the borrowers’ best interests. Further, credit unions hold most of their loans in portfolio. He observed that strong asset quality and high capital kept most credit unions “in the game” while the other lenders pulled back. He pointed out that, for the year ending March 2009, real estate loans at credit unions grew by nearly 9 percent, while banking industry real estate loans declined by approximately 2 percent. He also said business loans at credit unions grew by nearly 16 percent during this period, whereas commercial loans at banking institutions declined by 3 percent. In his view, the credit crisis has been exacerbated by the fact that credit unions are subject to a statutory cap on the amount of business lending they can do. He said Federal Reserve and SBA surveys have shown that it is now more difficult for small businesses to obtain loans and this is a market that credit unions are well suited to serve. He indicated a growing list of small business and public policy groups agree that now is the time to eliminate the cap and he hopes Congress will act on this issue.
Mr. Johnson stated that, in spite of the recession, community banks located in rural communities have expanded lending. He said loans from banks headquartered outside metropolitan statistical areas increased by 7 percent in 2008, and lending by farm banks had increased by 9.2 percent. He warned that these trends are not likely to be sustained and it is unlikely that loan volumes will increase in 2009. Although credit quality has suffered, he pointed out that community banks entered the recession with strong capital levels; however, he said it was extremely difficult to raise new capital in the current climate and without access to capital, the flow of credit in rural communities will be difficult to maintain. He pointed out that the Capital Purchase Program and other initiatives have been focused on the largest banks. Additionally, the changing nature of the CPP and its restrictive selection process prevented banks that could have benefited from the CPP from doing so. He suggested that now is a critical time to focus on strategies to assist community banks. He proposed the following: broadening capital programs to enable participation by a greater cross-section of banks; revising the risk-based capital rules to better reflect the risks presented; and, avoiding inappropriately conservative appraisal/asset valuations. Mr. Johnson said the ABA believes creation of a systemic risk regulator, providing a mechanism for resolving systemically important institutions, and filling gaps in the regulation of the shadow banking industry should be the focus of Congressional action.
Mr. Templeton reiterated most of the points made by Mr. Michael, including the appeal to remove the business lending cap. He also suggested a legislative change that would clarify the ambiguity regarding the ability of federal credit unions to add “underserved areas” to their fields of membership. He said NAFCU supports creation of a Consumer Financial Protection Agency, but believes that its mission should be limited to currently non-regulated institutions operating in the financial services marketplace.
Mr. Skillern reported that while a number of small banks across the nation have failed, far more have been lost through consolidation over time. He said that nationally, the number of banks under $100 million in assets dropped by 5,410 from 1992 to 2008. By contrast, he stated that in 1995, the top five banks had 11 percent deposit share; today, they hold nearly 40 percent. He noted that small banks are at a competitive disadvantage in terms of pricing, products and geographical area. He said that, while the effects of the recession are felt by every community, rural communities will shake off its effects much more slowly.
Subcommittee Chairman Johnson sought the panel’s views on the FDIC’s move to base its special assessment on institution assets, not deposits. Mr. Hopkins said he supported the move, since assets represent the risk, not deposits. He said it is a positive move for community banks and he suggested it be adopted for regular assessments going forward. Mr. Johnson said he had some concerns about a rush to make this change without further analysis of the impact. He further felt that no changes should be adopted until a decision is made on the program and process for a systemic risk resolution mechanism.
Chairman Johnson then asked the panel whether loan modification programs would be useful for rural areas. Mr. Michael said subprime, zero-down mortgages clearly contributed to the current problem and, while credit unions did not originate these loans, his institution is trying to assist customers who have these loans with other lenders. He said he had found those lenders to be slow on the modification process and were not geared to process these requests. He said delays are substantial and results generally are not positive. Mr. Johnson said his bank was experiencing higher levels of delinquencies and foreclosures. He said these problems had all been driven by unemployment issues, not product-type or initial underwriting issues, and his bank was working diligently to keep these families in their homes. He said he is also seeing customers who opted to take out mortgages from other broker/originators come in to request a solution to their problem, and he said he has been able to refinance approximately 20 percent of these cases. Mr. Templeton said he had not seen many questionable loans made in his market area, mainly because brokers were not interested in loans on homes in rural areas since they could not be packaged and sold – there was no appreciation in value.
Ranking Member Mike Crapo (R - ID) said he was concerned about the Administration’s plan to bifurcate prudential supervision and consumer protection functions and requested the panel’s views on this topic. Mr. Johnson said he does not believe the case has been made to do this and he believes it would be very difficult to administer, since the two interests may conflict. He said 94 percent of the high-risk lending that got us into this problem was originated by unregulated entities, and he felt the focus should be on that problem, not over-regulating the other 6 percent. Messrs. Hopkins, Michael and Templeton stated their agreement with Mr. Johnson. Mr. Skillern said he would disagree that the federal regulators had done their jobs well. Countrywide and Washington Mutual pursued their subprime and predatory lending practices under the watchful eye of the OTS and Wachovia crashed itself on exotic mortgage lending while regulated by the OCC. He said he is currently in a fight with the OCC over formal enforcement of its rules regarding a refund anticipation program at another institution. He concludes that proper consumer protection is just not happening. He stated that federal regulators have lost credibility on their willingness and ability to enforce the existing consumer laws. He believes a separate agency is needed to bring standardization to the application of consumer rules and reduce the apparent conflict of interest federal regulators have in enforcing such laws.
Senator Michael Bennet (D – CO) asked the panel’s views on how well TARP is working for small, community banks. Mr. Hopkins said in his view TARP has helped pick winners and losers. He said the big banks have been chosen as winners, because even though they were technically broke, they were bailed out. He noted that smaller community banks that are not 1- or 2-CAMELS rated cannot qualify for these funds. He observed that this creates an unfair advantage for larger banks. Mr. Johnson said that to some degree, everyone is guessing as to what the criteria are and how the process works, because details have not been made public either by Treasury or the regulatory agencies making the recommendations. He argues Treasury and the agencies should work hard to determine which banks are viable and make sure that they have access to capital, so that banks are not closed unnecessarily.
Senator Bob Corker (R – TN) implored Mr. Johnson to have the ABA weigh in on the Administration’s proposal on “too big to fail”. Senator Corker said it is evident that the Administration wants to continue business as it has been over the past year and basically “codify” TARP so they can decide on an ad hoc basis which firms will succeed and which will fail. He also expressed his concern that the Banking Committee had not held hearings on Fannie Mae and Freddie Mac in over one year. Senator Corker then asked the panel if they believed it would be better if Fannie and Freddie did not exist. Both Mr. Hopkins and Mr. Johnson firmly stated that it was essential that community bankers have a secondary market source where they could sell their originated loans. They explained to Senator Corker how lending capacity would quickly be reached if all loans were retained in portfolio. In response to a follow-up question from Senator Corker, Messrs. Hopkins and Johnson stated that their correspondent banking sources had significantly declined in the past year, making Fannie and Freddie “the only game in town”. Senator Corker retorted that the regional banks – “those folks who we are here constantly talking to about making loans and they are constantly telling us they are making more loans than they made in the past, those folks, as far as their correspondent relationship, from your perspective, that has gone away”? “It has gone away in that respect”, replied Mr. Hopkins.
Senator Corker concluded his questioning by stating his belief that regulators are helping create a self-fulfilling prophecy by virtue of the way they are dealing with institutions. He feels “regulators are clamping down and making this recession more severe than it otherwise would have been”.
Senator Jon Tester (D – MT) began his questioning by stating his agreement with Senator Corker’s assessment of regulator actions. Senator Tester then inquired as to the panel’s view on the Administration’s proposal to combine banking agencies. Mr. Hopkins said that, even if the OTS were merged into OCC, there should be a separate office that focuses on mortgage lenders. Senator Tester concluded his questioning by stating that “community banks need to be regulated, but you are not the ones who caused the problem. The Wall Street people were the ones and the ‘too big to fail’ is something I have a great disdain for, and we need to re-think some of these operating systems we have in this country.”
Subcommittee Chairman Johnson said that the Banking Committee will continue its review of the current structure of the financial system and develop legislation to create the kind of transparency, accountability, and consumer protection that is now lacking. As this process moves forward, he said it will be important to consider the unique needs of smaller institutions and to preserve their viability.
On July 8, 2009 the Senate Financial Institutions Subcommittee held a hearing focused on the role smaller financial institutions play in the nation’s economy, particularly in rural communities. In opening the hearing, Subcommittee Chairman Tim Johnson (D – SD) stated: “Throughout our nation’s economic crisis there has often been too little distinction made between troubled banks and the many banks that have been responsible lenders.” He said that community banks and credit unions, for the most part, did not contribute to the current crisis, yet small lending institutions in rural communities and their customers are feeling the effects of the subprime mortgage crisis. “Jobs are disappearing, ag loans are being called, small businesses can’t get the lines of credit they need to continue operation, and homeowners are struggling to refinance.”
The Subcommittee heard from the following witness panel: Jack Hopkins, President and CEO of CorTrust Bank N.A., Sioux Falls, SD, testifying on behalf of the Independent Community Bankers of America; Frank Michael, President and CEO of Allied Credit Union, Stockton, CA, testifying on behalf of the Credit Union National Association; Arthur Johnson, Chairman and CEO of United Bank of Michigan, Grand Rapids, MI, testifying on behalf of the American Bankers Association; Ed Templeton, President and CEO of SRP Federal Credit Union, North Augusta, SC, testifying on behalf of the National Association of Federal Credit Unions; and, Peter Skillern, Executive Director of the Community Reinvestment Association of North Carolina.
Mr. Hopkins stated that “community banks played no part in causing the financial crisis and have watched as taxpayer dollars have been used to bail out Wall Street investment firms and our nation’s largest banks considered ‘too big to fail’”. “During this same time period, dozens of community banks have been allowed to fail while the largest and most interconnected banks have been spared the same fate due to government intervention”. He cited an ICBA study completed in March indicating that community banks are still lending and 40 percent have seen an increase in origination volumes in the last year, while 11 percent believe the financial crisis has “significantly curtailed” their lending ability. He said the survey indicated that some of the reduction in lending activity was a reaction to the mixed messages coming from the government. While banks are being told by policymakers to lend money, he said they also feel the agencies are dissuading them from lending by putting them through overzealous regulatory exams. He said that, while the largest banks saw a 3.23 percent decrease in lending in 2008, institutions will less than $1 billion in assets experienced a 5.53 percent increase.
Mr. Hopkins said bankers are concerned with the potential for their regulators to second-guess their desire to make additional loans and some bankers are under pressure from their regulators to decrease their loan-to-deposit ratios. He said bankers also stated regulators do not want them to use FHLBank advances for loan funding purposes, suggesting they are not as stable as core deposits. He commented that bankers believe the real issue is the FDIC does not want to have a secondary position behind the FHLB should there be widespread bank failures. Mr. Hopkins stated that FHLBank advances have become an important source of funding for community banks and that it must be allowed to continue.
Mr. Michael testified that credit unions are careful lenders and that their incentives are aligned in a way that ensures little or no harm is done to member-owners. He said toxic mortgages such as subprime loans were made by non-credit union lenders and were focused on maximizing loan originations even though many of these loans were not in the borrowers’ best interests. Further, credit unions hold most of their loans in portfolio. He observed that strong asset quality and high capital kept most credit unions “in the game” while the other lenders pulled back. He pointed out that, for the year ending March 2009, real estate loans at credit unions grew by nearly 9 percent, while banking industry real estate loans declined by approximately 2 percent. He also said business loans at credit unions grew by nearly 16 percent during this period, whereas commercial loans at banking institutions declined by 3 percent. In his view, the credit crisis has been exacerbated by the fact that credit unions are subject to a statutory cap on the amount of business lending they can do. He said Federal Reserve and SBA surveys have shown that it is now more difficult for small businesses to obtain loans and this is a market that credit unions are well suited to serve. He indicated a growing list of small business and public policy groups agree that now is the time to eliminate the cap and he hopes Congress will act on this issue.
Mr. Johnson stated that, in spite of the recession, community banks located in rural communities have expanded lending. He said loans from banks headquartered outside metropolitan statistical areas increased by 7 percent in 2008, and lending by farm banks had increased by 9.2 percent. He warned that these trends are not likely to be sustained and it is unlikely that loan volumes will increase in 2009. Although credit quality has suffered, he pointed out that community banks entered the recession with strong capital levels; however, he said it was extremely difficult to raise new capital in the current climate and without access to capital, the flow of credit in rural communities will be difficult to maintain. He pointed out that the Capital Purchase Program and other initiatives have been focused on the largest banks. Additionally, the changing nature of the CPP and its restrictive selection process prevented banks that could have benefited from the CPP from doing so. He suggested that now is a critical time to focus on strategies to assist community banks. He proposed the following: broadening capital programs to enable participation by a greater cross-section of banks; revising the risk-based capital rules to better reflect the risks presented; and, avoiding inappropriately conservative appraisal/asset valuations. Mr. Johnson said the ABA believes creation of a systemic risk regulator, providing a mechanism for resolving systemically important institutions, and filling gaps in the regulation of the shadow banking industry should be the focus of Congressional action.
Mr. Templeton reiterated most of the points made by Mr. Michael, including the appeal to remove the business lending cap. He also suggested a legislative change that would clarify the ambiguity regarding the ability of federal credit unions to add “underserved areas” to their fields of membership. He said NAFCU supports creation of a Consumer Financial Protection Agency, but believes that its mission should be limited to currently non-regulated institutions operating in the financial services marketplace.
Mr. Skillern reported that while a number of small banks across the nation have failed, far more have been lost through consolidation over time. He said that nationally, the number of banks under $100 million in assets dropped by 5,410 from 1992 to 2008. By contrast, he stated that in 1995, the top five banks had 11 percent deposit share; today, they hold nearly 40 percent. He noted that small banks are at a competitive disadvantage in terms of pricing, products and geographical area. He said that, while the effects of the recession are felt by every community, rural communities will shake off its effects much more slowly.
Subcommittee Chairman Johnson sought the panel’s views on the FDIC’s move to base its special assessment on institution assets, not deposits. Mr. Hopkins said he supported the move, since assets represent the risk, not deposits. He said it is a positive move for community banks and he suggested it be adopted for regular assessments going forward. Mr. Johnson said he had some concerns about a rush to make this change without further analysis of the impact. He further felt that no changes should be adopted until a decision is made on the program and process for a systemic risk resolution mechanism.
Chairman Johnson then asked the panel whether loan modification programs would be useful for rural areas. Mr. Michael said subprime, zero-down mortgages clearly contributed to the current problem and, while credit unions did not originate these loans, his institution is trying to assist customers who have these loans with other lenders. He said he had found those lenders to be slow on the modification process and were not geared to process these requests. He said delays are substantial and results generally are not positive. Mr. Johnson said his bank was experiencing higher levels of delinquencies and foreclosures. He said these problems had all been driven by unemployment issues, not product-type or initial underwriting issues, and his bank was working diligently to keep these families in their homes. He said he is also seeing customers who opted to take out mortgages from other broker/originators come in to request a solution to their problem, and he said he has been able to refinance approximately 20 percent of these cases. Mr. Templeton said he had not seen many questionable loans made in his market area, mainly because brokers were not interested in loans on homes in rural areas since they could not be packaged and sold – there was no appreciation in value.
Ranking Member Mike Crapo (R - ID) said he was concerned about the Administration’s plan to bifurcate prudential supervision and consumer protection functions and requested the panel’s views on this topic. Mr. Johnson said he does not believe the case has been made to do this and he believes it would be very difficult to administer, since the two interests may conflict. He said 94 percent of the high-risk lending that got us into this problem was originated by unregulated entities, and he felt the focus should be on that problem, not over-regulating the other 6 percent. Messrs. Hopkins, Michael and Templeton stated their agreement with Mr. Johnson. Mr. Skillern said he would disagree that the federal regulators had done their jobs well. Countrywide and Washington Mutual pursued their subprime and predatory lending practices under the watchful eye of the OTS and Wachovia crashed itself on exotic mortgage lending while regulated by the OCC. He said he is currently in a fight with the OCC over formal enforcement of its rules regarding a refund anticipation program at another institution. He concludes that proper consumer protection is just not happening. He stated that federal regulators have lost credibility on their willingness and ability to enforce the existing consumer laws. He believes a separate agency is needed to bring standardization to the application of consumer rules and reduce the apparent conflict of interest federal regulators have in enforcing such laws.
Senator Michael Bennet (D – CO) asked the panel’s views on how well TARP is working for small, community banks. Mr. Hopkins said in his view TARP has helped pick winners and losers. He said the big banks have been chosen as winners, because even though they were technically broke, they were bailed out. He noted that smaller community banks that are not 1- or 2-CAMELS rated cannot qualify for these funds. He observed that this creates an unfair advantage for larger banks. Mr. Johnson said that to some degree, everyone is guessing as to what the criteria are and how the process works, because details have not been made public either by Treasury or the regulatory agencies making the recommendations. He argues Treasury and the agencies should work hard to determine which banks are viable and make sure that they have access to capital, so that banks are not closed unnecessarily.
Senator Bob Corker (R – TN) implored Mr. Johnson to have the ABA weigh in on the Administration’s proposal on “too big to fail”. Senator Corker said it is evident that the Administration wants to continue business as it has been over the past year and basically “codify” TARP so they can decide on an ad hoc basis which firms will succeed and which will fail. He also expressed his concern that the Banking Committee had not held hearings on Fannie Mae and Freddie Mac in over one year. Senator Corker then asked the panel if they believed it would be better if Fannie and Freddie did not exist. Both Mr. Hopkins and Mr. Johnson firmly stated that it was essential that community bankers have a secondary market source where they could sell their originated loans. They explained to Senator Corker how lending capacity would quickly be reached if all loans were retained in portfolio. In response to a follow-up question from Senator Corker, Messrs. Hopkins and Johnson stated that their correspondent banking sources had significantly declined in the past year, making Fannie and Freddie “the only game in town”. Senator Corker retorted that the regional banks – “those folks who we are here constantly talking to about making loans and they are constantly telling us they are making more loans than they made in the past, those folks, as far as their correspondent relationship, from your perspective, that has gone away”? “It has gone away in that respect”, replied Mr. Hopkins.
Senator Corker concluded his questioning by stating his belief that regulators are helping create a self-fulfilling prophecy by virtue of the way they are dealing with institutions. He feels “regulators are clamping down and making this recession more severe than it otherwise would have been”.
Senator Jon Tester (D – MT) began his questioning by stating his agreement with Senator Corker’s assessment of regulator actions. Senator Tester then inquired as to the panel’s view on the Administration’s proposal to combine banking agencies. Mr. Hopkins said that, even if the OTS were merged into OCC, there should be a separate office that focuses on mortgage lenders. Senator Tester concluded his questioning by stating that “community banks need to be regulated, but you are not the ones who caused the problem. The Wall Street people were the ones and the ‘too big to fail’ is something I have a great disdain for, and we need to re-think some of these operating systems we have in this country.”
Subcommittee Chairman Johnson said that the Banking Committee will continue its review of the current structure of the financial system and develop legislation to create the kind of transparency, accountability, and consumer protection that is now lacking. As this process moves forward, he said it will be important to consider the unique needs of smaller institutions and to preserve their viability.
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