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.