Hearing of the Senate Banking, Housing and Urban Affairs Committee

HEADLINE: HEARING OF THE SENATE BANKING, HOUSING AND URBAN AFFAIRS COMMITTEE
 
SUBJECT: MONETARY REPORT OF THE FEDERAL RESERVE
 
CHAIRED BY: SENATOR RICHARD SHELBY (R-AL)

WITNESSES: ALAN GREENSPAN, CHAIRMAN, FEDERAL RESERVE BOARD OF GOVERNORS

BODY:
SEN. MIKE CRAPO (R-ID): Thank you very much, Mr. Chairman.

Mr. Greenspan, again, thank you for coming with us and presenting your information about our monetary policy in the country.

I want to go back to an issue you and I have discussed several times over the last two years, and that's derivatives. As you know, we have for the last two years faced on two or three occasions efforts to change the manner in which we regulate derivatives. Under the Commodities Futures Modernization Act of 2000, the president's working group and others recommended a structure by which we approach the management of commodities in a number of contexts, and derivatives were handled in a particular way under that approach.

And by the way, let me interject. I want to thank you and the secretary of the Treasury and the chairman of the Securities and Exchange Commission and the chairman of the Commodities Futures Trading Commission for being so prompt in responding to our letter inquiring about this yet once again this year when the energy -- the amendment came forward on the energy bill once again to try to make this change in the way that we regulate derivatives.

The purpose of my bringing it up with you again is that there are yet again rumors that we will see another effort to try to in some way -- some way similar to the previous amendments -- change the Commodities Futures Modernization Act so that we create a new regulatory regime for derivatives and, in my opinion, create some confusion with regard to the regulator in terms of the introduction of regulation from FERC as well.

The question I have is has anything changed? Is there a reason that we should change our approach to the regulation of derivatives? Or does the Commodities Futures Modernization Act still represent a very solid approach to managing this issue?

MR. GREENSPAN: I'm of the opinion that that was an excellent act when it was passed in 2000, as I recall.

SEN. CRAPO: 2000, that's right.

MR. GREENSPAN: And as far as I can judge, I see nothing which would alter my view and my appraisal of it.

SEN. CRAPO: Could you give us -- again, I know you've done this before, but could you give us your understanding of why derivatives are helpful in our markets?

MR. GREENSPAN: We have a very complex financial system, in which we endeavor to regulate in a manner to enable the system to be stable and function in a manner which contributes to economic growth not only in our country, but for the world at large.

What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those who are willing to and are capable of doing so.

Prior to the advent of derivatives on a large scale, we did not have that capability. And we often had, for example, financial institutions, like banks, taking on undue risk and running into real, serious problems.

From 1998 to 2001 we had a trillion dollars' increase in debt in telecommunication worldwide. A significant part of that debt went into bankruptcy. And yet no financial institution of any significance was caught in that. And the reason was that, in this case, credit derivatives were employed to transfer the risk from these highly leveraged financial institutions to other institutions and pension funds -- insurance companies' pension funds, largely -- which had much more equity and could absorb the costs of default, which they did. They didn't like it, but they're still around, and they're still viable.

The vast increase in the size of the over-the-counter derivatives markets is the result of the market finding them a very useful vehicle. And the question is, should these be regulated? Well, indeed, for the United States, they are obviously regulated to the extent that banks, being the crucial creators of these derivatives, are regulated by the banking agencies, but not beyond that.

And the reason why we think it would be a mistake to go beyond that degree of regulation is that these derivative transactions are transactions amongst professionals. And the institutions which are involved have very considerable what we call counterparty surveillance, where, for example, one major bank will know far more about its customer, whether it's a bank or something else, than we could conceivably know as regulators. In a sense, this counterparty surveillance has become the crucial element which has created stability in that particular system.

My concern and others' concerns about going in an increasing degree of government regulation is that we will undercut counterparty surveillance and that the net effect will not be to enhance the stability of that overall structure, but undermine it. And it has become such a valuable tool, in my judgment, in the international financial system, that anything that we can do to enhance its capability of internal stabilization, which is what is currently the case, we ought to do. And I do not believe that many of the measures that have been offered to introduce increased regulation are indeed positive in the sense that they would have a positive outcome. My fear is that their effect would be counterproductive. And that's the reason I wrote the letter in response to you on occasion and why the president's working group came out the way it did on that issue.

SEN. CRAPO: Well, thank you very much for that extended explanation. Each time we face this issue, we pick up a little support and our strength grows, and I think it is because we are better able to explain to the members of the Senate the issues, as you have just done. So, thank you very much.