Hearing of the Joint Economic Committee - Wall Street to Main Street: Is the Credit Crisis Over and What Can the Federal Government do to Prevent Unnecessary Systemic Risks in the Future?

Statement

SEN. SCHUMER: Okay, good morning everyone. (Sounds gavel.) The hearing will come to order, and we're going to get started unusually and atypically right on time here.

First, I want to thank you, Chairman Volcker, as well as our other witnesses -- we have a second panel today -- for coming to this hearing about the financial system and the steps we need to take to reform our regulatory structure. Our discussion will be a broader one. We are not going to get into specifics -- that's the real province of the Banking Committee; I serve on that as well, and some of us on this committee do -- but rather the broader regulatory questions that we face, given everything that's happening in our new financial world.

I'm worried that because things do not seem as bad as they were a month ago, we're already starting to become complacent about the critical need to address the regulatory and market failures that have had much to do with troubling economic situation we find ourselves in.

The past year has been a stark reminder of the direct link between Wall Street and Main Street, between the health of financial markets and the economic well-being of all Americans.

A year ago, most of us had never heard of CDOs and CMOs and SIVs and of option ARMs and credit default swaps and auction rate securities. Now we know that those who knew about those complex financial instruments clearly didn't know enough to protect consumers, investors and our economy from them. And we've learned too much about the central role these financial tools have played in the worst housing crisis since the Great Depression, the freezing of credit markets worldwide and the onset of the current economic slowdown, which probably more than half of all economists call a recession.

Financial innovation is vital, both for the health of our financial system and our economy, but it's just as vital that financial regulation keep up with innovation. Unfortunately, it has not.

In my view, this credit crisis is as much a failure of regulation as it is a failure of the marketplace. The goal of regulation should always be to encourage entrepreneurial vigor while ensuring the health of the financial system. We have indeed found that balance in the past, but it seems to have been lost. We have a 21st century global financial system but a 20th century national set of financial regulations, and that has to change.

To begin, we need to acknowledge that consolidation has transformed the financial industry. We no longer have clear distinctions between commercial banks, investment banks, broker- dealers and insurers that we did 60 years ago, or even 20 years ago. Instead, there are a large number of financial institutions surrounded by many, many more smaller institutions, such as hedge funds and private equity funds with their own specialties. It's as though we have a handful of large financial Jupiters that are becoming more and more similar, encircled by numerous small asteroids. Our regulatory structure has to recognize that change. As large investment banks have come to act more like commercial banks, especially now that they can borrow from the Fed's discount window, then they need to be supervised more strictly.

We need to think very seriously about moving towards more unified regulation, if not a single regulator. We have too many financial regulators, each watching a different part of the financial system, while virtually no one can keep an eye on the greater threats of systemic risk. In the U.K., they have a single strong regulator who has responsibility for the entire system and the authority to act when necessary. Maybe a regulator with that authority could have prevented a debacle like the collapse of Bear Stearns by acting quickly and forcefully before things unravel.

In a certain sense, the prime regulator of Bear Stearns was the SEC. They're interested in investor protection and transparency, whereas the Fed, which has the primary jurisdiction over systemic risk, really didn't have much knowledge or ability to go look at Bear Stearns. So you had mismatched regulators for what needed to be done.

So we have to figure out how to regulate the currently unregulated parts of financial markets as well. For example, credit default swaps are a multi-trillion dollar industry almost completely outside the purview of regulators. Recently, there's been talk about creating a clearinghouse for credit default swaps. I think this an excellent idea and the sort of innovation we should be thinking about more broadly. I also believe we need to think about whether a unique change for these swaps might be an even more effective way to bring about greater transparency and limit systemic risk.

We must have greater transparency in the financial system. The credit crunch has been as much a crisis of confidence as it has been a real economic crisis. Financial markets operate on trust and on the belief that participants have that they can rely on the people they are entering into contracts with. As long as so many black holes remain in the financial system, it's going to be hard for that trust to be restored.

We also must involve our international partners. National regulations can achieve only so much in a global financial market. It does us no good to enact new rules here if other countries remain lax in their regulations or their enforcement. The global financial regulatory system should not be the arithmetical equivalent of the lowest common denominator. This crisis and the complexity of our system requires much more.

And finally, we must put aside the laissez-faire "no government is good government" mantra that we too often hear from this administration and from many of my friends on the other side of the aisle. Clearly, the market does not solve all problems by itself, and, of course, neither does government. That's why we need firm forward-looking regulation to prevent the sort of crisis we're facing now from recurring in the future.

I share with Treasury Secretary Paulson and Chairman Bernanke the hope that the worst of the credit crisis is behind us, but I'm not convinced that it's over. Whatever calm has been brought to financial markets today has been the result largely of extraordinary actions taken by the Federal Reserve. Chairman Bernanke deserves credit, but the actions he has had to take are a sign of just how unprecedented and how troubling this credit crisis have (sic) been. We cannot sit back, relax and hope for the best. The American people, our economy and the global financial system can't afford it.

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SEN. SCHUMER: Yeah. See, regulation moves onward. (Laughter.) But in any case, it is great to hear you and I have so many different questions.

Your analysis is troubling and sort of puts this in a different way. You know, when I look at this I sometimes say the international aspects are the most difficult. But you're saying no; we've had good progress there. The difficulty here is just the complexity of these markets and the inability of regulation to almost catch up. Transparency doesn't solve the problem because, in a sense, the markets are fragmented and opaque in themselves. That's worrisome and troubling and something we're going to have to think about a lot.

MR. VOLCKER: I have, just as a homely example, looked at a couple of annual reports of major financial institutions recently. They are very thick.

SEN. SCHUMER: Yes.

MR. VOLCKER: And if you can keep awake while reading them and understanding them, you're a better man than I am. And it reminds you that the executives of these companies, I think, to put it mildly, have great difficulty in really understanding the amount of risk and complexity involved in their organizations.

SEN. SCHUMER: Right. No, I agree with you.

First, and you can give a relatively quick answer here, the Federal Reserve did take the radical step -- you talked about it -- to prevent the collapse of Bear Stearns, and some people have said they've overstepped their authority. Do you think they had any choice? Could they have done it differently? Do you basically agree with what Chairman Bernanke did given his limited abilities ahead of time?

MR. VOLCKER: I was not there, but I can imagine that they were faced with a problem and with a very short time frame, worried about the contagion of the loss of Bear Stearns which was thrust upon their consciousness in suddenness -- very quickly. The interaction of a major investment banking firm -- it's interesting, the smallest of the major investment banking firms, nonetheless, created the possibility of a severe systemic crisis and difficult circumstances, so I can certainly understand why they felt they had to act.

SEN. SCHUMER: Do you think we have to follow up now and does this almost by definition require us to re-examine how regulation is done?

MR. VOLCKER: Absolutely. The financial -- in a way, this crisis forced attention to what existed --

SEN. SCHUMER: Exactly.

MR. VOLCKER: -- in fact already. The banking sector, which was protected and regulated, got relatively smaller. The other sector had gotten larger and larger. But legislation and banking regulations had not caught up with that fact. Now you're forced to look at it.

SEN. SCHUMER: Right.

MR. VOLCKER: That's easy to say.

SEN. SCHUMER: Hard to --

MR. VOLCKER: But okay, well, what is an investment bank? Who is protected? Who is not protected? It's put more in stark contrast when you think back to Long-Term Capital Management. This wasn't even an investment bank.

SEN. SCHUMER: Right.

MR. VOLCKER: It was a hedge fund. God, there are 40(,000) or 50,000 hedge funds in the world. This was supposed to have been a very sophisticated one. Have we got a financial system that cannot stand the particular loss of one hedge fund with a relatively concentrated number of creditors? That is a pretty sad commentary on the basic framework of the financial system.

SEN. SCHUMER: Right, and frightening in a certain sense. The interconnectedness and, as you say, the complexity and opaqueness allow a small flea on a tail of a dog to have the whole system sort of collapse.

Let me ask you two specific issues and just get your thoughts on them. I have been moving in the direction and talking about consolidating the system of regulation. When you have the combination that you've talked about, to have the regulators all chopped up in 25 different pieces doesn't make much sense. What do you think of that?

And second, these swaps and derivatives in general, as you say, are as opaque as could be and difficult, and transparency may not solve much, but there's a lot of talk about having some kind of clearinghouse so the trades don't just occur among two parties but at least a larger number of parties who are in the general area get to see what's going on.

What do you think of each of those ideas?

MR. VOLCKER: Well, let me take the second one first because I can give you a briefer answer. I'm not an expert on these kind of things, but this is one of the weak (tip ?) points, I think, in the present financial system, that you do not have a clearinghouse where a potential loss can be absorbed over a large number of participants. Until recently, the settlement arrangements for this explosion in derivatives has been very uncertain, in my understanding. That's been cleaned up, fortunately, to some extent, but by and large there's no clearinghouse for most credit default swaps, in particular, which is, I think, the biggest point of vulnerability.

So yes, I think that is a priority, and I won't say much more about it --

SEN. SCHUMER: Right. Good enough.

MR. VOLCKER: -- because I'm not an expert in that area.

On the consolidated regulatory authority, of course, this is a big issue. The English thought they got it right some years ago. They put it all in one big agency and had some liaison with the central bank but not apparently close enough. As soon as it was tested, it didn't pass the test very vigorously and the admiration for that system is somewhat diluted and leaves open the question.

I'll illustrate the difficulty, I guess, without an answer. From my point of view, it's always seemed rather clear -- maybe even obvious to me, but I'm biased -- that the Federal Reserve ought to be the principal financial supervisor, given its broad responsibilities. Partly because of its responsibilities as lender of last resort but also because of its independence, I think it's in a better position to resist political pressures on regulation and has a sense of continuity and the framework of regulation within the broader economic context.

So I would say yes, we need more uniformity, and it looks like the Federal Reserve seems to be the logical candidate.

SEN. SCHUMER: So one place you might look to is give them more authority over holding companies of so-called investment --

MR. VOLCKER: Well, that is one way to do it. But now I have a certain hesitancy. (Laughs.) How much do you want to give the Federal Reserve? If you make them, to go to the extreme, the sole regulator of financial stability considerations, which would include what you're saying, it becomes an even more powerful agency in the United States. It's getting into areas that are not typically thought to require the degree of independence that monetary policy does. What does that mean for the structure of the Federal Reserve?

I'm sure it means one thing administratively. The Federal Reserve is not equipped to do it now. And it would have to be reorganized itself, and to the degree the Federal Reserve takes on more responsibility -- even without that, I would urge the Congress to make some arrangement where within the Federal Reserve, there is an official, presumably subject to, I guess, congressional confirmation, that is the chief supervising regulator.

Now maybe he's on the Federal Reserve Board. I -- one thing could be the vice chairman of the Federal Reserve Board, but there has to be somebody there who's accountable more directly than is the case at the moment, when you begin combining these agencies, at least in my view. He's got to have stronger staff. You've got to be able to pay it. You've got to pay some of these mathematicians and experts to get it on your side instead of on the other side, or at least to match the other side.

So they're all kinds of interesting questions, and including whether the Federal Reserve really needs to be the sole supervisor. There's something to be said for the Treasury kind of outline. It was interesting.

SEN. SCHUMER: Which outline?

MR. VOLCKER: The one -- you know, they want to divide up the supervision, take kind of business practice, consumer protection, investor protection -- give that to a new super-SEC, I guess, create a super safety and stability regulator and then have the Federal Reserve oversee it in some sense. The obvious question that many people have pointed out to that is if the Federal Reserve's going to oversee it, it better get more involved than just -- (laughs) -- coming in after the event.

So I don't think that resolves the problem, but it's an interesting suggestion. I --

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SEN. SCHUMER: Well, Chairman Volcker said he had to go at 11:00, so I'm going to -- since you're such a great person for us to ask questions of, I'm going to try to have a second round for people who want to ask a question or two, and I'll take the prerogative of the chair.

First, I mean -- your testimony is incredible. And basically it says, we're in a brave new world here and we don't quite know what we're doing, and that's kind of frightening, and that's probably one of the reasons we had such worry. I think even the people who deal with these credit default issues or trading or whatever else sort of know that we're in this brave new world, and that's why you have a crisis of confidence in credit, which has been one of the big problems here.

But let me ask you two quick questions, related. First, we were talking about how to restructure, and your worry about having one regulator would be that it'd have too much power -- I understand that -- and not enough independence. Parts of it -- what about separating the central bank function from the overall regulatory function? Could the Fed be a good central banker if it didn't have the regulatory ability to reach into these banks and other institutions and know what's going on or have some degree of separation from that?

MR. VOLCKER: Well, this is what you've got to struggle with; there's no doubt about. But you can't completely separate them in my -- you can't come close to completely separating them. That is what the U.K. did. Now, they didn't do it completely, because there was some liaison between the Bank of England, but suddenly they had a crisis in a secondary bank. This is not a major British bank; it was kind of a -- something like a savings and loan, a sizable savings and loan. And the central bank suddenly felt it was faced with a crisis in a sense not of its making and not of its observation. And it reacted very strongly by saying -- talk about unprecedented moves -- they said -- well they said, on behalf of the government -- it gets to your political question. They didn't do it on their own. They said -- I don't know if it was under orders or in consultation with the chancellor of the exchequer, we will guarantee the deposits, or guarantee the creditors.

And what was really surprising then is now the chancellor of the exchequer, not the central bank, said, we will protect all the creditors of all the institutions in London for the time being. I don't know quite what that means. But it was a very sweeping statement. And I feel quite certain the central bank felt a little left out or a little abused, if I may say so -- (laughs) -- because it didn't have a good handle on this what should have been a relatively small problem with a savings-type bank.

SEN. SCHUMER: It worked once, but it may not work again.

MR. VOLCKER: That's right. And once you say that -- I mean, again, there is a moral hazard question.

Once you say you're going to protect all the creditors in a crisis, they're going to expect you to do it the next time, and that is the problem.

Look, you said there's some question about what the Congress can do, so let me make one appeal to you. Don't push all this help for particular credit markets off on the Federal Reserve. I mean, it's very convenient not to do it in the budget directly. It's very convenient not to do it by direct executive action. Let's push it off on the Federal Reserve. But that's the way to destroy the Federal Reserve in the long run, because it does need independence.

So that's why I get a little concerned about, you know, Fannie Mae or Freddie Mac. (Laughs.) But back in the Depression, or not just in -- in the late '80s, early '90s, the savings and loan crisis, you had a big problem in the mortgage market, a big problem with savings and loans. The government set up a separate institution to deal with that.

SEN. SCHUMER: The FTC.

MR. VOLCKER: They didn't tell the Federal Reserve to go out and buy all the savings and loans and --

SEN. SCHUMER: Right. That's a great point. It's a great point.

One final question; this is a more practical one: Recently, Treasury Secretary Paulson claimed the worst of the credit crisis is over. Chairman Bernanke yesterday stated, while the current situation is far from normal, turmoil in the financial markets has eased. It has, obviously, temporarily. On the other hand, we have all the issues of complexity, opacity, new instruments untested. Do you agree with their basic statement? The worry, I guess, everyone in the markets has is another shoe will drop and then all hell will break loose.

MR. VOLCKER: Let me say, first of all, even if we're over the worst of it and it gradually gets better, all the questions that you just raised are relevant -- opacity and all the other things and supervision policy. I think, when you look ahead, the outlook for the financial markets is going to be dependent upon the outlook for the economy. If the economy goes into a real recession, you could easily have another wave of defaults. You would, because that's the nature of it. And then all these strains and pressures would re re- emphasized. If the economy somehow moves along flatly for a while but then gradually -- you've got a different picture. But you can't exclude the possibility the economy's going to do worse, and that would have clear repercussions for the financial system.

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