U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001

50–402 PDF 2010

S. HRG. 110–1001 

TURMOIL IN THE U.S. CREDIT MARKETS: 

EXAMINING THE REGULATION OF INVESTMENT 

BANKS BY THE U.S. SECURITIES AND 

EXCHANGE COMMISSION 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

SECURITIES AND INSURANCE AND INVESTMENT 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TENTH CONGRESS 

SECOND SESSION 

ON 

STEPS TAKEN BY THE AGENCY THEN AND NOW TO ENCOURAGE THE 

INVESTMENT BANKS THAT IT REGULATES TO BETTER MANAGE 

THEIR RISKS AND HOW THE SEC CAN BE STRENGTHENED TO MEET 

ITS MISSION AS THE ADVOCATE FOR INVESTORS WHILE OVERSEEING 

SECURITIES MARKETS AND FINANCIAL STABILITY OF WALL STREET 

FIRMS 

WEDNESDAY, MAY 7, 2008 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html 


jbell on DSKDVH8Z91PROD with HEARING
(II) 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

ROBERT P. CASEY, Pennsylvania 

JON TESTER, Montana 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

BOB CORKER, Tennessee 

SHAWN MAHER, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director and Counsel 

DAVID STOOPLER, Professional Staff Member 

NATHAN STEINWALD, Legislative Assistant 

DAWN RATLIFF, Chief Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON SECURITIES AND INSURANCE AND INVESTMENT

JACK REED, Rhode Island, Chairman 

WAYNE ALLARD, Colorado, Ranking Member 

ROBERT MENENDEZ, New Jersey 

TIM JOHNSON, South Dakota 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT P. CASEY, Pennsylvania 

DANIEL K. AKAKA, Hawaii 

JON TESTER, Montana 

MICHAEL B. ENZI, Wyoming 

ROBERT F. BENNETT, Utah 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

DIDEM NISANCI, Staff Director 

TEWANA WILKERSON, Republican Staff Director 


jbell on DSKDVH8Z91PROD with HEARING
(III) 

C O N T E N T S 

WEDNESDAY, MAY 7, 2008 

Page 

Opening statement of Chairman Reed ................................................................... 1 

Opening statements, comments, or prepared statements of: 

Senator Allard ................................................................................................... 3 

WITNESSES 

Erik Sirri, Director, Division of Trading and Markets, Securities and Exchange Commission .............................................................................................. 33 

Prepared statement .......................................................................................... 4 

Arthur Levitt, Jr., Former Chairman, Securities and Exchange Commission ... 39 

Prepared statement .......................................................................................... 22 

David S. Ruder, Former Chairman, Securities and Exchange Commission ....... 43 

Prepared statement .......................................................................................... 24 


jbell on DSKDVH8Z91PROD with HEARING

jbell on DSKDVH8Z91PROD with HEARING
(1) 

TURMOIL IN THE U.S. CREDIT MARKETS: 

EXAMINING THE REGULATION OF INVESTMENT BANKS BY THE U.S. SECURITIES AND 

EXCHANGE COMMISSION 

WEDNESDAY, MAY 7, 2008 

U.S. SENATE, 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND

INVESTMENT, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The subcommittee met at 10:04 a.m., in room SD–538, Dirksen 

Senate Office Building, Senator Jack Reed (Chairman of the Subcommittee) presiding. 

OPENING STATEMENT OF CHAIRMAN JACK REED 

Chairman REED. Let me call the hearing to order. 

The events of the past year make it critically clear that there is 

a need to review the adequacy of the country’s existing financial 

services regulations, use lessons from the current market problems 

as an opportunity to improve regulation, and review the adequacy 

of resources devoted to regulation. Before we can look forward to 

determine what, if any, changes need to be made, there needs to 

be a sober review of how we got to this point. 

The intent of today’s hearing is to conduct such a review. It is 

critical that the review not only examine the authority of the Securities and Exchange Commission, but also assess the way it undertakes its responsibilities when it implements its regulations and 

supervises some of the largest securities firms through its Consolidated Supervised Entities (CSE) program. Through this program, 

the SEC has a window into these major firms that act as underwriters, issuers, dealers, and investors in many of the complex securities products that are in the market today. 

A little over a year ago, I chaired a Subcommittee hearing, along 

with my Ranking Member, Senator Allard, examining the role of 

securitization where witnesses from Bear Stearns, Lehman Brothers, S&P, and Moody’s, who all four are within the oversight of the 

SEC, testified that problems in the subprime area were confined to 

a small part of the market. Of course, since then we have learned 

that the fallout from the subprime turmoil is deeper and broader 

than we were led to believe. 

Recent estimates on worldwide losses stemming from the U.S. 

subprime mortgage crisis range from $600 billion to $1 trillion. To 

date, some of the largest banks and securities firms have recogVerDate Nov 24 2008 01:22 Mar 23, 2010 Jkt 050402 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 E:\HR\OC\A402.XXX A402

jbell on DSKDVH8Z91PROD with HEARING
2 

nized roughly $285 billion in losses. Moreover, writedowns in the 

financial services industry have led S&P to forecast 20 to 30 percent revenue reduction in the securities industry overall, with the 

potential for even greater revenue reductions. 

Throughout, the SEC and other financial regulators did not fully 

appreciate the risks that were piling up in SIVs and in the CDOs 

that have now collapsed and have come back on the balance sheets 

of some of these large institutions. Use of these ill-advised structures has led to massive losses and significantly depleted capital 

levels. 

On March 12th, merely days before the failure of Bear Stearns, 

I received a response from the SEC to my inquiry on disclosure and 

reporting requirements that applied to the structured finance market. In its response, the SEC stated that it is ‘‘actively engaged in 

investigating possible fraud or breaches of fiduciary duty involving 

structured finance products, such as CDOs, and also whether bank 

holding companies and securities firms made proper disclosure in 

their filings and public statements of what they knew about their 

CDO portfolios and their valuations. The letter further stated that 

the Commission was taking appropriate steps to ensure that there 

was proper disclosure in terms of firms’ CDO exposures and whether the deals considered suitability requirements when selling complex debt-related securities such as mortgage-backed securities. 

These are all appropriate actions by the regulator. However, in 

response to the current crisis, what needs to be addressed is how 

the SEC can avoid or mitigate the effects of these market problems 

for the future. We are interested in learning what knowledge has 

the SEC gained in response to the market turmoil and how is it 

applying that knowledge to improve oversight under the CSE program. Did the SEC’s CSE program, with a focus on the CSEs’ own 

models, lead to increased leverage and reduced capital? What is the 

SEC doing now to improve risk assessment procedures to ensure 

that future problems of this kind are caught at the outset and are 

not allowed to grow to the degree that they threaten the global 

economy and lead to the failure of another investment firm? 

What question does this raise about the reliance on CSEs’ risk 

models which could not adequately measure the risk of new financial products? How are some of the CSEs allowed to place significant amounts of liabilities in SIVs and SPEs beyond the scrutiny 

of investors and, indeed, the regulator? How did the SEC monitor 

and ensure that potential conflicts were managed within CSE firms 

as issuers of mortgage-backed securities and the NRSROs? How 

should regulation of CSEs change the result of the Federal Reserve’s dramatic action to stand behind certain firms which some 

have referred to as the ‘‘too interconnected to fail’’ doctrine? Finally, what is the balance between a principles-based approach and 

a rules-based approach that focuses more on examination and reviews of the firms’ activities to gain a better understanding of these 

firms’ operations? 

As everyone in the room knows, safety and soundness is not just 

about adequate capital levels, but also about ensuring that products offered by these entities are transparent and appropriate for 

consumers and investors and, indeed, the institutions themselves. 

We are again reminded that in times of easy money and access to 


jbell on DSKDVH8Z91PROD with HEARING
3 

cheap credit made possible by a low-interest-rate environment, regulators need to be more vigilant, not less. And, finally, in times of 

crisis, it is as important to understand what went wrong as it is 

to heed the lessons learned so we do not see repeated events. 

Now I would like to recognize Senator Allard for his opening 

statement. Senator Allard. 

STATEMENT OF SENATOR WAYNE ALLARD 

Senator ALLARD. First of all, Mr. Chairman, I would like to 

thank you for convening this hearing of the Securities Subcommittee to examine regulation of investment banks. 

As Chairman Cox said at our recent hearing on Bear Stearns, 

and I quote, ‘‘The SEC’s mission—the protection of investors, the 

maintenance of orderly markets, and the promotion of capital formation—is more important now than it has ever been. The recent 

turmoil in credit markets has made this a particularly challenging 

time.’’ 

That may be a bit of an understatement. 

Since 2004, the Securities and Exchange Commission has allowed a broker-dealer holding company and its affiliates to undergo 

consolidated, what we call, SEC supervision. The Consolidated Supervised Entity (CSE) program was created partly in response to 

a European Union requirement that brokerage firms doing business in the countries needed to be regulated on a consolidated 

basis. 

Unlike bank regulations, we are not talking about a large universe. The CSE program covered five entities, so naturally, when 

one of them—Bear Stearns—imploded, it raised a number of questions regarding the adequacy of the CSE regulation. 

Many people have happily taken on the role of Monday morning 

quarterback and offered all sorts of suggestions or criticisms of the 

CSE program. And I commend Chairman Reed for taking a step 

that is becoming all too rare around here and holding a hearing to 

get the facts. We need to understand the history of the CSE program as well as its goals, functioning, and failings. Only by understanding the current landscape can we make decisions about potential legislative actions. 

I would like to welcome our witnesses to the hearing today. Erik 

Sirri has testified before us on a number of occasions, and it is good 

to welcome him back today. I know that Mr. Sirri is currently leading an agency-wide task force composed of senior leadership, so his 

comments will be helpful. 

It is also a pleasure to welcome two distinguished former SEC 

Chairmen, David Ruder and Arthur Levitt, back before the Senate. 

Both of you led the SEC through challenging times, and so you 

bring a unique perspective to today’s discussion. Your experience as 

Chairmen gives us a keen understanding of the SEC, yet you have 

the luxury of being outside the politics of the SEC—something not 

enjoyed by the current Commissioners or staff. 

The question of how to best regulate large investment banks will, 

unfortunately, not be settled here today. However, this hearing is 

an important part of that ongoing process. I am confident that all 

our witnesses will aid our understanding of the matter. I sincerely 


jbell on DSKDVH8Z91PROD with HEARING
4 

thank them for being here today, and I look forward to their testimony. 

Thank you, Mr. Chairman. 

Chairman REED. Well, thank you very much, Senator Allard. 

As Senator Allard indicated, we are pleased to be joined today by 

Dr. Erik Sirri, the Director of the Division of Trading and Markets 

at the Commission. We are also on our second panel very delighted 

to have our distinguished former Chairmen of the Securities and 

Exchange Commission, Arthur Levitt and David Ruder. And I 

would also point out that former Chairman William Donaldson 

very much wanted to attend. 

Chairman REED. At this point I would like to recognize Dr. Sirri. 

Dr. Sirri. 

STATEMENT OF ERIK SIRRI, DIRECTOR, DIVISION OF 

TRADING AND MARKETS, SECURITIES AND EXCHANGE 

COMMISSION 

Mr. SIRRI. Chairman Reed, Senator Allard, I am pleased to have 

the opportunity this morning to describe the SEC’s program for 

regulation of investment banks and the lessons learned from the 

recent turmoil in the credit markets. 

Under the statutory scheme that Congress devised, most recently 

reflected in the Gramm-Leach-Bliley Act, the SEC is responsible for 

regulating the broker-dealer subsidiaries of investment banks, but 

no regulator in the Federal Government is given explicit authority 

and responsibility for the supervision of investment bank holding 

companies with bank affiliates. For investment banks that do not 

have U.S. banks within the consolidated group, it provides for holding company supervision in a structure that is purely voluntary. 

The four largest investment bank holding companies in the U.S. 

are ineligible because they have specialized bank affiliates, such as 

industrial banks or certain savings banks. 

Because the existing statutory scheme does not address how and 

by whom investment bank holding companies with specialized bank 

affiliates should be supervised, and in part because of the implications of the European Union’s Financial Conglomerates Directive, 

which required consolidated supervision either internationally or at 

the European level, the SEC adopted its Consolidated Supervised 

Entities—or CSE—program for U.S. investment banks in 2004. 

This, too, is a purely voluntary program, but in 2004 and 2005, the 

five largest investment banks volunteered to participate. 

The CSE program has been recognized as ‘‘equivalent’’ to that of 

other internationally recognized supervisors for purposes of the 

EU’s Financial Conglomerates Directive. It provides consolidated 

supervision to investment bank holding companies that is designed 

to be broadly consistent with the Federal Reserve’s oversight of 

bank holding companies. It allows the Commission to monitor for 

financial or operational weakness in a CSE holding company or its 

unregulated affiliates that might place the U.S.-regulated brokerdealers or other regulated entities at risk. 

It is within this context that the SEC confronted the rapid deterioration of liquidity at Bear Stearns during the week of March 

10th. I will not rehash the events of that week because they were 

covered amply in testimony before the Banking Committee last 


jbell on DSKDVH8Z91PROD with HEARING
5 

month. But I would like to reiterate to this Committee what Chairman Cox observed in his testimony before the full Committee on 

April 3, 2008. While the Federal Reserve, by extending temporary 

access to the discount window to Bear Stearns as well as to other 

major investment banks, forestalled a similar run on the bank from 

playing out elsewhere, it, nonetheless, remains for Congress to determine whether to provide more predictable access to an external 

liquidity provider and to harmonize any such measures with other 

aspects of the existing statutory scheme, in particular the framework established by Congress for considering the resolution of difficulties experienced by commercial banks, but not investment 

banks, similar to the framework in the Federal Deposit Insurance 

Improvement Act and the Federal Deposit Insurance Act for systemically important investment bank holding companies. 

In the wake of Bear Stearns, the SEC has taken a number of 

steps and additional protections that are being contemplated by 

CSEs in the wake of Bear Stearns. In addition to strengthening the 

liquidity requirements for CSE firms relative to their unsecured 

funding needs, we are closely scrutinizing the secured funding activities of each CSE firm, with a view to lengthening the average 

term of secured and unsecured funding arrangements. We are currently obtaining funding and liquidity information for all CSEs on 

a daily basis and discussing with CSEs the amount of excess secured funding capacity for less liquid positions. Further, we are in 

the process of establishing additional scenarios, focused on shorter 

duration but more extreme events that entail a substantial loss of 

secured funding, that will be layered on top of the existing scenarios as a basis for sizing liquidity pool requirements. This additional analysis is providing the basis for requiring firms to take 

steps such as increasing the term of secured funding and the diversity of funding sources. Also, we are discussing with CSE senior 

management their longer-term funding plans, including plans for 

raising new capital by accessing the equity and long-term debt 

markets. 

Because the CSEs now have temporary access to the Primary 

Dealer’s Credit Facility—or PDCF—which would operate as a backstop liquidity provider should circumstances require, and assures 

the necessary breathing space to implement the various measures 

outlined above, the SEC is in frequent discussions with the Federal 

Reserve Bank of New York about the financial and liquidity positions of the CSEs and issues related to the use and potential use 

of the PDCF. The SEC and the Federal Reserve Board are developing a formal Memorandum of Understanding that would provide 

an agreed-upon scope and mechanism for information sharing, both 

related to the PDCF and other areas of overlapping supervisory interest. Moreover, should Congress enact legislation to provide access to an external liquidity provider under exigent conditions in 

the future, the SEC stands ready to develop a process by which the 

Commission would formally communicate with the Federal Reserve 

or other relevant agencies in the event that an institution required 

access to any successor facility. Finally, the Chairman has publicly 

requested dedicated funding for the CSE program and a significant 

expansion in staff. 


jbell on DSKDVH8Z91PROD with HEARING
6 

In conclusion, Bear Stearns’ experience has challenged a number 

of assumptions, held by the SEC and by other regulators, relating 

to the supervision of large and complex securities firms. The SEC 

is working with other regulators to ensure that proper lessons are 

derived from these experiences and that changes are made to the 

relevant regulatory processes to reflect those lessons. 

An imperative from the Bear Stearns crisis is addressing explicitly how and by whom large investment banks should be regulated 

and supervised, and specifically whether the Commission should be 

given an explicit mandate to perform this function at the holding 

company level, along with the authority to require compliance. We 

look forward to working with you on these broader questions. 

Thank you again for this opportunity to discuss these important 

issues, and I am happy to take your questions. 

Chairman REED. Thank you very much, Dr. Sirri, for your testimony, and you have raised some very interesting topics, and I appreciate the thoughtfulness of your statement and the work you are 

doing today to review and then look ahead to what we can do to 

make the situation better. 

You state in your testimony that at no point did Bear Stearns’ 

customers risk losing any of their cash, which raises sort of the 

issue of what was the focal point of the CSE. Was it simply to regulate the broker-dealer/customer relationship? Or was it the broader 

issue of regulating the entity? And I think you suggested an answer, which is it was not quite sure in the SEC mind. Can you 

comment on that? 

Mr. SIRRI. Sure. I think you bring up two different but both very 

important aspects of our supervision generally. We obviously supervise broker-dealers, and in supervision of a broker-dealer, any 

broker-dealer, the focus is on preservation and the safety of a customer’s security and cash. That goes for broker-dealers that sit outside consolidated supervised entities as well as the large brokerdealers that are inside of them. 

The CSE program is a program that deals with the holding company that surrounds these large broker-dealers and deals with the 

financial and operational controls for risk that reside at the holding 

company. Those controls for risk also affect the broker-dealer itself. 

The goal of the CSE program is to ensure that the risk is managed in such a way that none of the regulated subsidiaries of that 

holding company, whether U.S. broker-dealers, foreign broker-dealers, U.S. banks, or foreign depository institutions, are impaired because of issues in unregulated affiliates of that holding company. 

Chairman REED. You suggest also, I think, in your testimony 

that explicit directions, legislative directions to you about your role 

of supervising investment banks would be appropriate. Is that a 

fair conclusion? 

Mr. SIRRI. Yes, it is. 

Chairman REED. And can you give us an outline of what you 

would think would be sort of the parameters of this role? 

Mr. SIRRI. Sure. I want to point out that now, at the current 

time, our supervision, our CSE supervision, is by rule. It is through 

a modification to our net capital rule. What we are talking about 

when it comes to legislation is actually providing some legislative 

clarity that would allow us to have examination authority, capital 


jbell on DSKDVH8Z91PROD with HEARING
7 

setting and monitoring authority, and authority to impose various 

kinds of progressive restrictions on the firm itself based on its risk 

controls, its financial and operational risk controls. 

I think we feel it is important to have the certainty that would 

arrive from having our authority embodied in legislation. Our rulebased system today accomplishes many of these, but there is an 

amount of certainty and clarity that arises from legislation that we 

think would be helpful. 

Chairman REED. And another obvious point would be the fact 

that it would no longer be voluntary, that this would be mandatory 

if a firm fell into the guidelines or the definition? 

Mr. SIRRI. Well, a firm could elect to fall under these guidelines. 

For example, a firm, if it wished to be supervised on a consolidated 

basis today, elects to come into it. I think, you know, it is for you 

to decide, and we are happy to have these conversations with you. 

But I think beginning a framework we are talking about, it is important that these holding companies be supervised. So it could be 

crafted on a voluntary basis, but if it were and one of these systemically important firms elected not to opt into it, I think there would 

be a difficult question of who was supervising that holding company. 

Chairman REED. Also, I presume that you are not going to wait, 

that you are actually reviewing the rules as we speak to see if additional proposed rules should be made public and request comments. Is that fair? 

Mr. SIRRI. It is a fair comment. I think we are reviewing many 

things. We are reviewing the way that we have supervised the 

firms and ways that we have been discussing. We are working in 

an integrated way with the Federal Reserve. We are looking at our 

rulemaking itself to see if those things can be improved and if 

there are steps that we can take in the interim. All of these things 

are on the table with the goal of accomplishing the goals of the 

CSE program. 

Chairman REED. You mentioned, Dr. Sirri, that you are entering 

into a Memorandum of Understanding with the Federal Reserve, 

and that, I presume, has been significantly influenced by the Bear 

Stearns situation, where they actually went in and essentially supported the investment banking industry. Can you comment on the 

Memorandum of Understanding, where you are and where you are 

going with that? 

Mr. SIRRI. Sure. The Memorandum of Understanding at the moment is in process. It is an interim draft, so it is in its early stages. 

The purpose of it is to cover a situation that we have now seen to 

say how are we going to work with the Federal Reserve in situations with the kind of exigencies that arose in Bear Stearns. But 

the Chairman has also asked us to look at our relationship with 

the Federal Reserve generally and see if in this Memorandum of 

Understanding we could broadly codify our working relationship 

with the goal of making it more useful and more clear. 

Chairman REED. Let me switch to a specific topic, that is, from 

2004 to 2007, at least three of the entities that you supervised 

under the CSE program—Bear Stearns, Lehman Brothers, and 

Merrill—made major purchases of subprime mortgage origination 


jbell on DSKDVH8Z91PROD with HEARING
8 

firms, placing them within the top 10 subprime mortgage originators in the country. 

What is the scope of your authority over these subsidiaries? Did 

you actively engage in any type of review of the transaction or the 

effect on the investment bank? 

Mr. SIRRI. We were fully aware of those transactions, and we 

were aware of their purposes. We understood what we did with respect to the risks to the firms. One of the reasons that these firms 

cited for these transactions was to have better control of the quality of the mortgages that came in from the outside into these firms. 

Chairman REED. That sounds somewhat ironic at the moment. 

Did you have the occasion or the ability to coordinate with the regulators of these mortgage firms, if they were regulated, State regulators or anyone else? Did you do that? 

Mr. SIRRI. I am not sure that we had—particularly at the CSE 

level, I am not sure that we had conversations with the entities 

that regulated those mortgage firms. 

Chairman REED. Now, the rationale was that they wanted to ensure better quality. Did you actually have the occasion to look at 

the process of origination and securitization so that you could 

evaluate what was going on with these subsidiaries? 

Mr. SIRRI. What we tried to understand, again, the purpose of 

the CSE program was to look at the holding company level risk 

controls. So to the extent that these risks that were imposed by the 

mortgage process, whether they involved the purchase of a mortgage originator or whether these mortgages were acquired at a 

market basis, we looked at the kind of risks they imposed on the 

firms. 

Chairman REED. But how deep did you drill down? I mean, did 

you go in and talk at the level of the firm about the ratings, the 

categorizations? Or were your examiners able to go out and look at 

the actual process and make an independent assessment? 

Mr. SIRRI. We did not make independent assessments. What we 

focused on were the risk controls within the firms and how they 

handled those risks, but we did not go out, say, to the mortgage 

originators and visit them. 

Chairman REED. Another aspect of this issue between 2004 and 

2007 is the proprietary trading activities of these firms. Did you 

have a chance to assess the management of risks associated with 

proprietary trading? And the specific issue of trading for their own 

accounts in a different way that they were trading in public accounts or offering securities to the public, was that ever part of 

your review? 

Mr. SIRRI. For the CSE program itself, we definitely paid attention to their proprietary trades. So, for example, we knew of their 

proprietary positions for various classes of securities and derivatives. Those would include equities, typical debt, as well as mortgage instruments, derivatives, and cash instruments. So we were 

aware of those positions. We were aware of the risk controls for 

those positions. And we were aware of the policies and operational 

controls they had in place. 

Chairman REED. But you were not consciously or institutionally 

aware of any discrepancies between positions they were taking for 

their own account versus positions for public account? 


jbell on DSKDVH8Z91PROD with HEARING
9 

Mr. SIRRI. When you say ‘‘public account,’’ I am—what you mean 

here is—— 

Chairman REED. The information and recommendations that 

were given to clients. 

Mr. SIRRI. Sure. I understand. 

Chairman REED. Suggestions to buy this, et cetera. 

Mr. SIRRI. I understand exactly what you mean. You are referring to sales practices, the way they approached customers in the 

purchase of these securities. 

Chairman REED. Yes. 

Mr. SIRRI. That would not properly be part of the CSE program. 

That said, you know, we do have, as part of our oversight of 

broker-dealers, authority over broker-dealers and their sales practices. So that was not part of the CSE program, but even now as 

we speak, we as a Commission are reviewing those sales practices, 

the suitability of those recommendations. And to the extent those 

recommendations were unsuitable, I think, you know, we will be 

looking at that. 

Chairman REED. Thank you, Dr. Sirri. 

We have the luxury of myself and Senator Allard, so I think we 

will do a second round, Senator, so go ahead. I have got one more 

series of questions. Senator Allard, please. And thank you for letting me go on. 

Senator ALLARD. You bet. I just have a direct question to follow 

up on how this all came about. The fundamental question, do you 

believe the Bear Stearns implosion was an indictment of the CSE 

program and its failings or was it unforeseeable? 

Mr. SIRRI. I believe that what happened at Bear Stearns was unprecedented. A liquidity event that characterized the failure of 

Bear Stearns was something we just had not seen. This was not 

the case as in the case, say, of a Drexel or other broker-dealers or 

large firms that have failed, of holding a class of instruments 

whose value declined over time and the firm was forced to liquidate. That did not happen at Bear Stearns. 

What happened at Bear Stearns was that secured funding typified by repurchase transactions in which a ‘‘money good’’ piece of 

security or some instrument is given to someone who provides you 

funding, but that mechanism fell apart. That is a secured funding 

market, which means that the paper I give you, the security that 

I give you, provides you confidence and security in the short-term 

loan you make me. That mechanism we always believed was governed by the quality of the collateral I provided you. The quality 

that Bear Stearns provided—treasuries, agency securities, as well 

as some other securities whose value was perhaps more questionable—that market fell apart. It fell apart in a way that we never 

anticipated. In our scenarios for risk management and I must say 

in the scenarios for risk management that were maintained by 

many regulators in the world, as well as other street firms, that 

was unprecedented. We obviously are more intelligent about that 

now, and we are incorporating that new reality into our risk management process. 

Senator ALLARD. Do you think you were too reliable on the value 

of real estate and the paper that went with the real estate because 

you had brokers, you had land appraisers, which is controlled by 


jbell on DSKDVH8Z91PROD with HEARING
10 

State regulation, and you assumed that that was working, but I 

know of instances in Colorado there was some serious breakdown 

in that relationship, and ordinarily with the consumer relying on 

between the title company and the broker and the appraiser, it 

tended to break down because of various market pressures, I think 

at the local level, and I think that the assumption was that this 

real estate had more value than it really did because of how that 

system was breaking down. 

How do you view that as it was coming up to your level when 

you were evaluating—taking on the value of the security? 

Mr. SIRRI. It is a good question. I think there are two separate 

issues here. You are pointing out a good question about the quality 

of the collateral, the underlying value of that collateral. The second 

issue is the process by which repurchase transactions are done. 

Senator ALLARD. Yes. 

Mr. SIRRI. In the repurchase market, the failing in the repurchase markets that we saw occurred in agency securities that were 

essentially money good. These are pass-through securities from 

Federal agencies that, because of their implicit guarantees around 

them, did not have the kinds of concerns that you are citing. 

The concerns that you are citing are also very important. They 

could relate to commercial mortgage-backed securities, which thus 

far, although we are watching very carefully, we have not seen the 

kind of issues that might loom large perhaps in the future. In the 

residential mortgage-backed security, which are the pieces of paper 

that underlay residential mortgage-backed, you know, 

collateralizations and CDOs, there, of course, we did see issues. 

I do want to correct one statement I made to Senator Reed. I was 

corrected by my colleagues in back. The CSE program, in fact, did 

visit originators, both at Bear Stearns and Lehman, and we 

checked with their audit oversight. So let me correct that statement, if I might, that our team did go out and visit two of the three 

that captured them. So I apologize for the mistake there. 

Senator ALLARD. The other question, this originated, this whole 

idea of the CSE originated because we had these investment banking holding companies that wanted to get involved in the European 

markets, and so there was a requirement from the European market that you had to have a regulated entity. And when you put together those regulations initially, were they basically the same regulations that European companies—a similar nature—had to deal 

with? Or were they less regulatory or more regulatory? How would 

you classify them? 

Mr. SIRRI. What the European Union was concerned about in 

their Financial Conglomerates Directive was that there be a single 

supervisor for the consolidated holding company and that supervisor be able to look at the risk controls at the holding company 

level as they affected the holding company and the various regulated subsidiaries. That was the core issue. 

If those firms that chose to do business in the EU did not have 

a consolidated supervisor, the EU would have forced them for their 

business in Europe to create a sub-holding company that had, if 

you will, a miniature consolidated supervisor. That was expensive 

in terms of doing business in Europe. 


jbell on DSKDVH8Z91PROD with HEARING
11 

The consolidated supervision program that we put in by rule is 

broadly consistent with the kind of risk management controls, operational financial controls that are the holding company level in Europe and in the United States. So that I would say Europe, the 

Federal Reserve in the United States, and the Securities and Exchange Commission are broadly consistent in that area. 

Senator ALLARD. Now, they have different accounting standards 

and approaches on accounting. How do you compensate for that? 

Mr. SIRRI. For us, we are looking at risk controls. So what is absolutely true is that valuation of securities is critically important 

in the risk management process. We don’t use accounting numbers 

per se in the risk management processes. The good thing, the thing 

that makes this easier, is that risk management in a securities 

firm is largely done on a marked-to-market basis. 

Senator ALLARD. OK. 

Mr. SIRRI. And marked-to-market is independent of your accounting framework. 

Senator ALLARD. OK. So if we had problems with the regulatory 

environment here in this country, what does that say about the 

regulatory environment in Europe with a similar instrument? 

Mr. SIRRI. Well, I think both us, the United States and our regulatory oversight, and worldwide securities and systemic regulators 

are thinking very carefully about the issue of liquidity when it 

comes to regulation of financial intermediaries. This issue is being 

revisited in the Basel II capital requirements. We are thinking 

more deeply about it, about what it means for securities firms, because liquidity is so much their lifeblood. And I know that in our 

conversations with the Federal Reserve, Tim Geithner is also 

thinking very deeply about those questions. 

Senator ALLARD. OK. Let me move on to the PART program. I 

am a strong proponent of the President’s PART program, where 

you put out measurable goals and objectives and then the OMB 

comes in and does an evaluation and they evaluate the program as 

to whether it is effective or not effective, depending on whether the 

agency actually even put any goals and objectives in. And I noticed 

in looking over the Internet on the PART program that you have 

not been evaluated—this particular program has not been evaluated by PART. 

Could you give the Subcommittee a brief kind of PART-type analysis of the program? Do they have measurable goals and objectives, 

for instance? 

Mr. SIRRI. The Division of Trading and Markets has been evaluated in the PART framework, and we received the highest evaluation. So that is for the division as a whole, but the CSE program 

was part of it. But let me—— 

Senator ALLARD. So the CSE program has been evaluated on 

goals and objectives? 

Mr. SIRRI. Trading and Markets, the division in which the CSE 

program oversight sits—— 

Senator ALLARD. I know. 

Mr. SIRRI [continuing]. Has been evaluated by PART. But I think 

you are asking about the CSE program itself. 

Senator ALLARD. Right. That is what I am after. 


jbell on DSKDVH8Z91PROD with HEARING
12 

Mr. SIRRI. Exactly. So I just wanted to point out there has been 

some measurement there. 

Let me try to answer your question directly. I think if you were 

to try and craft a system—all these things are difficult when it 

comes to supervision—a system of outcomes and measures, outcomes—inputs and outcomes here, I think we would have to think 

about issues related to, you know, quality, issues like the amount 

of liquidity that is being held within these firms. So let me give you 

a concrete example. 

Before the SEC came in and supervised on a consolidated basis, 

these firms had no requirement to hold liquidity at the holding 

company level. They just did not need to because there was a gap, 

as I said in my testimony, in Gramm-Leach-Bliley. As part of our 

supervisory program, we require tens of billions of dollars of liquidity at the holding company level, to the point that now for the largest of these firms, there is in excess of $90 billion of free cash sitting at the holding companies of these firms. That is cash that is 

unencumbered and that can be spent at the end of the day today. 

That cash was not there prior to our oversight of these programs. 

So I think a reasonable type of outcome measure would be something that related to the amount of free liquidity that was placed 

in these firms as a result of our oversight, perhaps as scaled to the 

risk of these firms. I think something like that would lend itself to 

a PART-type framework. 

Senator ALLARD. We are going to send you a question after the 

hearing, at least from my office, and I think maybe the Committee 

would be interested, too, and what I would like to have you do, a 

PART-type analysis. In other words, what is the specific purpose 

of the CSE program? Get that down on a piece of paper for us. And 

what are the specific measurable goals and how well is it achieving 

those goals? And how can it be improved? 

Mr. SIRRI. I would be happy to give you that. 

Senator ALLARD. That is sort of all encompassing, and I would 

like to see what kind of response we get back on that. 

Mr. SIRRI. Thank you. 

Senator ALLARD. Thank you. 

Chairman REED. Senator Schumer. 

Senator SCHUMER. Thank you, Chairman Reed, and thank you 

for calling this hearing. I thank our witnesses. 

I guess the thing I would say is that I understand why the CSE 

program is there. It came about because of the great dilemma we 

face in regulation here, which is globalization, and that is, we are 

in global financial markets, we have national regulation, and it 

really allows a flight to the lowest common denominator if we are 

not careful. And that does two things: First, it hurts jobs in America, which I care a lot about. I think it is cavalier to say just keep 

all the regulations the same here, and then if the jobs flee, that is 

nothing, there are hundreds of thousands of people in America, 

hundreds of thousands in my area who work there. But, second, it 

does not accomplish anything. We are talking now, for instance— 

this is a different area, but it is related, increasing margin requirements on oil futures. In my view, that ought to be done. But if we 

just do it here, all oil futures will be traded in London, and we will 

not accomplish anything. We just will not accomplish anything. 


jbell on DSKDVH8Z91PROD with HEARING
13 

So there is a balance here, and I know why you set up the CSE 

program, and that is because, otherwise, American companies 

would have had two choices: have two sets of regulation governing 

them, and that is not very good, especially when the regulations 

are in conflict. Just try to do it. It sounds benign. Try to be there 

when you are hearing different things from different regulators. Or 

they would have gone to Europe and had their regulation, for whatever that is worth. So I understand why you have it, and I think 

any call to abolish it is irresponsible given the dilemma. 

Having said that, it is weak regulation by nature. And I am for 

much stronger—you know, I think in the 1980s we had sort of an 

exquisite balance between entrepreneurial vigor and regulation. 

You need a balance. If you have too much of one, you do not get 

the benefits of capitalism. You have too much of the other, and you 

get the excesses of capitalism. And so having a good balance makes 

a great deal of sense. 

The trouble is that fundamentally when you regulate—one of the 

main reasons we regulate holding companies is safety and soundness, not only of the institution but of the system, systemic risk. 

And the SEC has never been a good safety and soundness regulator. It is not intended—the Fed is basically the experts on safety 

and soundness, particularly to the system. The SEC regime worked 

great. The basic view was since most of the people who were involved had some degree of sophistication that disclosure and going 

after fraud and other types of things was the way to go. But that 

is not the same way—it is not even the same mind-set as safety 

and soundness regulation. The Fed was always regarded as a 

friendlier regulator because it was more interested in safety and 

soundness, and the SEC was regarded as a more hostile regulator 

because it was interested in disclosure and fraud. And before technology had the two, banking and investment banking, blend—and, 

again, Glass-Steagall dealt with a reality, not created a reality— 

or getting rid of Glass-Steagall, which, again, in all due—I defended it for the longest time. But, second, the whole atmosphere 

of regulation is different. 

And so I think, frankly, Mr. Chairman, the problem here is far 

greater than how well is CSE functioning. We need to revamp our 

structure of regulation. We have a different financial structure 

than we did when all of this was set up. And we need a strong regulator. We need, in my judgment, a more unified regulator. And we 

need a regulator who can look at a company like Bear Stearns from 

both points of view together as opposed to having the SEC look and 

see if Bear Stearns is disclosing or defrauding its potential investors; and, second, a different regulator—in this case, the Fed—coming in at the last minute and not knowing and not being prepared, 

saying we are worried about safety and soundness. 

So I think that, again, the weakness of CSE is not the fault of 

the program itself. The weakness of CSE, which I would like to see 

a stronger regulatory regime, is because of the changes in the system, both technology and globalization. I think one of the reasons 

we had trouble with Bear Stearns, there should have been some 

regulator who went in in the summer and said, ‘‘You have got to 

raise capital. You have got to reduce your exposure to mortgages.’’ 

The SEC never does that. And it is not adept at doing things like 


jbell on DSKDVH8Z91PROD with HEARING
14 

that. And the Fed did not have jurisdiction, and the Bear Stearns 

mess fell between the cracks. 

And that is why I think, Mr. Chairman, one of the things we 

should be doing on this Committee is studying how we change our 

system of regulation. I would not do it quickly. I would do it carefully. And somehow we have to figure out a framework where 

whatever we do is in sync with the other major financial centers, 

London and Hong Kong and others, so you do not have—we can do 

all the regulating we want on our own. If everything goes somewhere else, as I said, we have not accomplished anything regulatory-wise, even if you do not care about the jobs, which I do. 

Would you just comment on my little rambling peroration here? 

Because I have thought a lot about this. I care a lot about this, obviously. 

Mr. SIRRI. Well, it is clear you have thought about it because 

what you said was extremely insightful. Let me begin with where 

I think you started, and I want to agree with you completely. You 

made a point about regulation and the balance that it strikes in 

the context perhaps—you used the example of oil futures and margin requirements in oil futures and the point that that business 

would just flee that higher margin setting. 

In our supervision of firms, generally, stepping even back from 

the CSE program, we are always conscious of that. We may have 

a wish at times to tighten regulation in a particular place, but the 

firms that we are talking about, the large globally incorporated 

firms that we are talking about, will shift that business in other 

places. 

I was speaking on a panel the other day with the general counsel 

of a very, very large financial intermediary, and I made a point 

about something where we thought additional oversight was needed. And the gentleman, whom I knew well, who is a very intelligent 

man, turned to me and said, ‘‘Well, you may elect to do this, but 

we will just do business in one of the other 17 countries in which 

we are incorporated.’’ And that is a reality that we face every day 

and which I think I appreciate that you said. 

Turning to the CSE program itself, you parsed regulation, I 

think quite correctly, into, the way I understand it, three distinct 

buckets, if you will. 

You pointed out that the SEC is typically involved in issues 

about sales practices or, you know, disclosure, our typical regime 

for investor protection. And that is a core mission of the SEC. 

You then pointed out that the Federal Reserve often takes on 

issues of supervision and prudential regulation. That is typically 

where they reside. 

And you pointed out there was, in fact, a third function, the function of a guarantor, also something that is often done by the Federal Reserve. 

The CSE program actually allows the SEC to fit in there in a 

particular way. We view the CSE program as a prudential program. It is not a disclosure program. It is not an investor protection program. Admittedly, it is done through rule and not through 

statute, something that our Chairman has said he would like to see 

change. But the framework that we have there is one that says if 

you want to get this alternate capital treatment for broker-dealers, 


jbell on DSKDVH8Z91PROD with HEARING
15 

then you must submit to the following, and to condense that down, 

it means supervision at the holding company and going through a 

set of undertakings. Within that set of undertakings, we have the 

ability to compel a firm to unwind a line of business, to compel a 

firm to increase their capital, to compel a firm to raise more liquidity at the holding company. 

I admit that it is not the same as statutory authority, but it is 

derived from a rule. What we do not have the ability to do is to 

provide a monetary safety net through access to a discount window. 

Senator SCHUMER. But it is true that the people at the SEC do 

not have a long history, long experience, even in that second function, do they? 

Mr. SIRRI. I am going to step up to that and say that for the 

building itself, we are building that pays greatest attention to investor protection. For this program itself, it is staffed uniquely. It 

is staffed with PhDs in finance, in economics, masters in statistics. 

It is staffed differently than any other program. There is but one 

attorney in that group when I came in. It is a group that is very, 

very similar to the staffing at the Fed or any kind of regulator like 

that in such a program, 

So, whereas, I will absolutely agree with you that it is the case 

that we are not typified by such staffing, for the purposes of this 

program it is staffed effectively, and it meets very well those requirements. Myself being—I am a finance PhD type. I was happy 

to see that kind of staffing when I came in because it is the kind 

of toolkit you need to do the work that is required. It is a quantitative discipline. 

Senator SCHUMER. Could I just ask—and I beg the Chairman’s 

indulgence—how many staff are there that are, you know, non-secretarial/clerical, but actually doing the looking? 

Mr. SIRRI. There are 25 professionals involved in the CSE program. The Chairman has indicated that he would like to raise 

staffing of that to the level of 40 people, and that staffing would 

come both—in various aspects of the program. 

Senator SCHUMER. Thank you, and sorry for going over my time. 

Chairman REED. Thank you, Senator Schumer. 

Senator Casey. 

Senator CASEY. Mr. Chairman, thank you very much, and I want 

to thank you, Doctor, for being here and for your testimony. Some 

of this may be redundant in terms of your testimony and some of 

the earlier questions, but I wanted to clarify or amplify the record 

on a few questions. 

One is, I guess, a broad question about conflicts or potential conflicts. Could you just take me through the perspective of the SEC’s 

ability in the role the SEC plays in monitoring conflicts between 

the rating organizations, the so-called NRSROs, and the consolidated supervised entities, the CSEs, as underwriters? Could you 

just kind of walk through in terms of this program how you will 

deal with and try to prevent conflicts? 

Mr. SIRRI. Sure, I would be happy to. 

Credit rating agencies fell—our oversight of credit rating agencies was extremely, extremely light, only through ‘‘no-action’’ letters that we granted. That was up until late 2006 when the Credit 

Rating Agency Reform Act was passed. We passed rules. The ComVerDate Nov 24 2008 01:22 Mar 23, 2010 Jkt 050402 PO 00000 Frm 00019 Fmt 6633 Sfmt 6602 E:\HR\OC\A402.XXX A402

jbell on DSKDVH8Z91PROD with HEARING
16 

mission approved final rules in June of 2007 to operationalize that 

new act. That covered several things. Broadly, that covered several 

things. 

We specifically are charged with drafting rules and enforcing 

issues around transparency for the credit rating agencies, as well 

as mitigating certain conflicts of interest. That goes for any firm 

that—that goes for the CSEs as a whole—excuse me, the credit rating agencies as a whole. So in that sense, the CSEs are not unique 

amongst underwriters who would come to these credit rating agencies. But let me turn to the conflict of interest point you asked 

about. 

In the rulemaking that we did, we basically prohibited certain 

kinds of conflicts. An example of one of those would be that someone, an employee who is involved in the actual crafting of a credit 

rating could not own the security being rated. That would be an 

example of a conflict we thought was unsupportable, and so we prohibited that directly. 

More broadly, we require policies and procedures to manage 

other conflicts. Examples of that would include the notion that 

there is payment made by the person, the underwriter, bringing 

the security. That payment is being made. Their paper is being 

rated. There is a clear conflict there. So policies and procedures 

would need to be in place to manage that conflict. 

Our Chairman has asked us to engage in rule writing immediately to try to improve and strengthen the regulatory framework 

for these entities. That rule writing will cover transparency, and it 

will cover additional rules in the area of conflicts of interest. 

Senator CASEY. Let me ask you where you are in that process. 

In other words, is this a question of procedures in place for conflicts of interest that have yet to be fully implemented or tested? 

Or do you still have more work to do in terms of developing procedures? 

Mr. SIRRI. It is a good question. We have been engaged in an examination of the credit rating agencies, so we have used our examination authority. We have been in there with teams at the three 

large credit rating agencies. Those examinations, we are not going 

to wait for them to be complete. They will inform our rulemaking 

because we have learned some things there. So an example of 

something that we may ask the Commission to consider would be 

perhaps a kind of prohibition that says that if a firm is involved 

in providing certain kinds of consulting or advice services to an underwriter related to a particular offering, they not be allowed, they 

be completely prohibited from rating that offering. 

I cannot tell you the precise form of that, but that is something 

that staff is giving consideration to. 

Senator CASEY. So the rulemaking is ongoing. 

Mr. SIRRI. The rulemaking is advanced at our stage in terms of 

a draft stage within the building. It is, of course, up to the Commission to decide when they want to consider it. But the Chairman’s instructions to me as the Director were to do that with all 

haste and try to bring that forward as rapidly as reasonably possible. 

Senator CASEY. Thank you. And I wanted to ask you the second 

question or second area of questioning about the examiners. I was 


jbell on DSKDVH8Z91PROD with HEARING
17 

the elected Auditor General of Pennsylvania for two terms and 

then State Treasurer after that, and one thing we were always concerned about in the context of State government in terms of auditors who were auditing public programs is that our auditors, our 

experts in that department, were well trained so they could go up 

against some pretty touch customers. That is mostly within the 

context of State government. 

But could you describe for us the profile of the typical examiner? 

What kind of training do they get or what are you hoping that they 

would get, their background, their experience? Just the profile that 

either you demand or you are developing for an examiner. 

Mr. SIRRI. It is an interesting issue to raise. Of course, there 

never have been examiners of credit rating agencies per se. These 

entities were registered as advisors before, so our Office of Compliance, Inspections, and Examinations did so some books and records 

type exams, but they are not going at the thrust of your question. 

I think the kinds of backgrounds that are reasonable, that you 

want to have here are varied. There is no one type of person. So, 

for example, the models that are run of credit rating agencies are 

very similar to the models that are run at principal investors, people who would be putting their own money at risk. That would include investment banks, hedge funds and such, because they are 

evaluating the probability that payments are made to the various 

tranches of securities. 

So, in fact, you need some—the credit rating agencies themselves 

need some fairly highfalutin talent to do that. We in turn need 

some people who are very teched up to understand those models. 

Now, again, the statute is very clear. We are not to second-guess 

their models or their methods. That is not what I am talking about. 

But within the statute, we want to understand that if they say 

they are applying their model in a certain way, that they, in fact, 

are applying that model in a certain way and that it is not being 

fudged, it is not being tilted for a favored client. Because the process is a process that is algorithmic, it is quantitative, you need people with similar skills. So I think that would account for one set 

of folks. 

Farther down the line, we need people who have just typical compliance and auditing backgrounds to go at the kind of conflicts 

issues, some of the ones that you were raising. So, for example, 

what are the indicia of situations where you believe that process— 

you know, codified written processes and procedures are not being 

obeyed? We need people who have skills at looking for that. 

We will be reviewing e-mails, so you need people who are willing 

to sit and read a lot of e-mails, and that is yet a different kind of 

person. 

So I think we really need a portfolio of people, and to be honest, 

I think we will be learning as we go because it is a new process. 

We have been using people from our Office of Compliance, Inspections, and Examinations to do this work now, but I expect, you 

know, that over time we will develop a specialized group of people 

here. 

Senator CASEY. I know I am out of time almost, but just one 

quick question about personnel and resources. Do you think as we 

stand here today that you have the resources and the—I will try 


jbell on DSKDVH8Z91PROD with HEARING
18 

to use a primitive or simplistic phrase here, but the ramp-up capability to get this job done? Or do you need an infusion of either personnel or resources to do that? 

Mr. SIRRI. We have been having that conversation internally. I 

believe our Chairman asked the Appropriations Committee for an 

increase in our staffing in the program for credit rating agencies. 

Senator CASEY. It is a good idea to do that around here. 

Mr. SIRRI. So he has asked for that. He has emphasized that this 

is a critically important part of what we do, and he is committed 

to say that he wants to see an increase in staffing in that area. 

Senator CASEY. Thank you very much. 

Chairman REED. Thank you very much, Senator Casey, and let’s 

take a brief second round. 

Senator ALLARD. Yes, Mr. Chairman, I just have one other question I can think of with other questions and everything. 

Chairman REED. Well, let me proceed quickly to my questions. 

Then I will turn it over to you, and then welcome our distinguished 

Chairmen who are going to join us. 

Now that the discount window is open to investment banks, that 

raises two possibilities: one is that they will be better risk managers; the other possibility is that now that they have in the wings 

the cavalry, they will be more cavalier. What do you think will happen? And how are you going to structure it so it is better risk management? 

Mr. SIRRI. Well, as part of that process, we have been meeting 

with the Federal Reserve to go over exactly those issues. Of course, 

the Federal Reserve is most focused on exactly that. I have met 

with Tim Geithner, and I met with him when we were meeting 

with the firms. I think he understands better than anyone the notion of moral hazard that you are citing that says that if you have 

access to this facility, you might actually let certain things lapse. 

There are some things that allow us—that give me comfort in 

this area. We, of course, know what their risk management practices were and what the benchmark was before they had access to 

these facilities. Admittedly, that baseline may be low, and it is 

something we want to raise. But at least we can tell when there 

is recidivistic behavior in that area. 

I think we know we want to step up capital liquidity requirements for these firms and our risk oversight for these firms. So the 

extent that we can implicitly—we can ask those kinds of questions 

that say, look, when we run a risk scenario and we see that they 

do not have adequate funding for pools of assets, if their answer 

to us is, ‘‘Well, don’t worry, we have access to the window there,’’ 

that is not going to be an acceptable answer in the long run unless, 

you know, that is a wholesale change that Congress would be involved in. 

So I think the precise answer to your question is that we would 

just not—in asking very precise, targeted questions, we would suss 

our way through those kinds of answers and see that our risk scenarios make them provide for the kind of funding they need. 

Chairman REED. Let me focus on an issue that a number of commentators have raised, and that is that under the alternative net 

capital rule, potentially questionable assets like subordinated debt, 

deferred return of taxes, and some securities for which there is no 


jbell on DSKDVH8Z91PROD with HEARING
19 

ready market, were allowed to be classified as risk-free capital. 

And for one, David Einhorn has suggested that the implication of 

this has been a reduction in the amount of required capital to engage in increasingly risky activities. 

At this moment, when we are all looking for sounder capital positions, have these net capital rules produced exactly the opposite effect, capital that is far from risk free? 

Mr. SIRRI. There has been a great deal of confusion around capital, liquidity, and whether you are talking about the broker-dealer 

itself or the holding company. There is an alternate capital treatment applied to the broker-dealer when they opt into this program. 

But I will tell you that when those broker-dealers opted into the 

program, a value at risk or some type of model like that was put 

in place that may have allowed for a lower minimum. But, in fact, 

what happened is that broker-dealers elected to keep higher levels 

of capital in there, so you basically saw almost no reduction in capital in those broker-dealers from before they entered the CSE program to after. It may have been that the minimums allowed them 

to take some out, but as a practical matter, they did not. 

But what I really want to emphasize is the massive gain in liquidity that was provided at the holding company level. Those are 

tens of billions of dollars that were just not there. If there was a 

practical reduction in liquidity at the broker-dealer, it is on the 

order of $1 to $2 billion. You are talking about tens of billions of 

dollars that came in. Net from coming into this program, I think 

it is fair to say that there was no decrease in capital at the brokerdealer, and there was a massive increase in liquidity at the holding 

company. 

Chairman REED. There is another aspect of this whole issue of 

liquidity and capital, and that is the asset issue, Level 3 assets in 

particular. There has been some question about the impact of these 

Level 3 assets on the balance sheets of these companies. Do you 

have a rough notion of how much on the balance sheets are Level 

3? You don’t have to be specific and detailed. But, also are you 

looking at these assets, since essentially the Level 3 means they 

are hard to price and maybe impossible to price, which would also 

suggest hard to sell? Can you comment? 

Mr. SIRRI. Sure, I can. You are referring to FAS 157. There are 

three buckets of assets there. You are referring to—FAS 157 fundamentally looks at the availability of inputs to price those assets, 

and you are pointing out a problem where, you know, over time 

that lower bucket may have—you know, assets may have dropped 

into that lower bucket. 

You know, we are tracking that. The Commission has recently— 

the Chairman has asked and the Division of Corporation Finance 

has issued a letter providing for additional guidance by issuers to 

talk about the kind of—the nature of the assets that are held in 

that Level 3 area. I know there is a lot of discussion going on recently about value at risk, so we are tracking this area very carefully, paying particular attention—I can also tell you that we have 

such discussions at the President’s Working Group, and we talk 

about marked-to-market accounting and the effects of FAS 157. So 

there is a great deal of attention being paid to this right now. 


jbell on DSKDVH8Z91PROD with HEARING
20 

Chairman REED. Let me ask a final question that is related. We 

talked about capital. We talked about assets. And you have also 

suggested the issue of leverage. One of the issues that is throughout the financial system is, it seems, the increasing amount of leverage on balance sheets. Bank regulators have consistently been 

requiring reduction in leverage. Are you taking the same approach 

toward these regulated entities? And was that done with Bear 

Stearns in particular? 

Mr. SIRRI. For us, you know, we have many discussions about leverage. When comparing leverage to a bank and leverage to a securities firm, the comparison is very, very difficult because of the different nature of the securities firm. They held a lot of match book 

repo. Their assets are typically very, very liquid because they hold 

securities. 

I think rather than speak about leverage per se, we talk about 

liquidity and capital. So as you raise capital, you implicitly decrease leverage. And as you raise liquidity, you implicitly lower the 

risk that is typified by leverage. 

So we have been focusing primarily on those, but they are a different way of getting at the risks that are typified by the leverage 

that you talked about. 

Chairman REED. Thank you very much, Dr. Sirri. 

Senator Allard. 

Senator ALLARD. Thank you, Mr. Chairman. I have a couple of 

brief questions. 

Would you classify those group of businesses that fall under the 

CSE regulatory as ‘‘too big to fail’’? 

Mr. SIRRI. ‘‘Too big to fail’’ is a difficult way to characterize them. 

I would characterize these as systemically important firms. I think 

when one thinks back to something like Bear Stearns, it is not necessarily the case that the firm is too large to fail. It was, after all, 

the smallest of the CSE firms. But it was the manner and the rapidity with which it got into trouble. 

Were you to have a CSE firm that, let’s say in a hypothetical example, found itself holding classes of assets that deteriorated in 

value over time, that firm may find itself slowly degrading in financial condition, hypothetically, over a period of 6 months. In such a 

world, it is quite likely that that firm could unwind and contract 

its balance sheet in such a way that the notion of too big to fail 

or too interconnected to fail might not be that large an issue. The 

key thing that came up most recently with Bear Stearns was the 

absolute rapidity with which funding disappeared. 

So, whereas, I am not—I appreciate the import of your question 

with too big to fail, but I would also add the dimension of rapidity 

and the interconnectedness of these firms. 

Senator ALLARD. If you take the smallest of the firms, which is 

Bear Stearns, and you did not allow them to fail, felt like you had 

to have Government support in that particular case, doesn’t that 

send a message that they are too big to fail? 

Mr. SIRRI. Well, again, Drexel Burnham a number of years ago 

also failed, but it failed over a period of time. I cannot—you know, 

this is a world that did not happen, but were the funding issues 

at Bear to have played out over a longer period of time, assistance 

in terms of liquidity may not need to have been provided. So I 


jbell on DSKDVH8Z91PROD with HEARING
21 

think when one of these firms gets into trouble rapidly, liquidity 

support is needed, and I think that is the import of—I understand 

that to be the import. 

But what I want to make the distinction is that were that trouble to play out more slowly, liquidity support might not be required. And I think, as I remember some of the comments that the 

individuals from the Federal Reserve made in their testimony, they 

talked about phrases like ‘‘breathing room’’ and ‘‘time’’ being important. I know our Chairman talked about that as well. 

Senator ALLARD. Now, I want to talk a little bit about the 

timeline. In opening of the Prime Dealer Credit Facility, it gave the 

SEC some breathing room that you talked about to do a real careful analysis of the CSE program. How much time does the Prime 

Dealer Credit Facility buy you? And what is your timeline? 

Mr. SIRRI. Well, we went to work immediately on the kind of 

issues that we are talking about, questions about liquidity and risk 

management. That happened. Those conversations began, in fact, 

before the Bear Stearns event. We realized that we needed to revisit some basic questions. They continue on today. 

The Primary Dealer Credit Facility was opened by the Federal 

Reserve, so I cannot speak to how long that—I just cannot speak 

to how long they will keep it open. But I will tell you we are coordinating with the New York Fed in our oversight of these firms, and, 

you know, I expect that in those conversations we will be working 

with them, talking to them about how we see oversight of these 

firms in such a way, and they will be telling us about their 

thoughts of the Primary Dealer Credit Facility. 

They have announced that it was—they have said at the outset 

it was a 6-month facility. Whether they choose to shorten or lengthen it is a question I just cannot answer. 

Senator ALLARD. So we have got the 6-month facility. You do not 

know whether it will go beyond that or not. 

Mr. SIRRI. I just cannot answer that question. 

Senator ALLARD. OK. Thank you, Mr. Chairman. 

Chairman REED. Thank you, Senator Allard, and thank you, Dr. 

Sirri, for your testimony. 

At this time I would like to welcome the second panel. I would 

like to welcome David Ruder and Arthur Levitt, former Chairmen 

of the Securities and Exchange Commission, distinguished Chairmen. When Chairman Levitt took over, he was, as many of his 

predecessors and successors, an advocate for investor rights, and he 

was particularly effective in creating the Office of Investor Education and Assistance. He also was active in reforming NASD, the 

penny stock rule, and many other critical efforts to protect investors and markets alike. 

Chairman Ruder assumed responsibilities a few weeks before the 

1987 market crash, and some of the steps he took are still guiding 

the activities of the SEC today. 

Both gentlemen are graduates of Williams College, and so we are 

proud to organize this reunion of Williams College. 

Mr. LEVITT. Thank you. 

Chairman REED. And we are glad to see you here. Chairman 

Levitt, would you begin, please? 


jbell on DSKDVH8Z91PROD with HEARING
22 

STATEMENT OF ARTHUR LEVITT, JR., FORMER CHAIRMAN, 

SECURITIES AND EXCHANGE COMMISSION 

Mr. LEVITT. Thank you very much, Chairman Reed, Ranking 

Member Allard, Members of the Subcommittee. Thanks for the opportunity to testify in front of you today and sitting alongside my 

very distinguished fellow Chairman, and for holding this hearing 

on such an important and timely topic. 

The downfall of Bear Stearns, the uncertainty and volatility in the capital and debt markets, and the close to $300 billion in 

writedowns and the resulting losses by some of the world’s largest 

financial institutions have created a crisis on Wall Street—one that 

rightly has gotten the attention of all of us who worry about the 

health of our capital markets. 

Yet the current crisis is one that involves Main Street as much 

as Wall Street. It has directly touched the lives of millions of people—investors and homeowners alike. 

And that is why I think it essential that we determine precisely 

what went wrong, to provide a basis for determining if there was 

a breakdown in regulation, and if any new regulatory structures 

and powers may be needed to restore trust in our markets and prevent this kind of run from happening again. 

As David, Bill Donaldson, and I recently argued in the New York 

Times, we believe that a high-level, bipartisan, and impartial examination must be launched to explore a series of possible business 

and regulatory failures that has produced this credit crisis. This is 

what President Reagan did after Black Monday in 1987, and I hope 

we soon have a similar Presidential level task force examining 

these complex issues. 

From where we stand today, it is apparent that a variety of players—including regulators, ratings agencies, standard-setters, and 

gatekeepers as well as institutional investors—simply did not live 

up to their responsibilities. 

In some cases—such as mortgage brokers—it was because there 

was a lack of meaningful regulation. 

In other cases—such as ensuring banks had adequate underwriting standards for loans—the relevant regulators simply refused 

to act. 

And in other cases, regulatory standards did not keep pace with 

financial engineering. 

Those who bought these new complex, financial instruments had 

no idea as to the extent of the risks that they were assuming since 

the creators of these instruments were either purposely—and legally—hiding these risks by placing them off the balance sheet in 

structured investment vehicles; or the banks themselves were 

clueless as to the magnitude of such risks. 

At the same time, investors were basing investment decisions on 

the judgments of rating agencies who were either conflicted or just 

plain careless in how they exercised their immense credit rating 

power. 

Moving forward, there are some obvious holes that need to be 

plugged immediately, and none more glaring than the issues surrounding the credit rating agencies. 

While those agencies have initiated a process of constructive selfanalysis and in some cases reform, Congress must take these conVerDate Nov 24 2008 01:22 Mar 23, 2010 Jkt 050402 PO 00000 Frm 00026 Fmt 6633 Sfmt 6602 E:\HR\OC\A402.XXX A402

jbell on DSKDVH8Z91PROD with HEARING
23 

flict-of-interest issues head on or at least empower the SEC with 

the proper oversight and disciplinary powers so they can do the job. 

The issue I believe is critical to the proper functioning of our 

markets. 

Just looking to the longer term, we must also consider whether 

new regulatory structures and authority may be needed to restore 

public confidence in the markets. 

I am a great believer in free markets as the very best way to allocate capital. At their best, markets are self-regulating and selfcorrecting. 

Integral to the functioning of a free market, however, is the presence of someone to ensure that the rules of the road are enforced 

fairly and swiftly. That is why we need to make sure that, moving 

forward, the market’s referees keep pace with the players. 

What worries me is that these creations of the financial engineers, while adding liquidity and depth to the market, have simply 

not been self-correcting but, rather, they have been destructively 

destabilizing. 

Assessing and monitoring the risk that these products have introduced into the financial system goes beyond the ability of one 

nation’s central bank. Indeed, I think it is a problem that begs for 

a global solution. 

It does not mean that solutions to the current crisis are beyond 

our reach. There is a series of steps we can take in our own regulatory structure to improve the functioning of our markets. 

That is why I welcomed Secretary Paulson’s recommendations 

about the structure of our financial regulatory architecture. There 

are aspects to it that I like very much, some that I do not, but I 

think it is a vitally important starting point in getting a dialog 

going that will continue, I believe, for months and years to come. 

Without getting into the details, let me sketch what I believe investors need from a capital markets regulator. 

First and foremost, any market regulator must put investor interests above all others. It is not only good for investors, but it is 

this focus which has made our capital markets the envy of the 

world. 

Second, as part of this commitment, such an agency must ensure 

that the public gets whatever information it needs to make informed investing decisions. 

Third, it must be a law enforcement agency. Vigorous enforcement of the rules of the road is a powerful deterrent to bad behavior and usually prevents the use for heavy-handed regulation. 

Fourth, to be effective in any of these roles, the regulator must 

have the resources in terms of funding, tools, staffing, and competencies to get the job done right. 

Right now, I fear that the SEC does not have what it needs to 

meet the demands of the day. 

The SEC’s 2009 enforcement budget does not keep pace with inflation. Staffing levels have not kept pace with the urgent work 

that needs to be done. And the Enforcement Division, I believe, has 

been unnecessarily hamstrung in negotiating corporate penalties 

because of recent procedural changes at the Commission. The result has been a lessening of the imposition of corporate penalties 


jbell on DSKDVH8Z91PROD with HEARING
24 

against egregious wrongdoers and a reduction in the corporate penalty numbers over the past year. 

Fifth, it is important that, by design, any capital markets regulator be independent—be independent of the White House—and depoliticized from the fights of the day. 

Finally, as we consider the future of the SEC and financial regulation in general, let us not forget that more powerful than any 

rule that can be written, regulation that can be passed, or standard 

that can be set is the power of the bully pulpit. 

Whatever leadership is chosen for a future agency, it needs to be 

led by an individual who understands the importance of public pronouncements and signals that are sent to the marketplace, signals 

in terms of the kind of aspirations that that leader wants for the 

Commission, whether he gets it or not. This is something that SEC 

Chairmen have understood from its founding 75 years ago up until 

the present day, and it must be preserved. 

In sum, the future of the financial markets and of the regulatory 

structures we construct to oversee them is in flux, and it should be. 

The gravity of the situation we are in today calls for everything 

to be on the table. Make no mistake: no agency, no existing structure, no gatekeeper should be immune from a thoroughgoing, hardheaded analysis of its relevance to today’s extraordinarily complex 

electronic markets. 

As we move forward with such a review, we must keep in mind 

that the strength of America’s capital markets lies in how high our 

standards of transparency, independence, and accountability may 

be. 

And no matter what changes we undertake, we have got to ensure that we have in place a market regulator that is as sensitive 

to the demands of the individual investor Main Street as it is to 

the demands of the institutional investors on Wall Street. 

Thank you. 

Chairman REED. Thank you very much, Chairman Levitt. 

Chairman Ruder, please. 

STATEMENT OF DAVID S. RUDER, FORMER CHAIRMAN, 

SECURITIES AND EXCHANGE COMMISSION 

Mr. RUDER. Mr. Chairman, Senator Allard, and Members of the 

Subcommittee, my testimony today will address the role of the Securities and Exchange Commission in regulating investment banks 

in today’s complex global financial markets. I will discuss the 

SEC’s regulatory obligations stemming from the recent credit crisis 

and its obligations relating to supervision of the securities markets, 

concluding that the SEC should have increased resources in order 

to fulfill its regulatory missions. I will argue that the SEC should 

not be required to substitute principles-based regulation of investment banks for its current enforcement-based regulation. I will 

urge the SEC to continue to communicate with investment banks 

regarding market innovations and risk positions. I will advocate 

giving the SEC new powers enabling it to improve its oversight of 

the financial stability of investment bank holding companies. 

Any investigation of the role of investment banks in the credit 

crisis will probably evaluate the role and responsibilities of the Securities and Exchange Commission, as you have started to do this 


jbell on DSKDVH8Z91PROD with HEARING
25 

morning. Now, one question will be whether the SEC’s enforcement 

practices and other policies regarding investment banks will be 

adequate. 

In my view, the SEC’s enforcement program is vital to its mission. The SEC has extensive power to impose sanctions on investment banks through court injunctive or administrative actions. The 

SEC’s enforcement activities are effective because they not only 

punish wrongdoing, but also send strong messages of deterrence. 

In the wake of the credit crisis, the SEC is undertaking investigations. Once it has gathered sufficient evidence, it will undoubtedly bring regulatory actions. Possible areas of inquiry regarding 

investment banks include failures to disclose the poor quality of 

structured securities when selling them to investors, sales of highrisk structured securities to investors for whom they were unsuitable, sales of auction rate securities without revealing possible 

market illiquidity, and failures to reveal known investment bank 

holding company low asset valuations to purchasers of holding 

company securities. 

The SEC’s ability to bring enforcement actions is dependent upon 

the size of its enforcement staff, which I believe, as does Chairman 

Levitt, should be increased so that it may be better able to engage 

in enforcement activities related to the credit crisis. I believe the 

additional communication and monitoring responsibilities that I 

will discuss in the remainder of my testimony will also require additional resources. 

In March of 2008, the U.S. Treasury released a Blueprint for Reform of the Financial Regulatory System containing both near-term 

and long-term proposals for financial system regulatory reform. 

The Treasury blueprint contains proposals that would change the 

SEC’s oversight of stock exchanges and investment banks from an 

enforcement system to a principles-based system. First, the Treasury urges the SEC to adopt the CFTC’s principles-based regulation 

approach to securities clearing agencies and securities exchanges. 

That approach involves discussions with the regulated entities regarding the appropriate means of achieving compliance with the 

principles. 

Treasury support for a principles-based system may come in part 

from a comparison with recent changes in the financial services 

regulatory system in the United Kingdom. In the U.K., regulation 

of banking, securities, insurance and investments has recently been 

merged into a single, unified regulator, the Financial Services Authority, utilizing a principles-based regulatory system. That system 

has been described by the FSA as follows: 

Principles-based regulation means, where possible, moving away 

from dictating through detailed, prescriptive rules and supervisory 

actions how firms should operate their businesses. We want to give 

firms the responsibility to decide how best to align their business 

objectives and processes with the regulatory outcomes we have 

specified. We will increasingly shift the balance of our activity toward setting out desirable regulatory outcomes in principles- and 

outcome-focused rules, enabling our people to engage with firms’ 

senior management in pursuit of these outcomes. We expect firms’ 

behavior, in turn, to change to adjust to this shift in emphasis. 


jbell on DSKDVH8Z91PROD with HEARING
26 

As a second step, the Treasury recommends a merger between 

the CFTC and the SEC and urges legislation that will merge regulatory philosophies and harmonize futures and securities statutes 

and regulations, including, I believe, adoption of a principle-based 

approach. I sought legislation calling for the combination of the 

SEC and the CFTC following the market crash of 1987, but to no 

avail. I welcome and support the current Treasury proposal, but I 

do not believe the merger should be the vehicle for imposing a principles-based regulatory system in the securities markets and the 

elimination of great portions of our enforcement-based system. 

Although I do not believe the SEC enforcement-based system 

should be abandoned, I am sensitive to the fact that the SEC is 

regulating U.S. investment banks and stock exchanges that are 

competing in a complicated and constantly changing world environment. And I believe, therefore, the Commission should embrace the 

communications objectives of principles-based regulation. Dramatic 

innovation and technological change in the world’s securities markets have created a need for the SEC to communicate constantly 

with the leaders of our investment banks, securities exchanges, and 

futures exchanges, as well as with domestic and foreign regulators. 

I also believe that the Commission should engage in prudential 

regulation with regard to the solvency, liquidity, and financial stability of investment banks. The Commission should play an active 

role in monitoring the overall risk management practices of investment banks. When possible, it should obtain information about the 

risk positions of unregulated entities controlled by those banks, 

such as hedge funds, private equity, and off-balance-sheet entities. 

Investment banks that are part of a bank holding company are 

subject to prudential supervision by the Federal Reserve Board. Investment holding banks not regulated as part of bank holding companies are, as you have been discussing, subject to risk-based supervision by the SEC on its voluntary CSE program. 

The CSE program requires the supervised entities to provide the 

SEC on a regular basis with extensive information regarding 

group-wide capital and risk exposures, including market and credit 

risk exposures, as well as an analysis of the holding company’s liquidity risk. In practice, the operation of this program is prudential 

because it involves attention to the affairs of the supervised investment bank holding companies on an individual basis, with close 

and regular contact between the SEC staff and the supervised entity. 

I believe the prudential supervision of investment bank holding 

companies by the SEC should continue and be expanded. It is extremely important that the risk positions of investment bank holding companies, including their unregulated affiliates, be known so 

that the SEC can confer with other regulators regarding systemic 

risk. This risk assessment regulatory function for investment 

banks should remain in the SEC because it is the agency that best 

understands the risk activities engaged in by investment banks. Indeed, using its expertise, the SEC might well cooperate with the 

Federal Reserve Board regarding the risk assessment of investment banks that are part of bank holding companies. I further believe that the voluntary program for SEC oversight of investment 

bank risk activities should be made mandatory through legislation, 


jbell on DSKDVH8Z91PROD with HEARING
27 

so that the non-bank holding company investment banks will not 

have the power to withdraw from the supervisory system when 

they are dissatisfied with the SEC’s supervision or unwilling to 

provide information. 

Thank you for the opportunity to be with you today. 

Chairman REED. Well, thank you very much, Chairman Ruder. 

I want to thank both of you gentlemen. We are extremely grateful 

that you would come here today. We received thoughtful testimony 

from the Securities and Exchange Commission, but there are few 

people that have the perspective, the experience, and the deep concern for the Securities and Exchange Commission and the market 

overall than you two gentlemen. So thank you very, very much for 

coming today. 

I just want to follow up, Chairman Ruder, with a question for 

both of you, but let me direct it to you first. The difference between 

a principles-based regulation and rule-based regulation, I think I 

heard in your testimony that at a certain level principles-based 

regulation might be appropriate, but at another level rules should 

be imposed. Can you help me understand if there is a line of demarcation? 

Mr. RUDER. Yes. I think as Mr. Sirri was discussing, there is a 

difference between the systemic risk questions that need to be addressed throughout our system and the regulatory aspects of the 

SEC’s supervision. The investment banks need to know by rules 

and an enforcement process that they may not engage in activities 

that are harmful to the investing public. They should not be allowed to have misrepresentations to engage in market activities 

that are unwholesome, to do a lot of other things that are prohibited by the Commission. I think that their activities in that regard 

ought to be effectively enforced by rules and enforcement. 

On the systemic side, I think it is very important for the SEC 

to be part of the risk-based supervisory system and to have its 

powers and staff increase so that it can do the kind of job that we 

all think it should be doing. And that is to me the prudential supervision part of it, and the other part of—the principles-based 

part of a regulation would be the establishment of a system where, 

instead of having a regulatory system based upon enforcement and 

punishment and deterrence, you would simply talk to the regulated 

bodies and say you really did not do such a good job this time, but 

we want you to tell us how you can do better in the future. 

I do not think that is a system that will work in the United 

States, but I do think that it is important that the SEC recognize 

the value of the communication process with the investment banks 

particularly. They need in their prudential supervision not only to 

look at what the risk problems are, but to look at the entire firm 

and see whether the firms’ regulatory posture is one that the Commission wants. And for that we need a very close interaction between the firms and the Commission. 

Chairman REED. Thank you very much. 

Chairman Levitt, your comments on this issue of principles 

versus enforcement. 

Mr. LEVITT. I agree with Chairman Ruder—— 

Chairman REED. Could you turn your microphone on? 


jbell on DSKDVH8Z91PROD with HEARING
28 

Mr. LEVITT. I agree with Chairman Ruder. Principles-based regulation is often based upon the U.K. FSA model. I do not think it 

has worked particularly well over there. I do not think it will work 

well over here. I think Chairman Ruder draws a very important 

distinction between the use of prudential regulation with respect to 

systemic issues, but the crux and core and heart and soul of the 

SEC, which is based upon investor confidence, comes about from 

enforcement-based regulation rather than the mushier prudential 

or principles-based regulation that is practiced elsewhere. 

Chairman REED. Well, let me follow up, I think, with a related 

question, and for both of you, but I will start with Chairman 

Levitt. In the Paulson recommendation, the suggestion that I saw 

was that the Federal Reserve sort of step up as the comprehensive 

regulator for all these different financial firms. Can you comment 

on that, Chairman Levitt? 

Mr. LEVITT. I think it is premature to choose any agency right 

now. It is ironic that—the Federal Reserve certainly was not there 

with respect to the problems at Citibank. The Federal Reserve does 

have resources not available to the SEC or any other regulator. But 

I think such a judgment right now is premature until we study exactly what went wrong. 

I think there is more that we do not know about what has happened in the past 2 years than that we do know about it. And I 

think that has got to precede any judgment as to who does what. 

I would be extremely cautious before I allocated to the Federal Reserve Board the total responsibility of regulating our markets until 

such a study is done. 

Chairman REED. Thank you. 

Chairman Ruder, your comments? 

Mr. RUDER. I believe that the SEC has the ability to understand 

the risk activities of our investment banks. I think its approach is 

to understand that risk and at the same time learn about the systemic risk that is involved. I do not think that the Federal Reserve 

Board really would be playing a regulatory role that recognizes the 

risk positions taken by our investment banks as part of the securities markets. So I would be very cautious in letting the Federal Reserve Board have power over the entire securities and banking system. 

Mr. LEVITT. Paulson did raise a very interesting suggestion about 

having a new agency created that would be concerned about investor considerations. I think that is an important idea. Whether that 

would be combined with the SEC I think remains to be seen. But 

the notion of the importance, the primacy of investor protection, 

implied by Paulson’s suggestion is one that I think we should give 

careful consideration to. 

Chairman REED. Thank you. I will recognize Senator Allard, and 

then I would like to do a second round also. This is, again, a great 

opportunity for us to ask questions. But just a final quick point. 

The SEC today suggested there would be some legislative definition 

that supports their CSE program. Would you concur, Chairman 

Levitt and Chairman Ruder? 

Mr. LEVITT. All I would say is that I think that the CSE program 

can be more clearly defined, can be mandated. I think there is a 

lot of fuzziness about it now. Clearly, it has not provided the anVerDate Nov 24 2008 01:22 Mar 23, 2010 Jkt 050402 PO 00000 Frm 00032 Fmt 6633 Sfmt 6602 E:\HR\OC\A402.XXX A402

jbell on DSKDVH8Z91PROD with HEARING
29 

swers. Clearly, it has been around and we have gone through what 

we have gone through. So a lot of work has to be done. 

Chairman REED. Chairman Ruder. 

Mr. RUDER. As my earlier testimony indicated, I favor legislative 

support of that program. 

Chairman REED. Thank you very much, gentlemen. 

Senator Allard. 

Senator ALLARD. Thank you, Mr. Chairman. I will have one 

round of questions. Then I am going to have to get to the floor. So 

I will leave you in charge at that particular point in time. 

Both of you now have indicated that you would support more of 

a congressional role in this and some authorizing legislation. How 

should the codified authority differ, if at all, from the current regulatory program? 

Mr. RUDER. Well, the current regulatory program involves the 

Fed supervising the bank holding companies and the Securities and 

Exchange Commission supervising the non-bank investment bank 

holding companies. I think that should continue, and I think the 

Commission should be given more power to look at the systemic 

risk aspects of the bank holding companies, and then to confer with 

the Fed about the appropriate regulatory postures. 

Senator ALLARD. Do you think we need to have some language 

in there that brings the Fed in specifically, then, do you? 

Mr. RUDER. The systemic risk-based part of this, yes. I must say 

that my great concern about this legislative program is a possible 

attack on the independence of the Commission. I believe that the 

Commission, the SEC, must remain as an independent agency and 

not subject to the political powers which might come from the 

Treasury or even from Congress, if I may say. 

Mr. LEVITT. That is a great danger. I share that feeling. The 

politicization of the SEC would be, if there is such a thing, an economic tragedy. I think that clearly the SEC needs greater resources in terms of risk management. Chairman Donaldson built 

up that capability at the time of his departure. It has diminished 

somewhat in recent years, and as I understand from the testimony 

before, there is a rapid buildup of that capability. I think that has 

got to be emphasized. 

Unfortunately, it takes an event, a crisis, to mobilize the attention of all the players, all the gatekeepers, all the regulators, all 

the legislators, and we have a real crisis. 

Senator ALLARD. We had some questions earlier from a member 

of this panel here that talked about the amount of resources needed to be made available for the SEC to carry on with their regulatory setting process and staffing levels and all that. And you both 

have advocated for greater staff and budgetary resources for the 

SEC. 

What level do you believe is necessary to do the right job? 

Mr. LEVITT. Well, I think that clearly, when you see a diminution 

of budget allocated to the SEC—and there has been a sharp diminution. In 2005, the SEC spent $917 million. In the most recent 

budget, it was down to $842 million. The director of the Los Angeles office this morning mentioned that he has had to cut staff by 

10 percent. That kind of statement in the midst of what we have 

been seeing says something has gone wrong. 


jbell on DSKDVH8Z91PROD with HEARING
30 

I noticed that the Chairman of the House Banking Committee has called for a $30 billion increase in funding. It is difficult to 

place a number on this except to say that the need is great. It is 

not just dollar-related. I share Chairman Ruder’s emphasis on the 

importance of prioritizing the enforcement program, the ability to 

have a cop on the beat, the ability to tell wrongdoers that our examiners, our enforcement people are out there looking at the marketplace and determining where steps should be taken. We have 

been moving in exactly the wrong direction, and I think that in— 

my long-winded response to your question is the agency needs 

greater resources in the areas of enforcement and inspection. 

Whether that be $30 billion, $20 billion, or $40 billion I leave to 

the dialog between appropriators and the agency. 

Senator ALLARD. Well, I am an appropriator on the appropriating 

committee, too, so I was very interested in your response. 

Mr. RUDER. If I may comment, in 2002, the SEC’s budget was $514 million. Following the Sarbanes-Oxley Act, which contained a 

dramatic increase in budget, the budget went up to $716 million. 

And it since has gone up some, but only as Chairman Levitt has 

told you, to $906 million in the 2008 budget. 

I think that the Commission’s job in this very complicated world 

is increasing in many ways that are not really apparent. The ability to deal with the complicated structural problems in the securities area, including competition between securities exchanges, the 

creation of new, innovative products, the problems of the 

counterparty risk management in the unregulated portion of this 

market I think—and I may say the Commission’s Mutual Recognition Project will require great—more assets for the Commission. 

And I think Congress ought to look very carefully at the whole 

Commission’s budget to see whether some dramatic increase in 

funding is not necessary in order for it to meet its market-protective objectives. 

Senator ALLARD. Yes, and I see also in here that the type of expertise that you have to have for the kind of oversight that we are 

talking about here is not readily available and may even demand 

a pretty high salary and benefits and whatnot, and just, you know, 

we need to make sure that we have that quality in the overseer as 

well as in the marketplace. 

Mr. LEVITT. And the overseer must see that that money is spent 

wisely. 

Senator ALLARD. Yes. 

Mr. LEVITT. And spent in the areas that corrects the problem. 

Senator ALLARD. Yes, where we need the expertise. 

Mr. RUDER. If you contemplate how the risk-based assessment 

might have taken place under the CSE program and ask yourself 

what kinds of skills would be needed to find the appropriate analysis, I think you really do need to look at much better paid and 

much more highly sophisticated individuals. 

Senator ALLARD. Thank you for your comments. 

Thank you, Mr. Chairman. 

Chairman REED. And we will keep the record open for 5 additional days for any statements or questions, and we would ask you 

gentlemen, if my colleagues submit questions, we look forward to 

your response. But let me ask a few quick questions. 


jbell on DSKDVH8Z91PROD with HEARING
31 

Following up on what Senator Allard said, I get the impression 

and I share the impression that at present in some respects the 

SEC is outgunned by the resources and expertise of those they are 

trying to regulate. Is that a fair assessment? 

Mr. LEVITT. Yes. 

Chairman REED. Can you put your microphone on when—— 

Mr. LEVITT. I am sorry. Of what regulators? 

Chairman REED. Well, the SEC regulators. 

Mr. LEVITT. Outdone by? 

Chairman REED. Outdone by the people they are regulating, the 

investment banks, all the broker-dealers with—instead of three 

SEC officials, there are 27 regulated personnel there, PhDs, and 

with models that will stun you. 

Mr. RUDER. And the salaries are a little higher in the investment 

banking world. 

Chairman REED. I have heard of that. But I think it raises several issues. One is the obvious point that both you gentlemen have 

made. We do have to invest in expertise at the SEC. And I think 

there is another issue, too, and it goes to the issue of anticipating 

innovation, because one of the problems and one of the issues today 

in the global markets is these products are innovative, so just as 

you develop kind of the feel for an expertise for a particular product, you find there is a different one. 

Let me ask just your impression. To what extent is the SEC prepared today not only to match their regulated populations out 

there, but to stay ahead or be ahead of the innovation? Chairman 

Levitt? 

Mr. LEVITT. I don’t think that any regulator has ever led the regulated in terms of almost anything, in terms of assets, in terms of 

legislative scope of activities. It is just impossible. I think it is the 

job of the regulator to survey the field and see where the greatest 

systemic threats and investor threats may lie and then address 

those, and address them not just by rulemaking but by their enforcement efforts and by the bully pulpit. I think that the SEC has 

the ability to take a look at the landscape and see the risks that 

were being taken to examine the extraordinary leverage that some 

of these firms had been implying—Bear Stearns, something like 36 

or 37 times—and say, ‘‘Hey, wait a second. What is going on?’’ And 

that note of skepticism, that note of caution and of care was absent 

from all sources. 

We had a runaway marketplace where leverage and greed 

trumped the efforts of the gatekeepers, the rating agencies, the 

auditors, and the regulators. And now we are playing catch-up. 

Chairman REED. Thank you. 

Chairman Ruder, your comments? 

Mr. RUDER. I have two comments. One is that although the SEC 

may be understaffed, it has a certain component of extremely 

bright, underpaid people whose dedication and loyalty will create 

results that are better than may take place in the larger firms. 

Second, I think if Congress is going to look at the structure and 

budget for the SEC, it might contemplate something in the budget 

to allow the Commission to go outside of the agency to hire specialized groups to deal with specific problems on a contract basis so 


jbell on DSKDVH8Z91PROD with HEARING
32 

that it will not have to have these people there all the time, but 

it might be able to accomplish what it needs to on a special project. 

Chairman REED. Thank you. This is a rare opportunity. Dr. Sirri 

gave very thoughtful and I think very substantive testimony today. 

But as you listened, were there any comments you might have with 

respect to his testimony or any other final conclusions you might 

want to give to us in terms of advice as we go forward? Chairman 

Ruder? 

Mr. RUDER. Well, I thought one of his responses was marvelously 

bureaucratic because I could not understand it. 

[Laughter.] 

Mr. RUDER. But I will say that to look at the Commission and 

ask what it did in the CSE problem in the face of a market in 

which the Fed, the investment banks, the world banks, and the 

SEC did not really know what was going on is not an appropriate 

way to look at this. What we need to do is to look forward and find 

a mechanism to prevent similar problems in the future. 

Chairman REED. Chairman Levitt. 

Mr. LEVITT. I think that so much of the effectiveness of the agency lies in terms of cases that it brings or cases that it does not 

bring, speeches that are made, issues that are known as investor 

important. The Commission has dealt with over recent years and 

months the question of shareholder access, the change in the way 

enforcement cases have been ordered in terms of pre-clearance by 

the Commission, which I think has had some dampening effect on 

that enforcement program. 

The New York Stock Exchange has called for shareholders to 

have a direct vote rather than giving to brokers that responsibility. 

The SEC has been sitting on this issue for some months. 

I think these are all issues that could send a signal that the 

agency places investor interests above all others, and I would hope 

that the agency is encouraged to move ahead of some of these important issues. 

Chairman REED. Thank you very much. Thank you for your testimony and your participation today and for your service to the Commission. I also ask that as we go forward and follow this issue, you 

are available for your advice and suggestions. 

Mr. RUDER. With pleasure. 

Chairman REED. Thank you very much, gentlemen. I will adjourn the hearing. 

[Whereupon, at 11:49 a.m., the hearing was adjourned.] 

[Prepared statements supplied for the record follow:] 


jbell on DSKDVH8Z91PROD with HEARING
33 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 87 here 50402a.001
34 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 88 here 50402a.002
35 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 89 here 50402a.003
36 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 90 here 50402a.004
37 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 91 here 50402a.005
38 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 92 here 50402a.006
39 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 93 here 50402a.007
40 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 94 here 50402a.008
41 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 95 here 50402a.009
42 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 96 here 50402a.010
43 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 97 here 50402a.011
44 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 98 here 50402a.012
45 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 99 here 50402a.013
46 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 100 here 50402a.014
47 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 101 here 50402a.015
48 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 102 here 50402a.016
49 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 103 here 50402a.017
50 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 104 here 50402a.018
51 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 105 here 50402a.019
52 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 106 here 50402a.020
53 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 107 here 50402a.021
54 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 108 here 50402a.022
55 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 109 here 50402a.023
56 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 110 here 50402a.024
57 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 111 here 50402a.025