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50–407 2010

S. HRG. 110–1006 

RISK MANAGEMENT AND ITS IMPLICATIONS FOR 

SYSTEMIC RISK 

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 

RISK MANAGEMENT AND ITS IMPLICATIONS FOR SYSTEMIC RISK 

THURSDAY, JUNE 19, 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 


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(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 

AMY S. FRIEND, Chief Counsel 

MARK OSTERLE, Republican Counsel 

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 


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(III) 

C O N T E N T S 

THURSDAY, JUNE 19, 2008 

Page 

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

WITNESSES 

Donald L. Kohn, Vice Chairman, Board of Governors, Federal Reserve System ......................................................................................................................... 3 

Prepared statement .......................................................................................... 33 

Erik Sirri, Director, Division of Trading and Markets, Securities and Exchange Commission .............................................................................................. 5 

Prepared statement .......................................................................................... 49 

Scott M. Polakoff, Senior Deputy Director and Chief Operating Officer, Office 

of Thrift Supervision ............................................................................................ 7 

Prepared statement .......................................................................................... 55 

Richard Bookstaber, Senior Research Associate, Bridgewater Associates .......... 20 

Prepared statement .......................................................................................... 69 

Richard J. Herring, Jacob Safra Professor of International Banking, and 

Co-Director, Wharton Financial Institutions Center, Wharton School, University of Pennsylvania ....................................................................................... 23 

Prepared statement .......................................................................................... 79 

Kevin M. Blakely, President and Chief Executive Officer, The Risk Management Association .................................................................................................. 27 

Prepared statement .......................................................................................... 86 


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(1) 

RISK MANAGEMENT AND ITS IMPLICATIONS 

FOR SYSTEMIC RISK 

THURSDAY, JUNE 19, 2008 

U.S. SENATE, SUBCOMMITTEE ON SECURITIES, INSURANCE, AND

INVESTMENT, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. 

The subcommittee met at 2:32 p.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. I will call the hearing to order, and I want to 

thank first the witnesses for joining us today. I know they made 

significant changes in their schedules to accommodate us, and I 

really appreciate that. 

This is a technical hearing in some regard. It does not have some 

of the drama or melodrama that we usually have around here, but 

I think it is very, very important. And I think we have to focus on 

these issues, and this is an opportunity to do so. 

The events of the past year exposed significant fault lines 

throughout our financial system. The impact of this financial crisis 

has been deep and broad. We have had financial firms with considerable writedown and losses, due mainly to their failure to recognize the risk embedded in complex financial products. This hearing 

will explore how supervisors oversee risk management at investment banks and seek to find ways to improve that supervision to 

reduce the likelihood that firm-level risk can expand throughout 

the economy. 

Risk management is critical. We have seen firsthand that when 

done poorly, it has the potential to ripple throughout the wider 

economy and impact others who have probably never heard of a 

collateralized debt obligation or a mortgage-backed security. The 

decisions at these firms have not only resulted in a tremendous 

loss of value for investors who have seen their retirement and personal savings ended and eroded, but also imperiled the health of 

the wider economy. 

Some of the losses may have been averted if risk management 

were better incorporated into the culture of these firms. Warren 

Buffett has commented that the chief risk officers should now be 

the CEOs. He draws attention to an important point. The top management must consider risk as an integral part of the decisionmaking, not as some control function off to the side. 


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The culture of risk management is all the more important in today’s world given that both firms and products have become so 

complex. Some of these financial firms have grown so large that 

identifying the concentration of risk in subsidiaries and throughout 

firm activities and then aggregating those risks at the holding company is a very difficult project to achieve. Given this great complexity, systems and models used at firms to measure the attendant risk have also become much more intricate. Federal Reserve 

Bank of Boston President Rosengren recently noted, as others have 

as well, that models have their limitations. Relying solely on models is never the answer. 

Along with failures in risk models, we have seen failures in decisionmaking at firms. During the boom times, no one wants to listen 

to the risk officer telling you not to make more money because the 

risks are too high. But those who do not heed these voices are 

among those with the largest writedown. 

Regulators also need to be on top of the complex risk models and 

governance structures at these firms. With globalized markets and 

more market participants, we have greater points of possible failure that require attention. The U.S. subprime mortgage exposure 

was magnified throughout the world, with banks in Germany and 

France and investors in many other locales experiencing deep 

losses. 

This reality requires a precise focus on risk management with sophisticated supervision that enforces the rules so that firms adhere 

to models of good governance and sound risk management. Discussions about the current regulatory structure have focused on this 

need to look at functional regulation, also systemwide oversight. 

This hearing is part of the broader dialog that ultimately must lead 

to action. The SEC and the Office of Thrift Supervision both look 

at risk at securities firms and investment banks at the holding 

company level. We also have the Federal Reserve onsite at these 

firms now. One has to ask if this is the most effective way to approach oversight and whether we are achieving the right outcomes. 

Federal Reserve Bank of New York President Tim Geithner was 

recently quoted as saying that ‘‘Risk management and oversight 

now focuses too much on the idiosyncratic risk that affects an individual firm and too little on the systematic issues that could affect 

market liquidity as a whole.’’ 

Our regulators need the proper tools to keep an eye on the risks 

that build up throughout the system, not just in individual firms. 

In the case of Bear Stearns, it appears that regulators were not 

completely aware of the potential risk of its failure due in part to 

its counterparty exposures through credit derivatives, necessitating 

the Fed’s involvement. We need a system where the regulators 

have a window into the risk at a systemwide level and can make 

informed decisions rather than decisions based on a lack of knowledge about risk and concentrations. 

We are also in the process in this country of moving from the 

Basel I framework to a more advanced Basel II capital adequacy 

framework. This framework brings us closer to measuring capital 

based on risk, but also involves models which have limitations. To 

counter these limitations, we need to ensure that supervisors have 

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essary, which falls under Pillar 2 of the Basel II model. Though 

Basel II will take some time to fully implement, we must address 

concerns now about how to improve risk management and its oversight by regulators. 

There have been numerous reports by regulators to address some 

of these issues on risk management and systematic risk. Though 

these reports have recent vintage, the issues do not. The fact is 

that financial regulators have been talking about these risk concerns for quite some time. We need to ensure that studying these 

issues results in robust changes to the manner in which supervision is undertaken by regulators rather than mere discussion. 

A larger question that comes out of all this has to do with risk 

taking at these firms. Is the risk that these firms are taking best 

in the long run? At what point might innovation be shorthand for 

creating complex financial products that camouflage risk and fail 

to add true economic value to investors and the economy? Innovation that merely adds to the bottom lines of financial firms but 

then ultimately leads to a bust, if that is the situation, then we 

have to do much, much more. 

We are here, I think, to discuss a very technical but a very important topic, and I am pleased that our witnesses have joined us. 

I am also pleased that Senator Corker is with us, and, Senator, 

would you like to make an opening statement or any remarks? 

Senator CORKER. Mr. Chairman, thanks for having the hearing, 

and out of respect for the witnesses, I would rather hear from 

them. 

Thank you. 

Chairman REED. Thank you very much, Senator. 

We have three distinguished witnesses who are not strangers to 

this Committee. Dr. Donald Kohn is the Vice Chairman of the 

Board of Governors of the Federal Reserve System. Thank you, 

Governor. Dr. Erik Sirri is the Director of the Division of Trading 

and Markets, United States Securities and Exchange Commission. 

And Scott M. Polakoff is the Deputy Director at the Office of Thrift 

Supervision. Each of these gentlemen will talk about the risks that 

they oversee and what they are doing to implement recent findings. 

Your whole statement will be made part of the record, and if you 

would like to summarize, that would be entirely appropriate. Governor Kohn. 

STATEMENT OF DONALD L. KOHN, VICE CHAIRMAN, BOARD 

OF GOVERNORS, FEDERAL RESERVE SYSTEM 

Mr. KOHN. Thank you, Mr. Chairman. I do appreciate the opportunity to appear today to discuss several issues related to the oversight of financial institutions. 

As Members of the Subcommittee are aware, 3 months ago the 

Federal Reserve Board approved the establishment of the Primary 

Dealer Credit Facility, or the PDCF. In taking this action, we 

judged that without increased access to the Federal Reserve’s liquidity by major securities firms, overall financial market conditions would have deteriorated further and would have had a substantially adverse effect on our economy. 

The PDCF, which was authorized for a minimum period of 6 

months, makes available overnight funding to primary dealers. We 


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recognize that the existence of the PDCF could diminish primary 

dealers’ incentives to maintain adequate liquidity and capital buffers, and thereby increase systemic risk. And as a lender, we need 

to increase our knowledge of the financial positions of our potential 

borrowers. 

Accordingly, in connection with the establishment of the PDCF, 

we created a program in close cooperation with the Securities and 

Exchange Commission to monitor the funding and capital positions 

of primary dealers, focusing on those primary dealers not owned by 

financial holding companies supervised by the Federal Reserve. 

We are currently working on an agreement with the SEC to enhance information sharing both for primary dealers owned by financial holding companies and those that are not. Broadly speaking, in spite of any moral hazard associated with the PDCF, we believe that primary dealers are strengthening liquidity and capital 

positions to better protect themselves against extreme events. We 

believe their management has learned valuable lessons from the 

events of the recent financial turmoil that can translate into better 

risk management, and we continue to monitor the effect of the 

PDCF and are studying a range of options going forward. 

I would now like to discuss the Federal Reserve’s recent activities relating to banking institutions we supervise. The Federal Reserve’s broad supervisory responses to recent events include requiring banking institutions to improve risk management, augmenting 

existing supervisory guidance, and, where necessary, enhancing our 

own supervisory processes. 

For instance, supervisors are reinforcing and strengthening their 

assessments and testing of fundamental risk management processes, requiring vigorous corrective action when weaknesses are 

identified. We are ensuring that institutions take a more comprehensive and forward-looking approach to risk management, understanding the potential for the risks to crystallize in times of 

stress. We have also redoubled our efforts to ensure that senior 

management properly defines overall risk preferences, creates appropriate incentives, and promotes firm-wide information sharing. 

Residential lending is a particular sector requiring continued supervisory attention. We are reminding institutions that they should 

conduct rigorous stress tests of potential future losses related to 

residential mortgage loans, home equity lines of credit, and mortgage-backed securities. We continue to encourage lenders and mortgage servicers to work constructively with borrowers at risk of default and to consider prudent workout arrangements to avoid unnecessary foreclosures. And we are working to finalize the proposed 

amendments to the rules under the Home Ownership and Equity 

Protection Act proposed in December. 

We have been stepping up our review of banks’ concentrations in 

commercial real estate, especially in those areas of the country exhibiting signs of weakness. We continue to monitor credit card 

markets, other consumer lending sectors for potential weaknesses, 

and have taken steps toward improving consumer protection for 

credit card users. Leveraged lending is another key area of focus. 

Consistent with the recommendations of recent reports, we are 

also looking at how firms are addressing weaknesses in 

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cent events. For instance, emphasizing that firms should use a variety of techniques, including stress testing and scenario analysis, 

to measure potential exposure of their contracts. 

We are also working with the private sector to make the market 

infrastructure for financial transactions more robust and resilient. 

Our examiners continue to remind bankers that allowance levels, 

loan loss allowance levels, should be reflective of loan portfolio 

quality based on sound processed and consistent with current supervisory guidance. We are working with institutions to improve liquidity risk management practices through guidance and through 

one-on-one discussions. And even though the banking system remains well capitalized, we are evaluating banks’ use of internal 

capital markets and whether firms adequately incorporate possible 

stress events in determining overall capital needs, and we are encouraging firms to raise capital. 

Finally, the Federal Reserve is nearing completion of enhancements to its supervisory guidance to clarify our role as consolidated 

supervisor of bank and financial holding companies. Improving our 

role as consolidated supervisor, for which we rely on close coordination with primary supervisors and functional regulators, should 

provide broad benefits for the financial system and the economy. 

Thank you, Mr. Chairman. 

Chairman REED. Thank you, Governor. 

Dr. Sirri. 

STATEMENT OF ERIK SIRRI, DIRECTOR, DIVISION OF TRADING AND MARKETS, SECURITIES AND EXCHANGE COMMISSION 

Mr. SIRRI. Chairman Reed and Members of the Committee, I am 

pleased to have the opportunity this afternoon to describe the 

SEC’s program for oversight of risk management practices at major 

investment banks. 

Since the events of mid-March that culminated in the sale of 

Bear Stearns, the SEC has revised its analysis of the adequacy of 

liquidity and liquidity risk management at these firms. The SEC 

has also engaged broadly with both international and domestic regulators to consider the far-reaching implications of these events. 

The Commission has strengthened liquidity requirements for the 

CSE firms. In particular, we are closely scrutinizing the secured 

funding activities of each CSE firm, with a view toward encouraging the establishment of additional term funding arrangements 

and a reduction of dependency on ‘‘open’’ transactions, which must 

be renewed as often as daily. We are also focusing on the so-called 

matched book of secured funding transactions where we are closely 

monitoring potential mismatches between the asset side, where positions are financed for customers, and the liability side of the 

matched book, where positions are financed by other financial institutions and investors. We are obtaining funding and liquidity information for all CSEs on a continuous basis and discussing with 

CSEs the amount of excess secured funding capacity for their less 

liquid positions. 

Further, together with the Federal Reserve, we have developed 

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ing, that will be layered on top of the existing scenarios as a basis 

for sizing liquidity pool requirements. Also, we have discussed with 

CSE senior management their longer-term funding plans, including 

plans for raising new capital by accessing the equity and the longterm debt markets. 

The Bear Stearns’ experience has challenged a number of assumptions, held by the SEC and by other regulators, related to the 

supervision of large and complex securities firms. The SEC is working with other regulators to ensure that the proper lessons are derived from these experiences and that changes are made to the relevant regulatory processes to reflect these lessons. 

The work is occurring in a number of venues, including working 

groups operating under the auspices of IOSCO, the Basel Committee on Banking Supervision, the Financial Stability Forum, and 

the Senior Supervisors Group. 

Because the CSEs now have temporary access to the Federal Reserve’s Primary Dealer Credit Facility, which would operate as a 

backstop liquidity provider should circumstances require, the SEC 

is in frequent discussions with the Federal Reserve Bank of New 

York both about the financial and the liquidity positions of the 

CSEs and issues related to the use or the potential use of the 

PDCF. 

The SEC and the Federal Reserve Board are nearing completion 

of 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. This MOU will provide one mechanism for the agencies to 

gain a broad perspective on key financial institutions and markets. 

This MOU will also provide a framework for bridging the period of 

time until Congress can address through legislation fundamental 

questions about the future of investment bank supervision, including which agency should have supervisory responsibility, what 

standards should apply to investment banks compared to other financial institutions, and whether investment banks should have 

access to an external liquidity provider under exigent conditions in 

the future. 

Another area of ongoing regulatory concern relates to the volume 

of novations of OTC derivatives contracts, the related increase in 

collateral disputes, and other operational issues experienced by 

dealers during the week of March 10th. Further, the increased novation activity away from Bear Stearns during that week had signaling effects in the dealer community that may have contributed 

to the loss of confidence in that firm. 

The SEC has been a long-time participant in the effort to improve the confirmation backlog of OTC derivatives, which has made 

substantial progress over the last several years, and continues to 

be involved in discussions with the industry on improving OTC 

market infrastructure. The SEC and other regulators, under the 

leadership of New York Federal Reserve President Tim Geithner, 

are discussing whether and how the market for OTC derivatives 

contracts might benefit from a central clearing counterparty and 

elimination of confirmation backlog, among other things. The dealer community is also moving forward on an initiative to improve 


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settlement of OTC contracts, a process that the SEC is also participating in. 

These intensified efforts to enhance risk management build on 

an extensive foundation that has developed over the years since the 

SEC began the CSE program in 2004. The Commission has taken 

lessons learned from the Bear Stearns event to improve the supervision of the remaining investment banks and to enhance existing 

relationships with other supervisors to address the issues that 

these and other financial institutions are experiencing in the current turbulent conditions. 

An imperative from the Bear Stearns crisis is addressing explicitly through legislation 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. 

Thank you again for the opportunity to discuss these important 

issues, and I am happy to take your questions. 

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

Mr. Polakoff. 

STATEMENT OF SCOTT M. POLAKOFF, SENIOR DEPUTY DIRECTOR AND CHIEF OPERATING OFFICER, OFFICE OF THRIFT 

SUPERVISION 

Mr. POLAKOFF. Good afternoon, Mr. Chairman. Good afternoon, 

Senator Corker. Thank you for inviting me to testify on behalf of 

OTS. 

OTS’ statutory responsibilities afford us the opportunity to observe risk management practices at commercial companies, depository companies, and investment banking companies. For example, 

we currently supervise holding companies such as General Electric, 

AIG, and Ameriprise Financial Group. Our supervisory program is 

internationally recognized by foreign regulators, including the 

U.K.’s FSA and France’s Commission Bancaire, and has achieved 

equivalency status from the European Union. 

In addition, we continue to supervise a number of commercial 

firms that own thrifts and were grandfathered by the GrammLeach-Bliley Act. These companies include General Motors Corporation, Archer Daniels Midland Company, John Deere Corporation, Nordstrom, and Federated Department Stores. These are all 

companies that own thrifts and are, therefore, deemed savings and 

loan holding companies. The Gramm-Leach-Bliley Act also confirmed that OTS is the responsible Federal agency for the consolidated supervision of an investment banking company that owns a 

thrift. As a result, we also supervise Merrill Lynch and Company, 

Morgan Stanley, and Lehman Brothers Holding. Our goal, obviously, is to work with the SEC, which is the functional regulator 

of the broker-dealer, to complete our legal responsibilities. 

Because these investment companies own thrift institutions, they 

are subject to OTS’ continuous consolidated supervision program 

that extends to the parent level as well as the thrift level. To provide some context, as of March 31st, Merrill Lynch’s thrift held $31 

billion in assets, Lehman Brothers’ thrift had $12 billion, and Morgan Stanley’s thrift had $5 billion. 


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Our risk-focused supervisory framework includes onsite and offsite monitoring, a rigorous risk assessment, in-depth or targeted 

on-site examination reviews by subject matter experts, regular reporting from the firms to us on key financial metrics, formal and 

informal discussions with senior leaders and risk managers within 

the organizations, and, importantly, coordination with functional 

supervisors in the United States and abroad. 

In the course of our reviews, we evaluate the effectiveness of risk 

management, the strength of the financial control structure, the fitness of management, and the strength and integrity of the firm’s 

earnings and financial condition. Further, our assessment of capital 

adequacy is handled on an individualized basis, with requirements 

tailored to the parent company’s risk profile. Our principles-based 

approach focuses on regulatory outcomes over prescriptive rules. 

This approach has ensured strong capital foundations overall for 

thrift holding companies. In fact, our analysis of capital levels at 

savings and loan holding companies showed that they compare 

very favorably with the capital levels of bank holding companies 

and evidence of the strength of our regime. 

We have worked closely with the firms and investors over the 

past year as they have raised significant sums of capital. Earlier 

this year, I met with John Mack and his Morgan Stanley team, 

Dick Fuld and his Lehman Brothers team, and John Thain and his 

Merrill Lynch team. These meetings were augmented by regular 

discussions between our supervisory staff and key leaders within 

the firm’s risk control centers. This dialog is geared toward understanding the inherent risk in these institutions and ensuring OTS 

has the information it needs to make informed supervisory judgments. 

While the firms have been cooperative with us throughout the 

process, I want to underscore for the Subcommittee the importance 

of regulatory cooperation as well. The Gramm-Leach-Bliley approach lays out a clear expectation that supervisors will coordinate 

and share information. This will continue to be our goal. We must 

ensure that there are no gaps in our supervision of these firms and 

no confusion on the part of the firms about the posture of regulators, particularly in times of market stress. 

On this front, we are striving for a more cooperative relationship 

with the SEC. We believe a robust information-sharing understanding with the SEC is in the interest of both OTS and SEC, and 

we will continue to press for a more collaborative working relationship. At the direction of OTS Director John Reich and SEC Chairman Cox, Dr. Sirri and I, with our respective staffs, will meet 

again in 2 weeks to address this issue. As we fulfill our statutory 

obligations, we will continue our efforts to develop the type of relationship you expect from regulators in supervising these important 

firms. 

Again, Mr. Chairman, thank you for the opportunity to testify. 

I look forward to your questions. 

Chairman REED. Thank you very much. Gentlemen, thank you 

for excellent testimony. I will take about 7 minutes, then go to Senator Corker, and then probably do a second round, too, because I 

think we will have adequate questions for two rounds. 


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Let me just try to get a feel for some of the details of your regulation. I presume for this purpose, Governor Kohn, the Fed was recently on the scene with investment bankers, so you did not have 

a presence there with Federal Reserve personnel until very recently. Is that correct? 

Mr. KOHN. That is correct. Our presence dates from the PDCF. 

Chairman REED. Dr. Sirri and Mr. Polakoff, one area is the very 

sophisticated nature of the products that now are being created 

and kept on the books. Is there a product review by SEC or the 

OTS in terms of products that are being presented? And how is 

that done? 

Mr. POLAKOFF. From our perspective, we try to work with the 

SEC. Many of these complex instruments take place at the brokerdealer. The SEC is the expert as the functional regulator for the 

broker-dealer, and we think from the Gramm-Leach-Bliley approach, it makes sense for us to defer to the SEC’s opinion of these 

instruments and then to leverage off their work from a consolidated perspective. 

Chairman REED. And, Dr. Sirri, is there an approval process? 

Mr. SIRRI. Yes. Within firms there is an approval process for new 

products, and through our supervision, one of the things we look 

at is the quality of that approval process. In particular, anytime 

you structure a new product, you are worried about the risks it entails. So we focus on whether the firm properly understands the 

risks that are embodied in a new product, whether it has a sufficient control system within the firm to support introducing that 

new product. 

Chairman REED. Let me just follow up. Without trying to be, you 

know, glib, is it a ‘‘check the box’’ thing, that they have a review 

and they have this and they have that, and that is fine? Or is it 

looking at or trying to really get into the nature of the product and 

the potential effect on the marketplace? And if that is the case, you 

know, who does that? Do you do that? 

Mr. SIRRI. That is a good question. It is not a ‘‘check the box’’ 

process at all. So there are, in a sense, two aspects to it. What we 

are concerned about in particular is the firm’s process for looking 

at new products. So we pay particular attention to how that works. 

Is Treasury involved? Are the risk managers involved? Do they 

have the proper infrastructure in place to support a new product? 

Occasionally, new products will come up that particularly catch 

our attention. At that point, we will dive much deeper into that 

new product. My staff will occasionally, for example, conduct special studies about issues of concern. Those studies may focus on 

products; they may focus on processes. These studies could be 

months long, and they result in a specialized report that goes to 

both myself and members of the Commission. 

Chairman REED. Do you have examples—or how routine is it for 

the SEC to object to a product and say, well, you cannot do this? 

Does that happen, or is this one where there is a negotiation about 

what they have to do to get it on the street? 

Mr. SIRRI. As a general matter, we are not likely to object to a 

product per se because of its design features or we think it is not 

useful in the market or we think it might not serve—you know, it 

might not be well designed. That is highly unlikely. 


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It is quite possible, however, that we think a firm might introduce a product that might have, say, some embedded optionality in 

it or something about it that creates risk for which the firm does 

not have adequate controls or, say, for which the firm cannot adequately check how much of this is being sold or how it is being 

funded. Those are much more likely things that we are going to 

pay attention to. 

Chairman REED. And let me ask you—and this is not about, you 

know, completely 20/20 hindsight, but looking at the Bear Stearns 

experience and the products that went through this process, has 

that caused you to reflect on how well a job you did or what 

changes you have to make, or were you satisfied that at least on 

the issue of product approval, it was adequate? 

Mr. SIRRI. With respect to Bear Stearns, I think we are generally 

talking about mortgages and mortgage-backed securities. In late 

2006, my staff finished a specialized report on mortgage products, 

not so much the approval product but a lot of risk management features around them, which leads one to naturally ask the question: 

If you studied such a thing, how could this go on? And the reason, 

I think, is because the kinds of risks that were embodied in these 

mortgage products, things we have talked about before, about correlation risks, about liquidity risk, were things that at the time 

were not properly understood, not properly appreciated. And I 

think the liquidity facilities that pool the liquidity necessary for 

those products were just not put in place. 

Chairman REED. And that lack of understanding was on both 

sides, both the regulators and the proponents, the investment 

banks. Is that fair? 

Mr. SIRRI. I think it is a fair statement that neither us, the 

street, nor other regulators appreciated all the attributes of these 

products, especially given what could happen to the market. I do 

not think any of us understood the rapidity with which liquidity 

could disappear from these markets. That was not a risk that was 

in our scenarios. I think, you know, we hear it talked about that 

as we go forward here, we are looking at new scenarios that account for such risk much more explicitly. 

Chairman REED. Let me ask one question of all the panelists, 

and if I exceed my time, I will compensate. We have had a series 

of reports—the Senior Supervisor Group, the Financial Stability 

Forum, the Basel Joint Forum, the President’s Working Group. 

Just today, I think, Secretary Paulson made another speech touching on issues of supervision and reform. 

Given all these and the experience, what is at the top of your 

list, Governor Kohn, in terms of the two or three things you think 

are most important going forward? 

Mr. KOHN. I think the three pillars of resilience for the system 

are capital, liquidity, and risk management, and those three are 

certainly at the top of our list. We have worked carefully and closely with the Basel Committee that just yesterday, I believe, or the 

day before, put out new guidance on liquidity management. And we 

will continue to work with the institutions we regulate and supervise on their liquidity management and how they are adequately 

readying themselves for the potential stress events, such as the 

type that Eric was talking about. 


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In capital, we are working again with the Basel Committee to 

look at how Basel II needs to be adjusted in light of the events we 

have seen for securitizations, resecuritizations, off-balance-sheet 

entities. And in risk management, we are going to our entities we 

supervise using the SSG report and other information we have, and 

those that were found not to be employing best practices, we are 

working very, very hard with them to bring them up to speed. 

Chairman REED. Dr. Sirri. 

Mr. SIRRI. I think I could easily resonate with the points that 

Vice Chairman Kohn made: capital, liquidity, and risk management. I would put a particular emphasis for our firms on liquidity, 

because our firms are investment banks, securities firms, liquidity 

is terrifically important to them. So while we certainly pay attention to risk management practices and capital, I would just emphasize a slightly even elevated level for us, for our firms’ liquidity. 

Chairman REED. Mr. Polakoff, please. 

Mr. POLAKOFF. Mr. Chairman, I am going to add No. 1 as greed; 

No. 2 as appropriate risk management, not just risk management; 

and then three, liquidity. 

Chairman REED. Can you elaborate? 

Mr. POLAKOFF. Yes, absolutely. 

So from the greed perspective, I think all of us at the table, but 

certainly OTS, has identified numerous situations where the risk 

management team brought to the proper senior management certain findings that would suggest it is time to either ease off the accelerator or start depressing the brake. Senior management has to 

take that information and make a decision, while at the same time 

recognizing such a decision is going to have a negative effect on 

revenues. What we saw was inappropriate action by senior management in some situations in doing so. 

Now there is many different ways to address that situation. A 

common guy like me, it comes down to the greed issue. 

Chairman REED. I appreciate that because that is a human motivation that seems to be ubiquitous and eternal, unfortunately. But 

how are you doing that now? I mean, are you requiring, for example, risk officers who make a recommendation that is denied to 

somehow memorialize that so you can review it later? 

Mr. POLAKOFF. Interestingly, most of the firms have changed 

their own practices as a result of this turmoil. So we had some situations where we observed the risk management team reporting to 

the business line. Holy cow, that is unacceptable and needed to be 

fixed right away. 

We had some situations where senior management was not sufficiently involved in hearing from the risk management team. Unacceptable, had to be fixed. 

So actually, what has happened is the system has corrected itself 

most of the way. Unfortunately, the turmoil contributed to it. 

Chairman REED. Just quickly—and excuse me, Senator—any 

comments about that from Dr. Sirri, in terms of correcting what 

seems to be these lapses in just the way risk is treated in the firm? 

Is that something you are working on, also? 

Mr. SIRRI. It is, indeed. And I think the Senior Supervisor’s 

Group report spoke very pointedly to the question of governance in 

these firms. We have been talking very generally about these firms 


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as if they are one. But they are, in fact, not one. We see considerable variation across the firms we supervise. Some of them have 

very strong risk practices generally, in particular, on the governance side. I think there are other firms that we have supervised 

that showed distinct weaknesses on governance. 

And one of the things we noticed as this credit crisis progressed, 

was that we could see a relationship between the strength of those 

practices and some of the losses they took on their positions for 

various reasons. 

So I think we believe very strongly that governance is important, 

things like reporting lines, internal prices, we pay a great deal of 

attention to and I think the credit crisis has emphasized how important that is. 

Chairman REED. Governor Kohn? 

Mr. KOHN. I completely agree. Risk management has to be integrated into every aspect of the institution’s behavior and it has to 

have support from the very top of the institution, the board of directors, the CEO on down. Greed has been, as you said, Mr. Chairman, a natural driving influence on all of our behaviors to one degree or another. Compensation schemes can reinforce that. I think 

what we need is more robust risk management to offset the compensation schemes and the greed, and that is where we are all 

working. 

Chairman REED. Thank you. Thank you all very much. 

Senator Corker. 

Senator CORKER. Mr. Chairman, thank you. I appreciate, certainly, the testimony of all of you and what each of you does to 

strengthen our financial environment. 

Before I step into specific questions, can you give us a sense of 

whether you feel like the worst today—I mean, we are looking at 

systematic risk management. Is the worst over today during this 

episode, as it relates to Wall Street? Are we on the edge of another 

potentially market crushing moment? Without obviously mentioning specific entities, just overall the entities that you regulate, 

where would you say today that the health of those entities are in 

where we are today as it relates to this episode, if you will, we are 

dealing with? Each of you. 

Mr. KOHN. I would say, Senator, that banks and the investment 

banks we work with the SEC on have improved their capital positions, reduced their leverage, improved their risk management, and 

tried to work—and worked very hard—on making their liquidity 

both longer term and more robust to stress events. 

So I think we have come a long way. The markets are in a little 

bit better shape than they were—certainly a lot better shape than 

they were in the first half of March. But having said that, I do not 

think anybody can really guarantee what is going to happen next 

and what the risks are. So I would expect that we will see a gradual improvement in financial markets, that our institutions have 

taken steps to make that possible and to contribute to that. But 

there are no guarantees. And that is one reason why the three of 

us and those that we work with are working so hard on this risk 

management, liquidity, capital issue, to make the system more robust to the unexpected. 


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Mr. SIRRI. I think I would agree generally with that statement. 

There is nothing from my particular vantage point that gives me 

any unique ability to foresee the future or the future of credit markets that we have been talking about. 

I will say that we are striving mightily to improve the resilience 

of these firms. We know more now about the kind of shocks they 

can experience and I think we are working strongly, mightily to get 

them to be more resilient to those shocks. Capital, liquidity, risk 

management, pillars that we have been talking about, these are 

the things that we are focusing on so that whatever the future portends that we have got a much better chance of coming through it 

strongly. 

Mr. POLAKOFF. Senator, in addition to my colleagues’ comments, 

what we have, I believe, is a loss of confidence by the consumer. 

And with two GDP quarters of under 1 percent, with consumer 

spending under 1 percent, with housing stock at over 10 months, 

this situation is going to take a while to work out. I think the regulators have a very robust program to work with the institutions 

that they have responsibility for. I think the institutions have instituted or continued with strong risk management programs. But we 

have a confidence issue in many different markets that will take 

a while to get to. 

Senator CORKER. Dr. Sirri, Tim Geithner, I guess, just wrote a 

letter to the editor of the Financial Times suggesting that we ought 

to have a clearinghouse for some of the over-the-counter derivatives 

and simply things, standardize things to some degree. I am just 

wondering if you would comment on that and what that might do 

to the pricing of these derivatives and certainly just the effect that 

it would have should that be necessary? 

Mr. SIRRI. I read that letter, so I know what you are speaking 

about. 

The point of having a—the first thing to appreciate is the kinds 

of instruments that he was discussing, things like credit default 

swaps, are over-the-counter instruments. So they are simply bilateral contracts. They are you meeting me over the telephone, us 

agreeing to the terms to some sophisticated derivative instrument. 

In the end, I am exposed to you as a counterparty, by which I mean 

as the value changes over time I depend on you to pay me if you 

owe me money. There is no one else involved in that arrangement. 

Over time, investment banks, securities firms, commercial banks 

develop networks of these contracts and they become very hard to 

keep track of. People are exposed to all kinds of risks because of 

it, many, many exposures. Some of them even building upon each 

other. 

By creating a central derivatives clearinghouse of some type, 

what is known as a central counterparty, a certain amount of risk 

can be reduced from that system. There is really two types of risk. 

The first is that there may be some netting that is possible. If our 

derivatives contracts are sufficiently similar, you may have sold me 

something that I may have later bought from someone else, who 

may have in turn sold it to you, and we may all flatten out and 

level out, stopping payments from flowing and reducing risk. 

The second thing that is true is that netting can occur, certain 

kinds of—excuse me, not netting can occur, but we have a central 


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counterparty. Once we have a central counterparty, I need to no 

longer worry about your particular credit. There is some entity that 

stands in the middle that is capitalized by some other group. So if 

you fail to make the payment to me, that other entity stands there. 

Most people have familiarity with this when they buy a stock on 

the New York Stock Exchange or NASDAQ. No one every worries 

who sold them that stock. The reason is it does not matter. There 

is some counterparty sitting in the middle that takes the risk if the 

person who sold you the stock does not give it to you. 

Senator CORKER. So you agree that that would be helpful? 

Mr. SIRRI. I do. 

Senator CORKER. And it appears that Chairman Kohn has a 

thought. 

Mr. KOHN. Thank you, Mr. Chairman. I agree with what Erik 

said. I would just add the following. Because the risk is concentrated in a central clearinghouse, it is really crucial, critical, 

that that entity exercise appropriate risk management itself, that 

it have financial resources so that it can withstand the failure even 

of its largest participant, that it have good margining and risk 

management procedures in place. 

So a central clearinghouse can reduce risks, but it concentrates 

risks. So once that risk is adequately taken care of, overseen by a 

regulator, I think it has all the advantages that Erik was talking 

about. But it does need that central clearinghouse to be very, very 

strong. 

Senator CORKER. So I assume that both of you agree with Dr. 

Bookstaber, who is going to testify here in just a minute, that we 

have a new breed of quantitative number crunchers that have created mechanisms that only a handful of people understand, and we 

ought to simplify that to some degree, to a large degree? 

Mr. KOHN. I am not familiar with his testimony, but I do think 

the market will be in the process of simplifying these instruments. 

That is part of the problem here, as the Chairman pointed out in 

his opening statement, that these instruments were so complicated 

and so complex, people did not really understand the risk associated. So I think the market is going to drive toward some simplification, standardization of a number of these instruments. 

Senator CORKER. But how would we move toward—I could not 

agree more that something needs to be done to simplify. How 

would we move toward this clearinghouse-type mechanism being 

put in place? 

Mr. KOHN. President Geithner and the other regulators are 

working with the private sector right now to see that they are moving toward a central clearinghouse and that that clearinghouse has 

the appropriate oversight and the appropriate risk control. So this 

is a process that is ongoing. 

Senator CORKER. Speaking of the private sector, what role should 

the private sector play in risk management in that, in essence, 

they really have more dog in the hunt than even the regulators do 

because it is going to affect them directly. And I am just wondering 

what can be done to even enhance their ability, if you will, to do 

that? 

Mr. KOHN. Well, I completely agree with you, Senator. It is really 

the private sector’s responsibility to do this. The shareholders of 


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these firms are the ones who will lose if the risk management systems do not work. It is their incentive to make them work. 

I think our job, as regulators, is to make sure that they are moving in the right direction, reinforce the incentives that the market 

has given, making sure that they are sufficiently robust so that 

their failure is much less likely, and their counterparties are sufficiently robust that if a major firm fails, then the system does not 

come down. 

So we are reinforcing and building on market—— 

Senator CORKER. Is there anything else we can do, though, to 

empower their ability at the private level to do even more assessment—— 

Mr. KOHN. I think we are working very closely with them, both 

as a group in this counterparty risk management and on individual 

firms. And we are trying to act as a convener for the private sector 

to get together to take the collective action they need to take that 

would be very hard on an individual firm-by-firm basis to reduce 

the risk in the system. I think there is something we can do, and 

I think we are doing it. 

Senator CORKER. I think you alluded to this earlier, but in essence these derivatives that are now so prevalent have concentrated risk instead of diversifying risk in many ways. Would 

you like to make a comment in that regard? 

Mr. KOHN. They have diversified risk in a number of ways, but 

I think they were not as diversified as some people thought they 

were, and people were not as cautious about or as knowledgeable 

about the counterparties and the concentrations that they might 

have had. So I think fundamentally, the derivatives are very good 

at diversifying risk and spreading it out, but the people who use 

them need to be informed and understand better what they are 

doing. 

Senator CORKER. Mr. Chairman, my staff has grabbed me for 

some reason to leave for a second. I have some questions for Scott. 

I do thank you for your thoughts, by the way, on the negative equity certificates and I thought that was a valuable contribution. 

Mr. Chairman, I might step out and I may or may not be back. 

Thank you for your testimony. 

Chairman REED. We hope you return, Senator. 

Senator CORKER. Thank you, sir. 

Chairman REED. Gentlemen, if I could follow up with some additional questions, following the line of Senator Corker about a potential clearinghouse for credit defaults swaps, would that require 

any legislative incentive or support? 

Mr. KOHN. I do not believe it would require any legislation. I 

think it is in the process of happening. It will require regulatory 

approval. A central clearinghouse must be supervised and regulated, and the clearinghouse will have to decide who it wants to be 

regulated by and who will require—but I do not believe it requires 

any legislation. 

Chairman REED. The choice of regulator would be theirs the way 

it is structured? In that sense it would be their choice or its choice? 

Mr. KOHN. Essentially, I think. 

Chairman REED. Dr. Sirri, any thoughts? 


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Mr. SIRRI. I think that is right. They will have to decide how it 

is structured. Those discussions are underway. So it depends on 

how it is owned, how it is structured, that will determine supervision. 

Chairman REED. Let me ask a general question to all of you, and 

that is the—and you touched upon it previously. That is what is 

now a routine mechanism for coordination between your three 

agencies? As Mr. Polakoff pointed out, he has statutory jurisdiction 

over three investment banks. You have, essentially, jurisdiction on 

the compliance of the identity program of the remaining major investment banks. The Fed is now there because of their lending facility. 

Is there a routine now in which information is shared on a regular basis? And getting to the point of, this would seem to me the 

first way you responded, systematic risk is getting all of the regulators around the table and talking about what they are seeing. Is 

that happening? 

Mr. KOHN. Yes, it is, Mr. Chairman. Certainly, especially there 

is a lot of information sharing with the OTS. And that goes back 

a long way, sharing information about depository institutions on 

the FFEC, working with them on consumer mortgage regulations, 

things like that. 

With the SEC, as both Dr. Sirri and I have noted in our testimony, we have stepped up the cooperation and coordination since 

the Bear Stearns crisis. And there is a lot of coordination, cooperation, talking back and forth. 

And we are in the process of entering into a memorandum of understanding about these information sharing issues and other oversight issues. 

Chairman REED. Your comments, Dr. Sirri? 

Mr. SIRRI. I would say there is quite a bit of information sharing 

and cooperation going on. We each have different mandates within 

these organizations and so I think our views on them depend on 

our mandates. I think—and I will let Scott speak for himself—but 

there are thrifts that I think they pay particular attention to. We 

pay particular attention to the broker-dealer and certain issues 

around them. I think with the primary dealer credit facility has 

particular emphasis that the Fed has now. 

With that said, there are common interests, as well as distinct 

ones. And I think we are striving to work together to make that 

more seamless. Chairman Cox and Chairman Rich have met together recently, as Scott said. I think we, with the Federal Reserve, 

are working on a memorandum of understanding. 

So I think we are finding our way to new territory for us to find 

our way through this kind of a situation. I think we are making 

good progress. 

Chairman REED. I presume you have identified gaps and that 

you are, through this coordination process, trying to fill those gaps. 

I presume also, since you have not requested any formal legislative 

approval that you are confident that those are regulatory matters 

not requiring any additional legislation? Why don’t you comment, 

Scott? 

Mr. POLAKOFF. Mr. Chairman, we are making progress. There is 

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the-Beltway approach, the examiners in the field need to communicate better. And I do not think necessarily, Mr. Chairman, it is 

gaps. I think it is duplicative efforts. So when there are meetings, 

relevant meetings, all the right parties need to be at the table. 

When there is analysis, all the right parties need to see the analysis. 

Each party will be better by leveraging off the product of each 

other, and I think we still need much more progress in the area, 

at least between Erik’s team and my team. It may be with the Fed 

and the other banking regulators we simply have had a longer history and trust of working together. 

Chairman REED. Any additional comments, gentlemen, in this 

general issue of getting it to be seamless? 

Mr. SIRRI. Look, I think we all appreciate the importance that it 

has. We are in a unique time here. We are in a time where we 

have certain exigencies that have required us to work together in 

different ways. 

One thing Chairman Cox has said, as we work through this, is 

that he sees this as a somewhat temporary solution and that ultimately we will need legislation here. You raised the legislation 

question. I think working together today we do not need legislation 

to fulfill, to see us through this temporary period here. But I think 

ultimately a legislative solution is needed for a number of aspects 

here. 

Chairman REED. You raise the issue of temporary. Governor 

Kohn, the lending facility, by the nature of the expediency and the 

urgency and the extreme nature of your action, is temporary? 

Mr. KOHN. That is correct. 

Chairman REED. And so what would you anticipate being sort of 

the ballpark figure where you are no longer in this temporary mode 

and you have to pass the time to Mr. Sirri and then Polakoff, and 

therefore there might be the need for legislation? Can you elaborate? Or is that—— 

Mr. KOHN. With regard to the lending facilities themselves, we 

are looking at this issue right now and have a number of alternatives under consideration and are talking about this within the 

Federal Reserve. I am not prepared to say something right now. 

I think part of the cooperation with Erik and his team is to look 

at, as he said in his testimony, this period of bridging two potential 

legislative actions. So I would say that even if those liquidity facilities, or when they begin to be wound down, we would expect still 

to have a cooperative relationship with the SEC. 

Chairman REED. Let me ask you another question, Governor 

Kohn. We have talked about risk assessment. Dr. Sirri and Mr. 

Polakoff are sort of regulators. They do not have a fund like you 

do, and credit, and all those things. How about your risk assessment at the Federal Reserve in terms of the—particularly with respect to the collateral you have assumed from the Bear Stearns 

transaction. It was about $29 billion which you are liable for at this 

juncture? 

Mr. KOHN. Right. 

Chairman REED. And I am also under the impression that you 

are operating under accounting rules that are not the same acVerDate Nov 24 2008 04:10 Apr 02, 2010 Jkt 050407 PO 00000 Frm 00021 Fmt 6633 Sfmt 6602 E:\HR\OC\A407.XXX A407

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counting rules that everyone has, in terms of recognizing the value. 

That is an issue, I hope, that you are looking at seriously. 

Mr. KOHN. That we expect that transaction to settle on or about 

June 26th and we expect—as President Geithner said—to publish 

on a quarterly basis the value of these assets using market value, 

fair value accounting. I think we will be adhering pretty much to 

generally accepted accounting principles for that particular limited 

liability corporation. We understand our responsibility to be transparent about what we have and what the risks are that we have 

undertaken. 

Chairman REED. Thank you. 

A final question, and this goes to the—and you can probably help 

explain and increase my knowledge. But it strikes me that there 

are probably situations where you have looked very closely and you 

can look very closely legally at the regulated company, the investment bank, et cetera. But they have relationships with counterparties, with unregulated institutions, and many of them, I suspect. 

How do you get the same confidence in their counterparty that 

you would have in the regulated entity? And is there anything we 

need to do to give you more authority in that regard? Start with 

Mr. Polakoff. 

Mr. POLAKOFF. Mr. Chairman, many of the counterparties have 

rating associated with them. Frequently there is publicly available 

information. It does come down to concentration risk and it is simply one of the elements of a strong risk management program. How 

one measures counterparty risk, how one monitors counterparty 

risk, and then how one mitigates such. 

So it can be done even when the counterparty, as you mentioned, 

is frequently unregulated. 

Chairman REED. And you are confident, as best you can, that 

this counterparty risk evaluation is going on and it is adequate at 

the moment? 

Mr. POLAKOFF. Yes, sir. 

Chairman REED. Dr. Sirri. 

Mr. SIRRI. Securities firms have all sorts of counterparties. I am 

going to primarily break them down into two. They could have 

counterparties because of proprietary trading that they do, and 

they could have counterparties that arise because of certain agency 

business they conduct. 

So for example, the prime brokerage business is an important 

one, where we watch counterparty risk. Prime brokerage is a business where entities such as hedge funds come to securities firms 

for their financing for their trades, for lending of securities, these 

kinds of things. Counterparties become very important then. 

Securities firms, the kind that we are talking about, have fairly 

well developed and very sophisticated counterparty risk management operations that go on there. 

That said, they are continually evolving and through the shocks 

that we have seen, the kind of things that happened post-Bear 

Stearns, we have watched how those counterparties behave. Do 

they move contracts away from a particular firm? Do they shift all 

of their business? How quickly do they run? 

And so one of the things we have learned from that is we had 

some beliefs on how they would behave before. Those beliefs have 


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changed. We have learned something about how they behave. 

Those new beliefs are being incorporated into the models that we 

have these firms run. And so we are cycling that through all these 

firms to say now that we know something, how counterparties behave under stress, let us learn from that. Let us cause all the firms 

to factor that into their models, resulting as you would expect, in 

increased liquidity, increased capital, increased demands for risk 

management. 

Chairman REED. Governor Kohn. 

Mr. KOHN. Sir, I would only add to what my colleague said, that 

this work that we are doing, that we have talked about on the infrastructure for the derivatives markets and the over-the-counter 

markets, is a very important aspect to controlling counterparty risk 

and managing counterparty risk. So the more seamless we have 

that flow of information and settlement and clearing, the easier it 

will be for the securities firms and the commercial banks to understand their risk, where it is, and then to manage it. So that is critical to that aspect. 

Chairman REED. Thank you very much, gentleman. Thank you 

for your service. As always, it has been an enlightening session. 

Thank you very much. 

Mr. KOHN. Thank you, Mr. Chairman. 

Chairman REED. We will call the second panel forward. 

[Pause.] 

Chairman REED. Gentlemen, thank you for joining us this afternoon. 

We are very pleased to have a distinguished panel of experts on 

the issue of risk analysis and risk assessment. Our first witness is 

Richard Bookstaber, a senior research associate at Bridgewater Associates. Mr. Bookstaber has a great deal of experience in the area 

of risk management, having worked in the field since the 1990s at 

Morgan Stanley, Salomon Brothers, and other firms. He brought 

this experience together in a book published last year titled ‘‘A 

Demon of Our Own Design: Markets, Hedge Funds, and the Perils 

of Financial Innovation.’’ 

Dr. Richard Herring is the Jacob Safra Professor of International 

Banking and Co-Director of the Wharton Financial Institutions 

Center at the Wharton School, University of Pennsylvania. He is 

the author of numerous articles and books on various topics in financial regulation, international banking, and international finance, including risk-related topics. He is co-chair of the U.S. 

Shadow Financial Regulatory Committee and a member of the Financial Economists Roundtable, the Advisory Board of the European Banking Report in Rome, and the Institute for Financial 

Studies in Frankfurt. Welcome. 

Kevin Blakely is President and Chief Executive Officer of The 

Risk Management Association. Prior to this position, he was Executive Vice President of Key Bank in Cleveland, Ohio. He also served 

as chief risk officer of KeyCorp from 1994 to 2005, where he implemented a number of risk management processes. Before joining 

KeyCorp, Mr. Blakely was with the Office of the Comptroller of the 

Currency for 17 years. 

Gentlemen, your statements are all part of the record, so if you 

would like to summarize or any variation thereof, please. Mr. 


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Bookstaber. Could you bring the microphone closer and push the 

button? Thank you. 

STATEMENT OF RICHARD BOOKSTABER, SENIOR RESEARCH 

ASSOCIATE, BRIDGEWATER ASSOCIATES 

Mr. BOOKSTABER. Thank you, Mr. Chairman. In the letter of invitation, we received three questions for discussion: the state of current risk management models and systems; the adequacy of risk 

management by risk officers and executive boards; what regulators 

could do to improve their response to future market problems; and 

how regulators can better equip themselves to monitor risk. I 

would like to address each of these questions in turn. 

In terms of the state of current models and systems for measuring risk management, large financial institutions evaluate the 

risk of their positions on a daily basis using systems and models 

that I believe are well developed and are adequate for the risks 

they are designed to measure. The problem is that the systems are 

not designed to measure—and in the current state of the world perhaps cannot be designed to measure—the risks that we care the 

most about, which are the risks related to market crises. 

To understand why they cannot, we must understand how market crises develop. Consider as an example a highly leveraged firm 

that has a sizable position in a market that is under stress. The 

firm faces losses and its collateral drops to the point that its lenders force it to start selling. This selling leads to a further drop in 

the market, which leads the collateral to decline still further, forcing yet more sales. This downward cycle reduces liquidity in the 

market so that the manager must start to sell positions he might 

be holding in some other markets. This selling drops the prices in 

these markets, and highly leveraged funds with exposure in these 

markets are then forced to sell. And thus the cycle propagates. The 

result is that the stresses in the first market might end up devastating another unrelated and perfectly healthy market. 

As a simple example of the unlikely yet powerful linkages that 

can occur with this sort of dynamic, consider the silver collapse in 

1980. The decline in the silver market brought the cattle market 

down with it. The improbable linkage between silver and cattle occurred because the Hunt brothers needed to raise capital to post 

margin for their silver positions when those declined, and to do so 

they sold off the cattle positions that they happened to hold. 

Another example of this, the LTCM crisis in 1998, was precipitated by the default in the Russian debt market, even though 

LTCM did not have a substantial position in Russia. But some of 

those who did also had positions in markets where LTCM was active. When they were forced to sell in these markets, LTCM was 

caught up in the downward spiral. Many of these markets, such as 

Danish mortgage bonds, had nothing to do with Russia, save for 

the fact that they were in the crosshairs of the same leveraged investors that were holding the Russian debt exposure. 

The point is that during market crises, the usual economic linkages and historical market relationships do not matter. Rather, 

what matters are questions of who owns what, who is under pressure to liquidate, and what else do they own. And as I will discuss 


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below, regulators do not have the requisite data to answer these 

questions. 

In terms of the adequacy of risk management by risk officers and 

executive boards, I would have to say that whatever the limitations 

of the risk models and systems, these were not the culprits in the 

case of the multibillion-dollar writedowns over the past year. These 

positions were patently visible; no detective work or models were 

required. 

Indeed, what occurred really leaves me scratching my head. It is 

hard to understand how this risk was missed. How can a risk manager see inventory grow from a few billion dollars to $10 billion 

and then to 30 and then $40 billion and not react by forcing the 

inventory to be brought down? My view is that it was a failure of 

management. The risk managers did not have the courage of their 

convictions to insist on the reduction of the inventory, or the senior 

management was not willing to heed their demands. 

More must be required of the risk manager than monitoring and 

understanding risks. He also must have the willingness and independence to force issues up the chain of command. And, furthermore, the CEO must have the capacity to assess the risk manager’s 

advice and have the willingness to take bold action. 

Adequacy in these dimensions requires the correct incentives. As 

it stands now, those who are responsible for protecting the firm 

from unwarranted risks often have incentives that are more closely 

aligned with those of a risk taker. 

So what can regulators do to improve their response to future 

problems in the market? Here I would like to put forward two 

points for consideration. 

The first is establish a liquidity provider of last resort. In my October 2, 2007 testimony before the House Financial Services Committee, I proposed ‘‘the Government maintain a pool of capital at 

the ready to be the liquidity provider of last resort, to buy up assets of firms that are failing.’’ The Federal Reserve’s action with respect to Bear Stearns is along the lines of this proposal. 

The reason for the Government to act as a liquidity provider of 

last resort is that by taking rapid and decisive action to infuse liquidity, regulators may break the cascade of an emerging crisis 

and curb a systemic threat. 

The concept of a liquidity provider of last resort has already been 

employed successfully in the private sector. The large hedge fund 

Citadel has used its capital to buy up the assets of other hedge 

funds that were in distress, in one case with the failure of Amaranth and again with the failure of Sowood. Citadel’s actions did 

not bail out the failing firms. These firms still went out of business. 

But its actions forestalled positions being thrown into a jittery, uncertain market, and thereby prevented the failure of one firm from 

cascading out to have a systemic effect. 

Now, I hasten to emphasize that if the Government considers formalizing a role of this type, a liquidity provider of last resort to buy 

up assets of firms that are failing, it will not be stepping into the 

business of bailouts. There is no moral hazard problem because the 

firm will still fail. But the collateral damage will be contained; the 

market will not go into crisis, the dominos will not fall. And it 


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might be one of those rare Government enterprises that actually 

turns a profit. 

Second, rethink the application of mark-to-market accounting. 

Marking positions to market is intended to price the positions according to what they would be worth if they were sold at the 

present time. The mark-to-market concept loses its meaning when 

applied during market crisis. Indeed, in times of crisis, mark-tomarket accounting might even be destabilizing. 

In a crisis the market is drained of liquidity. Many who otherwise would be natural buyers are facing large losses, yet others are 

running for the sidelines. In this situation a mark-to-market price 

is next to meaningless. If a financial institution has a large inventory, it could not sell at that price. And if the institution has no 

intention of selling, then the crisis-induced fire sale prices bear no 

relationship to what the positions will be worth in the long term. 

But pricing inventory on a mark-to-market basis can end up 

being destabilizing. It might force yet more assets into the market 

because the institution might appear to be below a regulatory capital limit, or it might need to satisfy the covenants of its creditors. 

It might erode the market’s confidence in the viability of the institution. In such cases, mark-to-market accounting will cause the crisis to become more severe. 

I suggest regulators investigate the systemic risk implications of 

mark-to-market accounting rules. 

Now on the last question, how regulators can better equip themselves to monitor risk, I would put forward two points. 

No. 1, get the critical data. Prior to the recent financial crisis, my 

firm, Bridgewater Associates, performed an analysis of the incredible buildup of leverage in derivatives throughout the financial industry. The firm was able to put together a rough but useful picture; however, the clearest lesson from the exercise was how little 

anyone knew about where the risks lie. 

Regulators are ill-equipped to monitor risk because they lack the 

right data. That is particularly true when we are looking at the 

issues of crises and potential systemic risks. As I have already 

mentioned, what matters for these risks is who is leveraged, what 

they own, and what they owe to whom. Yet regulators do not have 

the essential information to monitor leverage. Nor can they track 

the concentration of investors by assets or by strategies. Nor can 

they assess the risks at the foundation of the huge swap and derivatives markets because they do not know the positions of all of 

the counterparties—who owes what to whom and how losses would 

propagate if a set of counterparties failed. 

It is important for regulators to determine the data that are necessary and then get access to these data. And getting the critical 

data may require looking not just at commercial and investment 

banks, but also at hedge funds. 

Second, create a regulatory risk management function. In my 

congressional testimony, I suggested the need for ‘‘a regulatory 

body, a Government-level risk manager with a role perhaps modeled after that of industry-level risk managers.’’ I am pleased to see 

a similar recommendation come forward from the Department of 

Treasury in the form of the role of the market stability regulator. 


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Such a regulatory body would acquire the relevant data and then 

use these data to monitor systemic risk. It would have the ability, 

either directly or in cooperation with other regulators, to put 

checks on the risk-taking activities of the institutions under its 

purview. It also would be the natural home for the liquidity provider of last resort. As with the issues of data acquisition, the success of such a function depends on it having oversight for all major 

risk-taking institutions, including hedge funds. 

With this, I will close my prepared remarks. I thank the Chairman for inviting me to provide this testimony, and I look forward 

to your questions. 

Chairman REED. Thank you very much, Mr. Bookstaber. 

Professor Herring. 

STATEMENT OF RICHARD J. HERRING, JACOB SAFRA PROFESSOR OF INTERNATIONAL BANKING, AND CO-DIRECTOR, 

WHARTON FINANCIAL INSTITUTIONS CENTER, WHARTON 

SCHOOL, UNIVERSITY OF PENNSYLVANIA 

Mr. HERRING. Thank you very much. Good afternoon, Chairman 

Reed. I am very grateful and honored for the invitation to testify 

here today. 

I would like to address four questions in my allotted time. One 

is, How did Basel I contribute to the crisis, and would Basel II 

have prevented it? Second is, What weaknesses in Basel II have 

been highlighted by the crisis? Three, What lessons have been 

learned by risk managers and regulators? And, four, What additional regulatory tools need to be developed to limit systemic risk 

without exacerbating moral hazard? 

First, how did Basel I contribute to the current crisis? Well, 

Basel I actually created very strong incentives for regulatory arbitrage, and subprime mortgages were a very good example of that. 

If a bank wished to hold a subprime mortgage on its own balance 

sheet, it would be charged a full 100-percent risk weight. On the 

other hand, if it created a special purpose entity off balance sheet 

and backed it up with a line of credit that was revocable and under 

365 days, it would have a 0-percent capital charge. So by simply 

booking the asset, selling it to the special purpose entity, it could 

do that a number of times using its capital much more efficiently, 

generating fees for not only originating the loans but also servicing 

the loans and creating what was, in effect, an off-balance-sheet 

banking system. 

Would Basel II have actually caused the system to be less prevalent? Optimists assert that Pillar 1 of Basel II would have reduced 

the incentives by requiring a modest capital charge for the shortterm line of credit backing up the SPE. I am skeptical about 

whether that would have actually made much difference because 

the U.S. has had that rule in place for a couple of years, and 

Citibank actually had more SIVs outstanding than any other bank. 

It seemed not to have slowed it down at all. 

Every optimist claimed that Pillar 2 of Basel II is designed exactly to prevent this sort of abuse from taking place. It enhances 

the scope for regulators to require capital above the regulatory 

minimum if they believe that the bank is exposed to some risks 

that are not well captured by Pillar 1 capital charges. 


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Again, I am skeptical that this will have much practical importance because bank supervisors have a very tough time in criticizing or disciplining banks that appear to be in good condition and 

are highly profitable. It has just never been very effective. 

We have, in fact, a very good recent example of just how ineffective it can be. Only weeks before Northern Rock collapsed, the Financial Services Authority in Great Britain authorized it to use the 

IRB approach under Basel II, which reduced its capital requirement by about 30 percent, which was dividended out to shareholders, and there is absolutely no evidence that the FSA even contemplated adding a Pillar 2 capital charge to compensate for it, although it could have done so on grounds that the Pillar 1 charge 

was inadequate or that the bank was exposed to an illiquidity 

shock or that its business model was simply too risky. But none of 

those things happened, and I think it is, in fact, very hard for it 

to happen. 

Finally, optimists say that Pillar 3, market discipline, would 

make a big difference because you would have better disclosure and 

better market discipline. I am skeptical on both counts, again. Pillar 3, as currently configured, does not really contemplate disclosure about SPEs or contingent commitments that would be at all 

useful to outside holders, although I understand that may well 

change at mid-year. Moreover, the way in which the authorities 

have dealt with this crisis has not really led to greater incentives 

for market discipline. In each of the cases—IKB in Germany, 

Northern Rock in the U.S., and Bear Stearns here—the authorities 

have acted in such a way that all counterparties and all creditors 

have been thoroughly protected from many of the consequences. 

And so there is really no incentive for market discipline in that. 

What are some of the defects in Basel II that have been highlighted by the crisis? Well, I think, again, there are defects in each 

and every pillar. Pillar 1 has two ways of levying capital charges. 

The simple way is the Standardized Approach, and the Standardized Approach relies very heavily on ratings by the ratings agencies. This strikes me as having two problems, one of them rather 

subtle and the other one really very apparent after our recent problem. 

The subtle problem is that the whole incentive for giving good, 

honest credit ratings changed markedly when the investors stopped 

paying for them, essentially, and it is made even worse when the 

demand for credit ratings is coming from regulated institutions 

that get lighter capital charges if they get better credit ratings. So 

I think it sort of adds to the pressures that tend to distort the credit rating system and lead to a world in which we have, say, structured credits and corporate credits bearing the same letter grades, 

even though they are strikingly different in actual risk. 

More importantly, however, I think that relying on ratings may 

introduce an element of systemic risk that we did not have before. 

If the ratings agencies get it wrong for an entire category of securities that are widely held, then that can be a systemic problem as 

opposed to simply getting it wrong for a corporation or even a country, which usually has a much lesser effect on the broader system. 

Pillar 2 is problematic because its treatment of liquidity is really 

very qualitative. I have not yet had a chance to study the new 


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guidance from Basel, but certainly improvement is highly warranted. More importantly, Pillar 2 leaves out any attention to 

reputational risk, yet it was concern over reputational risk that led 

a number of institutions to spend billions of dollars to take securities back into their books or to prop up funds. This happened with 

money market mutual funds. It happened even with some hedge 

funds. But probably most importantly of all, Pillar 2 completely ignores business risk, yet business risk has been responsible for 

about 18 percent of the volatility of U.S. bank earnings over time, 

and it is the fundamental reason that any business will hold capital. Yet it is really ignored by the Basel system. 

Finally, with regard to Pillar 3, the new disclosures are really 

not adequate to help external investors understand the exposures 

of individual banks to either structured debt or SPEs. But, more 

fundamentally, I think Basel II is actually making it more difficult 

to compare capital adequacy across banks, both within countries 

and especially across countries. Part of this is because Basel II 

comes with lots of implementation options. The Europeans have 

well over 100 different options, which have to be understood to understand what the capital number actually means. Moreover, differences in risk models mean that the very same asset held in two 

different banks may well have a different capital charge associated 

with it, which also makes it very hard to compare across banks. 

And, finally, although there have been attempts to achieve convergence between U.S. GAAP and IFRS or International Financial 

Accounting Standards, there are still huge differences. We got a 

glimpse of it recently when Deutsche Bank was obliged to go back 

to IFRS, having made the transition to U.S. GAAP previously. In 

January 2006, its treating position was 448 billion euros under 

U.S. GAAP, yet the same position counted as 1 trillion ten euros 

under IFRS. And that, too, creates problems in comparing across 

banks. 

What are the lessons that have been learned by risk managers 

and regulators? Well, lessons are an important stimulus for learning, and there has certainly been a considerable amount of learning 

by losing over this time. One of the problems has been simply one 

of having the right information and acting on it. It is terrifically 

difficult for a very large, complicated institution to be able to actually understand its exposures across a wide range. The studies we 

have seen that compare the banks that have done reasonably well 

in the current crisis with those that have not, usually begin with 

a much better management information system. And beyond that 

is what you do with it, and a number of firms simply had the information on hand, but did not really act very quickly. 

It is a matter of debate how soon you should have seen this coming, but I think, arguably, the losses that were reported by HSBC 

in February of 2007 were a time when any bank should have 

known that there was serious trouble coming down the pike. And 

yet we saw several institutions continuing to increase their participation in the market. 

Several firms experienced great difficulty in assessing liquidity 

risk. It appears that often the treasury function was not really fully 

integrated in the risk management system, and so there was little 

contingency planning for off-balance-sheet commitments or 


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reputational commitments, such as funding sponsored money market mutual funds to enable them to avoid ‘‘breaking the buck.’’ In 

some cases, this also involved sponsored hedge funds as well. 

Firms also experienced problems within the traditional risk silos, 

as they are called in the business, which are usually market risk, 

credit risk, and operational risk. The crisis exposed some of the 

limitations of value-at-risk or VaR-like analysis, particularly in 

dealing with illiquid instruments that are exposed to credit risk. 

They also showed a lack of attention to basis risk in hedging. 

There were correlations that simply did not work in the new crisis, 

and firms were very slow to realize that the changes were happening. 

Stress test scenarios also failed to prepare some institutions for 

the conditions that actually occurred. The crisis also exposed weaknesses in credit risk analysis. First and foremost was the failure 

to comprehend the deterioration in underwriting standards that occurred. But in addition, many firms had trouble tracking their multiplicity of exposures to various borrowers and counterparties, and 

in a very big, complicated bank, it is a very big challenge. 

With regard to operational risk, we have already commented on 

the weakness of many management information systems that were 

simply too slow to provide timely information about exposures 

across counterparties and products. But, also, I think there were 

problems in the lack of rigor for pricing systems. You could sometimes see the same asset priced differently if it were held in the 

firm’s own portfolio or if it were being priced as collateral for a 

counterparty. 

The crisis also exposed problems across the traditional risk management silos in firms that simply failed to realign their management to deal with the convergence of risk types in new products 

such as subprime-related debt. And there was a failure to anticipate the correlation to cross these risk types. 

I really think I will not comment on what the regulators may 

have learned because you have just heard from them, and I think 

they are still in the process of letting us know what they have concluded. What I would like to conclude with, however, is a weapon 

that I think is essential but is missing from the regulatory toolkit. 

In March, with the hastily improvised bailout of Bear Stearns, it 

seems to me the Fed crossed a regulatory Rubicon without the 

right weapons. They were very concerned that Bear was going to 

apply for bankruptcy, and we know that under a bankruptcy filing, 

the central feature is to impose stays. Stays can be incredibly disruptive in a firm that trades actively in markets and has primarily 

financial assets. The problem is, although they certainly have their 

merit in helping the courts understand who owes what to whom 

and how to get the best price, the problem in imposing stays in this 

kind of firm is that it can generate very substantial systemic 

spillovers. Clients and counterparties may lose access to their 

funds, and that causes problems for their own clients and counterparties in addition. And the lack of clarity regarding hedge positions also may transmit problems to other counterparties. 

If Bear had been a bank, the Fed, working with the FDIC, actually would have had a highly appropriate tool for dealing with the 

problem. Bridge banks, which Congress developed during the late 


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1980s and have subsequently been adopted by the Japanese and 

the Koreans—and I am told the British are even interested—would 

have enabled the regulators—and it is not clear exactly which regulator in this case because it did not contemplate investment 

banks. But it would have allowed it to take over the institution 

temporarily, continue the systemically important features, and impose discipline on some counterparties that should have been monitoring more carefully. 

Now that the Fed has actually crossed this regulatory Rubicon, 

it really needs to be better prepared for the next failure, even 

though we hope it does not come. Better resolution policies I think 

deserve a really urgent position on the policy agenda for both the 

United States and globally as well. 

Thank you. 

Senator REED. Thank you very much, Professor Herring. 

Mr. Blakely, please. 

STATEMENT OF KEVIN M. BLAKELY, PRESIDENT AND CHIEF 

EXECUTIVE OFFICER, THE RISK MANAGEMENT ASSOCIATION 

Mr. BLAKELY. Chairman Reed, thank you for the opportunity to 

offer commentary today on the subject of risk management and 

systemic risk. I have been asked to address three specific issues: 

the state of current models and systems for measuring risk management at large financial institutions; adequacy of risk management by risk officers and executive boards, including the sharing 

of information and communication among senior management; and 

what regulators have likely learned about risk management and 

what they can do to improve their response to future problems. 

Let me start by saying that the financial services industry is experiencing a great deal of difficulty today. It has been battered by 

a severe liquidity shortage and plunging valuations of marketbased assets. Those problems are now giving way to the next stage 

of distress, and that is, deteriorating asset quality, which may result in a new round of credit-related losses. 

Many have faulted financial models for playing a major role in 

the collapse of the capital markets, but I think that this charge is 

overstated. It is the human factor that played a greater role in the 

models’ dysfunction. Humans built the models, fed them their historical data, provided the assumptions that drive them, and interpreted their outcome. Before we villainize models as the guilty 

party in the market’s demise, we humans need to first take a look 

in the mirror and acknowledge our own significant role. 

As an industry, we now have a greater appreciation of models’ 

limitations and have discovered the need to supplement them with 

forward-looking analyses. The discipline of risk management is an 

evolving one. While many improvements have been made, many 

more are yet to come. Greater board-level attention on matters of 

risk will help. In that regard, financial institutions would be well 

advised to consider adding members to their boards who are conversant in risk management. Boards need to make certain that 

management focuses not just on revenue production, but also on 

the understanding of and pricing for risk that the company takes. 

Key elements that will facilitate such an outcome include defining 

a risk appetite for the company and implementing an appropriate 


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risk-based incentive compensation scheme. CEOs must play an active role in advocating the importance of risk and risk management. By witnessing the CEOs’ interest in risk, subordinates would 

be compelled to follow suit. Such engagement fosters a healthy exchange of risk information, ideas, and strategies throughout the 

company. The CEO must also ensure that risk management is the 

responsibility of everyone in the company. Allowing abdication of 

that responsibility to the chief risk officer is a recipe for failure. 

Regulators have already provided many valuable insights into 

the causes of the market turmoil and are taking steps to respond 

to it. They are also beginning to focus on the threats to the financial system specifically and to the economy more generally. By performing scenario analyses on financial sectors such as the credit 

derivatives market, as they are now doing, they are trying to anticipate problems before they have a chance to manifest themselves. Regulators have done a noble job of tempering a bad situation, despite having jurisdiction over only a fraction of the financial 

services industry. Changes to the scope of regulatory oversight of 

the industry, some of which have been offered by the current 

Treasury proposal, may assist in that regard. An increased level of 

dialog between regulators and boards of directors on risk governance will help elevate its importance and understanding. Further, 

with the insights gained from their oversight role, regulators are 

in a great position to share sound risk management practices 

throughout the industry. Although much work needs to be done to 

remediate deficiencies revealed by the market crisis, all concerned 

parties must be cautious in their approach. Overreaction can make 

a tenuous situation only that much worse. 

That concludes my opening remarks, and I would be pleased to 

answer any questions you might have. Once again, thank you, Mr. 

Chairman, for the opportunity to offer comment. 

Chairman REED. Thank you, Mr. Blakely. Thank you all, gentlemen, for excellent and thoughtful testimony. 

I know Professor Herring declined to comment on how well the 

regulators are doing, but my impression is that they are taking it 

extremely seriously, that they are looking at all the places that we 

would want them to look, but I think it is significant—and perhaps 

you might comment, all of you, please—that, you know, they did 

not suggest that there were any limitations in access to data or, as 

you would say, Professor, the right information. And I just wonder, 

not in sort of a ‘‘gotcha’’ sense, but in a sense of what you think 

specifically they should be doing—they very well might be doing it, 

but what they should be doing to sort of deal with what we have 

learned from this crisis to date. Let’s start with Mr. Bookstaber 

and go right down the panel. 

Mr. BOOKSTABER. I was sort of surprised, looking at their testimony versus my recollection being on the other side. I did not quite 

see the level of interaction that was described there, and that may 

just be because of the time that has passed since I was in these 

positions on the sell-side firms. 

The key thing that I think is missing in regulation in the United 

States is a true partnership with the risk management people inside the firm. I always felt that the FSA model was a very good 

model. And it contrasts quite a bit from what I would think of as, 


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say, the SEC model. You know, the SEC model is one where you 

have a legalistic view. You tend to work through subpoenas and so 

on, and basically it has a formalistic rule-based approach. 

The alternative is to have somebody on the regulatory side who 

has risk management expertise actually work more closely with the 

risk manager within the firm. He can also serve almost as an ombudsman, so that if the risk manager observes a risk which he 

thinks is of concern and maybe he is not getting the ear of senior 

management or they disagree with him, here is an outside, objective party who can look at it and can escalate it in a way that he 

cannot. So that may be a way of getting around some of the problems that we observe with incentives or with senior management 

that either does not care about or does not understand risk within 

an organization. 

The other difference is that if you are rules based in how you do 

risk management and you work on the basis of rules and regulations, you get into a gaming situation, because you set a barrier 

and the game then is for the financial institutions to find ways to 

get around that barrier, whether it is going off balance sheet or 

creating some innovative swap. And so the result is not only that 

you defeat the regulation, but that you increase the complexity of 

the market in the process so that the regulation actually is counterproductive. 

So that, again, suggests a move more toward the notion of what 

I think of as the FSA approach to risk management. 

Chairman REED. Thank you. 

Professor Herring, as you pointed out, FSA with respect to 

Northern Rock seemed to—I guess the moral of the story, there is 

no perfect form of regulation. 

Mr. HERRING. Yes, I think that model does not look quite as 

sparkling as it did perhaps a year ago, although I am in general 

agreement with the point that Mr. Bookstaber is making. The 

kinds of improvements that appear to be headed in the future are 

really more in the line of sort of refining and adding to what is already an enormously prescriptive system. We have moved from a 

very loose system in some sense to something that is enormously 

detailed and hideously complex. And the kinds of improvements we 

see indicated in some of these documents, although the details are 

really not available to us on the outside, strike me as heading us 

in the direction of still more complexity and still a more prescriptive setting. 

I agree that fundamentally it is a losing game. The regulators 

are never going to be quick enough or astute enough or have 

enough resources to catch up with the very innovative capital markets and the bankers that are really innovative. 

What should be done? Well, it seems to me that the regulators 

have to enlist the assistance of market discipline, that the market 

discipline is the only real prospect for keeping up with the incredible kinds of innovations going on in these institutions. 

Now, you have to ask where that market discipline should come 

from, and it probably would not be the shareholders, because the 

shareholders have a very different payoff function than society or 

creditors or the regulators. They will want to try to maximize the 


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present value of their investment, but they have no incentive to 

take account of spillover effects. 

On the other hand, creditors and counterparties do. Creditors 

and counterparties have a lot at stake if they actually believe that 

they are going to have to live with their choices. But my concern 

about the trend of bailouts over the last year is that creditors and 

counterparties are being pretty much assured that if it is a very 

large, very complicated institution, they are not going to have to 

worry. And I think that makes the system fundamentally more 

dangerous. I think we need to work toward a system where absolutely no institution is too big, too complicated, too interconnected 

to fail. And I think, in fact, we should have live, active plans to actually unwind any one institution, and that means having communications with press officers and knowing exactly who goes in 

where, because in that event you have some real prospect of market discipline. And if you use the bridge bank kind of format, you 

can do it without having massive disruption and spillovers in other 

markets. 

Chairman REED. Thank you. 

Mr. Blakely, the same general issue. You know, what do you 

think the regulators learned? What should they be learning? What 

should they be doing? And, obviously, give them credit for working 

hard at this issue. 

Mr. BLAKELY. Absolutely, they are, and I think they deserve a lot 

of credit for what they have done so far. And, in fact, as we talked 

throughout the industry, the industry itself is very grateful for 

what the regulators have done. 

But as I think about what more could they be doing, I think that 

one of the things that I would really encourage them to do is focus 

on the risk governance process in institutions, because I am not 

sure that that is an area that enough financial institutions are paying sufficient attention to. And the ways that they can do that is 

the regulators can make a pretty good assessment of is there a sufficient risk expertise at the board level; and, second, is the CEO 

adequately involved in the process of risk management; and, third, 

do both the board as well as the CEO understand what they’re 

incenting their employees to do. 

And I think by having frank discussions between the regulators 

themselves and the board of directors directly, we cannot underestimate the power of those kinds of conversations. Speaking from 

personal experience, I know that it is quite influential. 

Chairman REED. Thank you. For the information of the panelists, 

we have a vote scheduled shortly, so I—this could go for many, 

many hours given the expertise that we have assembled. But let 

me ask a final question—that is, pending written questions that 

you should be prepared to accept. 

We have talked about and focused and the last few comments 

have been on enterprise risk, understanding the CEO of all the different subsidiaries, et cetera, and that is an issue you just addressed. But then there is the larger question for the regulators, 

the systemic risk, and I am just wondering—you might comment 

again, Mr. Blakely, and we will go down the line about what we 

have to do if we get enterprise risk right, I think you have commented, to ensure that we get systemic risk. Is it about data? Is 


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it about formalized communication between regulators? Is it, as 

Professor Herring suggests, kind of making sure that the moral 

hazard issue has been removed and it is the market itself that regulates? 

Mr. BLAKELY. Well, clearly, I believe that the involvement of the 

Fed in the broader financial markets is a good thing. They have a 

history of dealing with the financial services industry in a way that 

some other regulatory agencies do not. They bring a breadth of experience and, frankly, tools to the table that other regulatory agencies may not. I think that they need to have a greater and deeper 

understanding of what goes on inside of individual institutions so 

that they can make an adequate assessment as to what type of a 

risk that poses to the industry at large. I also believe, too, that the 

regulators should work collectively together to try and identify systemic risks such as they are doing right now with regard to the 

credit markets—I mean the credit derivatives market, where they 

are bringing together folks from the industry as well as other regulatory agencies to try and understand in advance before a disaster 

happens just what might happen and what are the alternative 

courses of action. 

Chairman REED. Thank you. 

Professor Herring. 

Mr. HERRING. I would certainly agree with Kevin’s point. In addition, I think one might try to rethink how stress tests are devised. 

Typically, regulators are very reluctant to specify particular stress 

tests because they feel the institution will know what is most appropriate for its own conditions. But I think there is room for both. 

I think the regulators, in order to tell systemic effects, really ought 

to have at the same point in time returns from all institutions regarding particular stress scenarios so that they can anticipate what 

the market-wide consequences might be. 

I think there is another source of systemic risk that has sort of 

crept into the system without anybody paying much attention to it, 

and that is the sheer institutional complexity of our larger institutions. One of our institutions, for example, has 2,400 majorityowned subsidiaries, and they are in more than 90 different countries. It presents an incredible obstacle, I think, to the managers 

of that institution, but surely to the outside world to understand 

what in the world is going on. And I think that there is great merit 

and greater simplicity in institutional structure as well as in looking at stress tests that will cover all institutions. 

Chairman REED. Thank you. 

Mr. Bookstaber, please. Can you turn your microphone on, 

please? 

Mr. BOOKSTABER. I could comment a little bit on those two 

points, the stress test and the complexity. In my book, I focused on 

two components I thought were responsible for a lot of what we observe in market crises. One was leverage and the other was complexity. And the focus was on the complexity of innovative securities and derivatives, but also I had one chapter called ‘‘Colossus,’’ 

which used Citigroup as a case study. And it is interesting, I wrote 

that chapter in 2004, but the story was the same then as it is now, 

that when you get an organization that is as big as some of the organizations we observe, it is hard to get your arms around all of 


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32 

the risks and everything that is going on. And the solution is not 

simply to have a risk management structure that is bigger and bigger and bigger, because all that tends to do is diffuse the information flow. So I think what we need is a flight to simplicity, both 

from the structure of the types of instruments that we use and 

from the nature of the organizations. 

In terms of stress testing, this gets back to a point that I made 

in my oral remarks and in my written testimony that the problem 

is we do not have the data to stress what we need to stress. It is 

one thing to pose a scenario and stress based on that scenario; and 

if you do that, usually the scenario that you will choose is something that is based on history or based on the normal financial and 

economic relationships. But when a crisis finally occurs, what is 

driving it is a firm that is very leveraged, they are forced to sell, 

and then they have to sell in some other market where they are 

also big. 

So every time a large institution changes its positions, the nature 

of the risks that potentially can occur will also change. So ultimately, to really understand where a crisis might emerge and how 

it will propagate out, you finally need to know who is highly leveraged, what do they own, who else is leveraged, and what are the 

relationships between them. And those are where the stress tests 

have to be taking place, and the essential data still does not exist 

for the regulators to do this sort of stress test. 

Chairman REED. And is that something—just a quick follow-up 

question. That is something that you think would be appropriate 

for regulators to begin to collect on a systematic basis? Is it possible to do that, or is it—— 

Mr. BOOKSTABER. I think it is appropriate. I think you have to 

do it in a way that is very careful to realize the proprietary nature 

of the data, because we are talking about leverage and position 

data where, if other institutions knew about it, they could trade 

against the people and they actually would be adverse to liquidity 

in the market. This is sort of a technical point, but with the use 

of markup languages and so on, these types of data, though vast 

and varied, can be standardized in a way that they are relatively 

easy to collect compared to the way they used to be historically. So 

I do not think there is really a technological issue, and the key 

point, as I mentioned earlier, is you have to do it for all risk-taking 

organizations. 

Chairman REED. Well, gentlemen, thank you very much for your 

excellent testimony. My colleagues may have written questions 

which they would submit through the Chair, and I will set a June 

26th deadline. We would forward them to you, and we would ask 

you to respond within a week or two. But thank you very much for 

excellent testimony, and I have to run off for a vote. But we appreciate very much your participation. 

The hearing is adjourned. 

[Whereupon, at 4:18 p.m., the hearing was adjourned.] 

[Prepared statements supplied for the record follow:] 


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