```

[Senate Hearing 111-771]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 111-771

 
 PROHIBITING CERTAIN HIGH-RISK INVESTMENT ACTIVITIES BY BANKS AND BANK 
                           HOLDING COMPANIES

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             SECOND SESSION

                                   ON

   EXAMINING RECENT RESTRICTIONS PLACED ON COMMERCIAL BANKS AND BANK 
           HOLDING COMPANIES' HIGH-RISK INVESTMENT ACTIVITIES

                               __________

                            FEBRUARY 2, 2010

                               __________

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

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

                  U.S. GOVERNMENT PRINTING OFFICE
57-709                    WASHINGTON : 2010
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia             JUDD GREGG, New Hampshire
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

        William D. Duhnke, Republican Staff Director and Counsel

                 Amy Friend,  Democratic Chief Counsel

        Charles Yi, Democratic Counsel and Senior Policy Advisor

                     Dean Shahinian, Senior Counsel

               Mark Jarsulic, Democratic Chief Economist

                   Deborah Katz,  Legislative Fellow

                      Mark Jickling, CRS Detailee

                      Matthew Green, FDIC Detailee

                Mark Oesterle, Republican Chief Counsel

                 Jeff Wrase, Republican Chief Economist

                Hester Peirce, Republican Senior Counsel

               Mike Piwowar, Republican Senior Economist

                  Jeff Stoltzfoos, Republican Counsel

                    Andrew Olmem, Republican Counsel

                    Jim Johnson, Republican Counsel

           Rhyse Nance, Republican Professional Staff Member

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                       TUESDAY, FEBRURAY 2, 2010

                                                                   Page

Opening statement of Chairman Dodd...............................     1
Opening statements, comments, or prepared statement of:
    Senator Shelby...............................................     3
    Senator Johnson..............................................    48
    Senator Brown................................................    48

                               WITNESSES

Paul A. Volcker, Chairman, President's Economic Recovery Advisory 
  Board..........................................................     5
    Prepared statement...........................................    49
    Response to written questions of:
        Senator Bunning..........................................    57
Neal S. Wolin, Deputy Secretary, Department of the Treasury......     8
    Prepared statement...........................................    53
    Response to written questions of:
        Senator Bennett..........................................    58
        Senator Bunning..........................................    58
        Senator Vitter...........................................    59

              Additional Material Supplied for the Record

Gone Fishing: E. Gerald Corrigan and the Era of Managed Markets, 
  The Herbert Gold Society.......................................    61
The Volcker Rule & AIG: Hedge Funds and Prop Desks Are Not the 
  Problem, Christopher Whalen....................................    68
Prepared Statement of The Financial Services Roundtable..........    71

                                 (iii)

 PROHIBITING CERTAIN HIGH-RISK INVESTMENT ACTIVITIES BY BANKS AND BANK 
                           HOLDING COMPANIES

                              ----------                              

                       TUESDAY, FEBRUARY 2, 2010

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 2:30 p.m. in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd, Chairman 
of the Committee, presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. The Committee will come to order, and let me 
welcome our very distinguished witnesses this afternoon and the 
audience who is here and my colleagues, and I am sure there 
will be more coming in. This is a little out of the ordinary. 
Normally hearings like this we conduct in the morning, but I 
know that Chairman Volcker had conflicts in the schedule, so we 
are very grateful to you, Mr. Chairman, for accommodating us 
this afternoon and meeting with us here. And Neal Wolin we 
always welcome back. He does a great job at the Department of 
the Treasury, and it is an honor to have you here as well.
    As many of you may know, we are going to have a hearing on 
Thursday as well to follow up and hear from industry and other 
people talk about these ideas that have been proposed by the 
Administration, particularly by Chairman Volcker. So we are 
grateful to you for being with us this afternoon.
    What I will do is make a few brief opening comments myself. 
I will turn to Senator Shelby for any opening comments he may 
have, and then following what I now affectionately call the 
Corker rule, we will go right to our witnesses, unless some 
member here feels absolutely compelled to want to be heard 
before they are heard. Then we will accept any and all 
supporting documents and information you think would be 
worthwhile for the Committee to have. And then we will begin a 
line of questioning, and depending upon the number of people 
here, we will try and make enough time available so we have a 
thorough discussion of these ideas.
    With that, today's hearing is entitled ``Prohibiting High-
Risk Investment Activities by Banks and Bank Holding 
Companies.'' And, again, Chairman Paul Volcker and Neal Wolin 
are here as our witnesses, so I thank all of you for joining 
us.
    We meet today, as we have over these past number of months, 
in the shadow of a financial crisis that nearly toppled the 
American economy. It is worth repeating again the cost of the 
greed and recklessness that brought us here. Over 7 million 
jobs in our country have been lost. The retirement plans of 
millions of Americans have been dashed. Trillions of dollars of 
household wealth and GDP are gone. And, obviously, all of us, 
regardless of what your political party is or affiliation, we 
cannot allow this to happen again.
    The Obama administration has proposed bold steps to make 
the financial system less risky, and we welcome those ideas.
    The first would prohibit banks or financial institutions 
that contain banks from owning, investing in, or sponsoring a 
hedge fund, a private equity fund, or any proprietary trading 
operation unrelated to serving its customers. The President of 
the United States has called this the Volcker rule, and today 
Chairman Paul Volcker himself will make the case for it. I 
strongly support this proposal. I think it has great merit.
    The second would be a cap on the market share of 
liabilities for the largest financial firms which would 
supplement the current caps on the market share of their 
deposits.
    I think the Administration is headed in the right direction 
with these two proposals. Now, I know the timing of them and 
how they have been proposed at a critical time when we have 
been deeply engaged on this Committee on proposing ideas to 
reform the financial services sector has raised the eyebrows 
and other considerations by people. But I think we need to get 
past that, if we can, and think about the merits of these ideas 
and how they would work if they could, in fact, be put in 
place. So I would welcome the conversation we are going to have 
today and the remainder of this week on these issues.
    These proposals deserve our serious consideration, and so 
today we will have from the Chairman and the Deputy Secretary 
of the Treasury, Neal Wolin, and on Thursday we will hold 
another hearing with business and academic experts.
    These proposals were born out of a fear that a failure to 
act would leave us vulnerable to another crisis and a 
frustration at the refusal of financial firms to rein in some 
of these more reckless behaviors. I share that fear, and I 
share that frustration as well. And I strongly oppose those who 
would argue that the boldness of these proposals is out of 
scale with the need for reform. We need to take action, and we 
must consider scaling back the scope of activities banks may 
engage in while they are using deposits.
    And so today I look forward to hearing how these proposals 
may be most effectively applied to protect consumers and our 
economy and also, as a devil's advocate, why these ideas may 
not work and what risks they may pose if adopted.
    Some have objected to the Volcker rule on the grounds that 
it might not have prevented the crisis or that these particular 
limits are unwise. I think those objections are worth 
discussing, and I am interested in giving our witnesses and our 
colleagues here a chance to raise these items and a chance to 
have the kind of vibrant, robust debate and discussion about 
them. But we must take steps, I believe, to change the culture 
of risk taking in our financial sector, including the 
management and compensation incentives that drove so much of 
the bad decisionmaking.
    I applaud the Administration's commitment to scaling back 
risky behavior on Wall Street, and I thank Chairman Volcker and 
Deputy Secretary Wolin for joining us today to share their 
thoughts and ideas on these proposals. And I look forward to 
working with them and, of course, my colleagues here on this 
Committee, Democrats and Republicans, as we have been working 
over these past many weeks and months, to fashion a reform 
package that would allow us to step forward on a bipartisan 
basis here, a consensus bill that we could bring to our other 
87 colleagues in the Senate for their consideration and 
ultimately a conference with the other body and ultimately, of 
course, for the signature of the President of the United 
States.
    We have a lot of work left to be done, so this debate is an 
important one, and we welcome you today to share your thoughts 
and ideas on these proposals.
    Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    Chairman Volcker, welcome again to this hearing. I think 
one of my first few weeks on this Committee was you testifying 
when you were Chairman of the Federal Reserve. That was a few 
moons ago, as we both know, but we welcome you back.
    The financial crisis has had a devastating effect on our 
economy. Millions of people have lost their jobs, trillions of 
dollars of household wealth have evaporated, and the American 
taxpayer is on the hook for nearly all of it. We cannot allow 
such a calamity to occur again.
    For this reason, and others, I am willing to consider any 
proposal that will strengthen our regulatory framework and help 
our economy, including the President's latest recommendations. 
That is why I joined my Republican colleagues and asked for 
this hearing. Today, we hope we can gain a better understanding 
of the specific activities that would be banned under the 
President's proposal and the risks associated with those 
activities. We also need to understand clearly the costs and 
the benefits associated with the plan's proposed changes. 
Finally, we need to determine whether we should incorporate the 
President's latest ideas into the current regulatory reform 
debate or whether they can be considered at a later date.
    I believe our main goal today in regulatory reform must be 
to eliminate taxpayer exposure to private risk while 
establishing the strongest, most competitive, and economically 
efficient regulatory structure possible. Achieving this goal 
will involve ending bailouts, addressing ``too big to fail,'' 
reorganizing our financial regulators, strengthening consumer 
protection, and modernizing derivatives regulation, among 
others.
    Putting this together in a legislative package is a very 
difficult task, yet as difficult as our task may be, I remain 
committed to considering any concept that may help us achieve 
our overarching goal.
    With that said, however, I am quite disturbed by the manner 
in which the Administration has gone about introducing their 
latest proposals for consideration. We are more than a year 
into our deliberation on regulatory reform. The House already 
has completed action. Regrettably, the Administration waited 
until a little over a week ago to bring this very significant 
concept to the table. Seven months after the Administration 
first introduced broad recommendations that the President 
characterized as ``sweeping reform not seen since the Great 
Depression,'' this concept that we have before us today was 
air-dropped into the debate.
    I applaud Chairman Dodd for giving us the opportunity to 
begin a thoughtful process regarding the President's latest 
notions on regulatory reform. I hope, however, that this is not 
an indication that the Administration intends to substitute 
thoughtful analysis with whatever polls will on a given day. 
This is too important, it is too complex to be subject to the 
vagaries of political litmus testing. I know Chairman Volcker 
knows this, and I hope that he will continue to work with us.
    Mr. Chairman, last fall you offered a regulatory reform 
discussion draft, and while I supported your policy aims, I 
questioned the means at that time. In response, you rightly 
slowed the process to consider more carefully how to accomplish 
our mutual objectives. I believe we have made tremendous 
progress in that regard. Whether we ultimately reach a 
consensus remains to be seen, but we are working at it. And as 
I have said many times, we must get it right, and this is a 
goal that I know we both share.
    Thank you.
    Chairman Dodd. Thank you, Senator Shelby.
    Do any other members want to be heard on this matter? I 
made that offer before.
    Senator Bunning. Can I put one in the record?
    Chairman Dodd. Any comments at all in the record, by the 
way, obviously we will include that. I presume members may have 
opening statements, and they will be included in the record.
    Chairman Dodd. Chairman Volcker, again, I think most people 
here know you, but just for the sake of the record here, Paul 
Volcker currently serves as Chair of the President's Economic 
Recovery Advisory Board. He also heads up the Group of 30, 
which has been engaged internationally on financial regulations 
and last year released a very influential report, I might add, 
on financial reform. And prior to this time, as I think all on 
this Committee know and others working in the investment 
banking world, Chairman Volcker served as Chairman of the 
Federal Reserve from 1979 to 1987 under Presidents Carter and 
Reagan.
    Neal Wolin serves as the Deputy Secretary of the Treasury, 
having been confirmed by the Senate in May of this past year. 
Prior to assuming this position, he served in the 
Administration as Deputy Assistant to the President and Deputy 
Counsel to the President for Economic Policy. Prior to that, 
Deputy Secretary Wolin was the chief operating officer of the 
Hartford Financial Services Group and also served in various 
positions with the Clinton administration.
    Very impressive records, both of you. Chairman Volcker, 
again, welcome once again. You have been before this Committee 
on countless occasions over many years, over the past 30 years, 
and we welcome you here once again.

 STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, PRESIDENT'S ECONOMIC 
                    RECOVERY ADVISORY BOARD

    Mr. Volcker. Thank you very much, Mr. Chairman.
    Chairman Dodd. You have to turn that microphone on.
    Mr. Volcker. A familiar location, but I forgot to push the 
button.
    Let me say I do appreciate this unusual scheduling of the 
hearing. I did have a conflict this morning, coincidentally 
with the British Parliamentary Committee considering financial 
reform in Britain. So I am able to touch both sides of the 
Atlantic today with your rescheduling, and I appreciate that.
    Let me say off the bat, making a very simple statement 
because I think there is some confusion. A lot of this issue we 
are talking about today revolves around proprietary trading, 
and some people say, well, is it a big risk or a small risk or 
whatever. It certainly is a risk. Everything the banks do is a 
risk. This is not a question in my mind of what is the greater 
risk. It is a question of what risks are going to be protected 
by the Federal Government through the safety net, through 
deposit insurance, through the Federal Reserve, and other 
arrangements. And my view is that commercial banks have an 
essential function in the economy, and that is why they are 
protected. But we do not have to protect more speculative 
activities that are not an inherent function of commercial 
banking, and we should not extend the safety net, extend 
taxpayer protection to proprietary activities. So that is a 
very short summary of at least one of the issues here.
    As you know, the proposal that the President set out, if it 
was enacted, would restrict commercial banking organizations 
from certain proprietary and more speculative activities. But 
the first point I want to emphasize is that the proposed 
restrictions should be understood as part of the broader effort 
to deal with structural reform. It is particularly designed to 
help deal with the problem of too big to fail that Senator 
Shelby just emphasized--too big to fail and the related moral 
hazard that loom so large as an aftermath of the emergency 
rescues of financial institutions, bank and non-bank alike, in 
the midst of crises.
    Now, attached to this statement is a short essay that 
appeared in the press on Sunday to try to point out that larger 
perspective, but the basic point is that there has been and 
remains a strong public interest in providing a safety net--in 
particular, deposit insurance and the provision of liquidity in 
emergencies--for commercial banks carrying out essential 
services. There is not, however, a similar rationale for public 
funds--taxpayer funds--protecting and supporting essentially 
proprietary and speculative activities. Hedge funds, private 
equity funds, and trading activities unrelated to customer 
needs, unrelated to continuing banking relationships should 
stand on their own, without the subsidies implied by public 
support for depository institutions.
    Those quintessential capital market activities have become 
a part, a natural part of investment banks. And a number of the 
most prominent of those firms, each heavily engaged in trading 
and other proprietary activity, failed or were forced into 
publicly assisted mergers under the pressure of the crisis. It 
also became necessary to provide public support via the Federal 
Reserve, the Federal Deposit Insurance Corporation, or the 
Treasury to the largest remaining American investment banks, 
both of which assumed the cloak of a banking license to 
facilitate the assistance. The world's largest insurance 
company, caught up in a huge portfolio of credit default swaps 
quite apart from its basic business, was rescued only by the 
injection of many tens of billions of dollars of public loans 
and equity capital. Not so incidentally, the huge financial 
affiliate of one of our largest industrial companies was also 
extended the privilege of a banking license and granted large 
assistance contrary to longstanding public policy against 
combinations of banking and commerce.
    Now, what we plainly need are the authority and methods to 
minimize the occurrence of those failures that threaten the 
basic fabric of financial markets. The first line of defense, 
along the lines of the Administration proposals and the 
provisions in the bill passed by the House last year, must be 
authority to regulate certain characteristics of systemically 
important non-bank financial institutions. The essential need 
is to guard against excessive leverage and to insist upon 
adequate capital and liquidity.
    It is critically important that those institutions, its 
managers and its creditors, do not assume--do not assume--a 
public rescue will be forthcoming in time of pressure. To make 
that credible, there is a clear need for a new ``resolution 
authority,'' an approach recommended by the Administration last 
year and included in the House bill. The concept is widely 
supported internationally. The idea is that, with procedural 
safeguards, a designated agency be provided authority to 
intervene and take control of a major financial institution on 
the brink of failure. The mandate is to arrange an orderly 
liquidation or merger. In other words, euthanasia, not a 
rescue.
    Apart from the very limited number of such ``systemically 
significant'' non-bank institutions, there are literally 
thousands of hedge funds, private equity funds, and other 
private financial institutions actively competing in the 
capital markets. They are typically financed with substantial 
equity provided by their partners or by other sophisticated 
investors. They are, and should be, free to trade, free to 
innovate, free to invest--and free to fail. Managements, 
stockholders, or partners would be at risk, able to profit 
handsomely or to fail entirely, as appropriate in a competitive 
free enterprise system.
    Now I want to deal as specifically as I can with questions 
that have arisen about the President's recent proposal.
    First, surely a strong international consensus on the 
proposed approach would be appropriate, particularly across 
those few nations hosting large multinational banks and active 
financial markets. That needed consensus remains to be tested. 
However, judging from what we know and read about the attitude 
of a number of responsible officials and commentators, I 
believe there are substantial grounds, very substantial 
grounds, to anticipate success as the approach is fully 
understood.
    Second, the functional definition of hedge funds and 
private equity funds that commercial banks would be forbidden 
to own or sponsor is not difficult. As with any new regulatory 
approach, authority provided to the appropriate supervisory 
agency should be carefully specified. It also needs to be broad 
enough to encompass efforts sure to come to circumvent the 
intent of the law. We do not need or want a new breed of bank-
based funds that in all but name would function as hedge or 
equity funds.
    Similarly, every banker I speak with knows very well what 
``proprietary trading'' means and implies. My understanding is 
that only a handful of large commercial banks--maybe four or 
five in the United States and perhaps a couple of dozen 
worldwide--are now engaged in this activity in volume. In the 
past, they have sometimes explicitly labeled a trading 
affiliate or division as ``proprietary,'' with the connotation 
that the activity is, or should be, insulated from customer 
relations.
    Most of those institutions and many others are engaged in 
meeting customer needs to buy or sell securities: stocks or 
bonds, derivatives, various commodities or other investments. 
Those activities may involve taking temporary positions. In the 
process, there will be temptations to speculate by aggressive, 
highly remunerated traders.
    However, given strong legislative direction, bank 
supervisors should be able to appraise the nature of those 
trading activities and contain excesses. An analysis of volume 
relative to customer relationships and particularly of the 
relative volatility of gains and losses would itself go a long 
way toward informing such judgments. For instance, patterns of 
exceptionally large gains and losses over a period of time in 
the so-called trading book should raise an examiner's eyebrows. 
Persisting over time, the result should be not just raised 
eyebrows but substantially raised capital requirements.
    Third, I want to note the strong conflicts of interest 
inherent in the participation of commercial banking 
organizations in proprietary or private investment activity. 
That is especially evident for banks conducting substantial 
investment management activities, in which they are acting 
explicitly or implicitly in a fiduciary capacity. When the bank 
itself is a ``customer''--that is, when it is trading for its 
own account--it will almost inevitably find itself, consciously 
or inadvertently, acting at cross purposes to the interests of 
an unrelated commercial customer of a bank. ``Inside'' hedge 
funds and equity funds with outside partners may generate 
generous fees for the bank without the test of market pricing, 
and those same ``inside'' funds may be favored over outside 
competition in placing funds for clients. More generally, 
proprietary trading activity should not be able to profit from 
knowledge of customer trades.
    Now, I am not so naive as to think that all potential 
conflicts can or should be expunged from banking or other 
businesses. But neither am I so naive as to think that, even 
with the best efforts of boards and management, so-called 
Chinese walls can remain impermeable against the pressures to 
seek maximum profit and personal remuneration.
    Now, in concluding, I have added a list of the wide range 
of potentially profitable activities that are within the 
province of commercial banks. Without reading that list, the 
point is there is plenty for banks to do beyond any concept of 
a narrow banking institution. It is quite a list, and I submit 
to you to provide the base for strong, competitive, and 
profitable commercial banking organizations able to stand on 
their own feet domestically and internationally, in fair times 
and foul.
    What we can do and what we should do is to recognize 
curbing the proprietary interests of commercial banks is in the 
interest of fair and open competition as well as protecting the 
provision of essential financial services. Recurrent pressures, 
volatility, and uncertainties are inherent in our market-
oriented, profit-seeking financial system. But by appropriately 
defining the business of commercial banks, and by providing for 
the complementary resolution authority to deal with an 
impending failure of large capital market institutions, we can 
go a long way toward promoting the combination of competition, 
innovation, and underlying stability that we seek.
    Thank you.
    Chairman Dodd. Thank you very much, Mr. Chairman.
    Secretary Wolin.

STATEMENT OF NEAL S. WOLIN, DEPUTY SECRETARY, DEPARTMENT OF THE 
                            TREASURY

    Mr. Wolin. Chairman Dodd, Ranking Member Shelby, members of 
this Committee, thank you for the opportunity to testify before 
this Committee today about financial reform--and, in 
particular, about the Administration's recent proposals to 
prohibit certain risky financial activities at banking firms 
and to prevent excessive concentration in the financial sector.
    The recent proposals complement the much broader set of 
reforms proposed by the Administration in June, passed by the 
House in December, and currently under active consideration by 
this Committee. We have worked closely with you and with your 
staffs over the past year, and we look forward to working with 
you to incorporate these additional proposals into 
comprehensive legislation.
    The goals of financial reform are simple: to make the 
markets for consumers and investors fair and efficient; to lay 
the foundation for a safer, more stable financial system, less 
prone to panic and crisis; to safeguard American taxpayers from 
bearing risks that ought to be borne by shareholders and 
creditors; and to end, once and for all, the dangerous 
perception any financial institution is too big to fail.
    From the start of the financial reform process, we have 
sought to constrain the growth of large complex financial 
firms, through tougher supervision, higher capital and 
liquidity requirements, the requirement that larger firms 
develop and maintain rapid resolution plans, and the financial 
recovery fee which the President proposed at the beginning of 
January.
    In addition, both the Administration's proposal and the 
bill passed by the House would give regulators explicit 
authority to require banking firms to cease activities or 
divest businesses that might threaten the safety of the firm or 
the broader financial system. The two additional reforms 
proposed by the President a few weeks ago complement those 
reforms and go further. Rather than merely authorize regulators 
to take action, we propose to prohibit certain activities at 
banking firms: proprietary trading and the ownership or 
sponsorship of hedge funds and private equity funds, as well as 
to place limits on the size of the largest firms.
    Commercial banks enjoy a Federal Government safety net in 
the form of access to Federal deposit insurance, the Federal 
Reserve discount window, and Federal Reserve payment systems. 
These protections, in place for generations, are justified by 
the critical role that the banking system plays in serving the 
credit, payment, and investment needs of consumers and 
businesses.
    To prevent the expansion of that safety net and to protect 
taxpayers from the risk of loss, commercial banking firms have 
long been subject to statutory activity restrictions. Our scope 
proposals represent a natural evolution in this framework.
    The activities targeted by our proposal tend to be volatile 
and high risk. The conduct of such activities also makes it 
more difficult for the market, investments, and regulators to 
understand risks in major financial firms and for their 
managers to mitigate such risks. Exposing the taxpayer to 
potential risks from these activities is ill-advised.
    In addition, proprietary trading, by definition, is not 
done for the benefit of customers or clients. Rather, it is 
conducted solely for the benefit of the bank itself.
    Accordingly, we have concluded that proprietary trading and 
the ownership or sponsorship or hedge funds and private equity 
funds should be separated from the business of banking and from 
the safety net that benefits the business of banking.
    This proposal forces firms to choose between owning an 
insured depository institution and engaging in proprietary 
trading, hedge fund, or private equity activities. But--and 
this is very important to emphasize--it does not allow any 
major firm to escape strict Government oversight. Under our 
regulatory reform proposals, all major financial firms, whether 
or not they own a depository institution, must be subject to 
robust consolidated supervision and regulation--including 
strong capital and liquidity requirements--by a fully 
accountable and fully empowered Federal regulator.
    The second of the President's recent proposals is to place 
a cap on the relative size of the largest financial firms.
    Since 1994, the United States has had a 10-percent 
concentration limit on bank deposits. This deposit cap has 
helped constrain the concentration of the U.S. banking sector, 
and it has served the country well. But its narrow focus on 
deposit liabilities has limited its usefulness.
    With the increasing reliance on non-bank financial 
intermediaries and non-deposit funding sources, it is important 
to supplement the deposit cap with a broader restriction.
    Before closing, I would like to emphasize the importance of 
putting these new proposals in the broader context of financial 
reform. The proposals I have outlined do not represent an 
``alternative'' approach to reform. Rather, they complement the 
set of comprehensive reforms put forward by the Administration 
last summer.
    Added to the core elements of effective financial reform 
previously proposed, the activity restrictions and 
concentration cap that are the focus of today's hearing will 
play an important role in making the system safer and more 
stable. But like each of the other core elements of financial 
reform, the scale and scope proposals are not designed to stand 
alone.
    We look forward to working with you to bring comprehensive 
financial reform across the finish line. Thank you, Mr. 
Chairman and Senator Shelby.
    Chairman Dodd. Thank you very much, Mr. Secretary.
    We have a good participation here by members, so I will ask 
the Clerk to--why don't you put up 7 minutes on the clock for 
each of us, and again, I won't rigidly hold anyone to that, but 
sort of keep in mind that timeframe. We will ask both of our 
witnesses, if you can, to try and not filibuster. Although it 
is a habit here, we are not going to allow it with our 
witnesses, not too often, anyway. So if you will, try and keep 
your answers brief.
    Let me just say at the outset, again, I think the proposal 
you are making makes sense to me. But the question is, that we 
have as a Committee in the coming days, is crafting a bill. Any 
good idea, including this one, can have unintended 
consequences. What are the effects of this? How does it work? 
How do you put it into place? So I want to emphasize for my 
line of questioning, anyway, that while I am supportive of this 
idea, I want to raise some questions about the practicalities 
of how this would function and work, and so I begin with that 
in mine.
    Let me begin, if I can, because observers and others, and I 
am sure we will hear on Thursday some of these issues, not to 
mention today, as well, maybe from the members here themselves, 
have raised questions about how this prohibition on proprietary 
trading should be interpreted. How should Congress, for 
instance, set the boundaries of proprietary trading? 
Presumably, a separate trading in the design to produce trading 
profits would be prohibited. That is the presumption. But can 
we clearly separate bank hedging behavior, which I presume is 
something we would insist upon, from profit-making trades? How 
do you separate those activities? Would regulators have a 
difficult time enforcing this prohibition when you have that 
dual conflict, it seems to me, occurring?
    Why don't you begin. I don't care, either one of you can 
begin. Paul, if you want to start that.
    Mr. Volcker. Well, I addressed that question to some extent 
in my testimony, Mr. Chairman. It does put a burden, I think, 
inevitably, on the supervisor and the legislative intent ought 
to be very clear. Essentially, trading for one's own account 
unrelated to customer trading would be prohibited. Trading 
incidental to a customer relationship would be permitted.
    Now, how do you make that distinction? I think you can do 
it clearly over a period of time with sufficient accuracy to 
make the policy appropriate. One thing, as you said, you just 
look at sheer volume compared to the volume of customer 
business. You look at the pattern of gains and losses, which 
have a strong suggestion of proprietary trading, because if you 
are just quickly accommodating a customer, there are not likely 
to be big gains or losses.
    You don't have to have a cliff prohibition. It is clear 
that you want prohibition of purely proprietary trading, but if 
the other volume gets big enough to raise suspicion, you have 
the tool of capital requirements, which I think should be 
available and is available to the supervisor to suggest in a 
particular circumstance there ought to be a very heavy capital 
charge for this activity, and that would automatically limit 
it.
    Chairman Dodd. Secretary Wolin?
    Mr. Wolin. Thank you, Chairman Dodd. I agree with Chairman 
Volcker. I think that there are important questions here, 
obviously. I think we would basically want to embed in statute 
the basic principle that if it is not customer-related, that it 
is proscribed, but that if it is related to customer activity 
and hedging customer activity or making markets with respect to 
customer services, that that is on the other side of the line--
--
    Chairman Dodd. But how does hedging--if you are hedging at 
a bank, isn't that to the advantage of the customer of the 
bank, as well, so that the bank doesn't end up in financial 
trouble?
    Mr. Wolin. That is right, and Mr. Chairman, I think to the 
extent that they are doing proper hedging activity--and right 
now, regulators and accountants and so forth look at hedging 
activity and make judgments about whether it is true hedging 
activity or not all the time--I think that a big burden is to 
be placed on regulators in implementing the basic principle 
that I have just articulated and that Chairman Volcker has 
articulated, and I think they do this in a range of ways, 
including with respect to hedging currently and whether it is 
legitimate hedging activity or whether it is something else, 
with the basic principle again being whether it is customer-
related or whether it is for the firm's own balance sheet.
    Chairman Dodd. But you acknowledge this is an area where it 
poses some challenges for the regulator?
    Mr. Volcker. Well, it is an area you have got to work on 
and establish policies and procedures. I point out that 
accountants already face this problem in developing accounting 
standards as to which transactions of a bank are hedging and 
which are not hedging in accounting reporting.
    Take the case of AIG. They were heavily into credit default 
swaps. A credit default swap is presumably a hedging 
instrument. But I don't think anybody would look at what AIG 
was doing and say, oh, this is a hedging operation. It is not a 
trading operation. It was obviously a trading operation. It had 
nothing to do with protecting AIG. In fact, it was ruining AIG, 
it wasn't protecting it. And they were engaging in credit 
default swaps with people who were perhaps speculating on the 
other side.
    Chairman Dodd. I thought one of the problems there was they 
didn't hedge enough.
    [Laughter.]
    Mr. Volcker. They didn't hedge.
    Chairman Dodd. They didn't do what bookies do. They didn't 
lay off their bets.
    Mr. Volcker. That is quite right.
    Chairman Dodd. Let me ask you this, because your testimony 
on page three, Chairman Volcker, because this is an important 
point, I think, and you make it in your statement, you say--and 
I am talking to your first point here on page three. You say, 
first, surely a strong international consensus on the proposed 
approach would be appropriate, particularly across those few 
nations hosting large multinational banks, and you pointed out 
there may be 12 or so around the world that would fall into 
this category, and active financial markets. Further down, and 
I will just read the last clause, ``I believe there are 
substantial grounds to anticipate success as the approach is 
fully understood.''
    Again, being the devil's advocate, to some extent, because 
obviously the question is raised here, for us to impose this 
kind of a rule and not to have a complementary set of rules 
adopted internationally makes this basically unworkable, to a 
large extent.
    Now, to what extent--I agree with you. I would like to see 
the international community adopt what we would adopt here. But 
you have got a heightened degree of anticipation of this 
occurring, maybe more so than we could anticipate. Do we make 
ourselves vulnerable by insisting upon a certain standard here 
that we have to hope the international community might adopt, 
and if they don't, then we have left our institutions exposed 
to a vulnerability?
    Mr. Volcker. Well, I don't think it is impossible for us to 
do it alone if we had to. That is obviously not the desired 
outcome. But I wouldn't want to make the challenge too rigid. 
The really important other financial center, of course, is 
London, and if we can have some agreement, basically, a basic 
outline with the British, you have gone a long ways. Now, the 
Governor of the Bank of England has already called for an 
almost identical approach. The opposition party, at least, in 
the U.K. has indicated strong approach for development along 
this line. I cannot speak for----
    Chairman Dodd. They are not in government yet. The 
opposition party----
    Mr. Volcker. No, I understand. I understand. But the 
parliamentary committee which has people that are in office 
will issue a report. The government will decide, not that 
parliamentary committee, but we will be interested----
    Chairman Dodd. How did that committee go? Were these issues 
raised----
    Mr. Volcker. Pardon me?
    Chairman Dodd. You just said you had a hearing this morning 
with the parliamentary committee.
    Mr. Volcker. Right.
    Chairman Dodd. Was this issue raised, and what was the 
response?
    Mr. Volcker. Yes, the issue was definitely raised.
    Chairman Dodd. And what happened? What was the reaction to 
it?
    Mr. Volcker. Well, I told them--they pressed us to how wide 
this international comity ought to be and we discussed it was 
particularly important between the British and the United 
States. You may have noticed that President Sarkozy made some 
welcoming comment----
    Chairman Dodd. Yes, I saw those.
    Mr. Volcker.----about President Obama's initiative. The 
Finance Minister of France did, as well. So there is some 
quarreling among the banks, there is no doubt about it, 
relatively few banks. But I think the prospects for achieving 
what I think and many other people think is a very sensible 
approach is good.
    Chairman Dodd. Neal, do you want to comment on this?
    Mr. Volcker. Yes, Mr. Chairman. I would just add, the 
proposals that the President put forward a week or two ago with 
respect to scale and scope, I think are consistent with the 
principles that have been articulated by the G-20 leaders in 
London last year, again in Pittsburgh. A lot of the 
implementation work in that process is being carried out by the 
Financial Stability Board, and last week, the Chairman of that 
Board, Mr. Draghi, put out a statement consistent, I think, 
with some of the statements that Chairman Volcker was talking 
about, welcoming these proposals as a constructive part of this 
whole dialog with respect to financial reform.
    So I think we are moving forward in terms of creating 
agreement amongst the G-20. Obviously, we will need to keep at 
it. But I think there is reason to believe that this is 
consistent with a lot of the discussion that is happening in 
those fora.
    Chairman Dodd. Well, let me just say, and I will conclude 
on this and turn to Senator Shelby, I think it is also 
important in the United States to lead. We are the leading 
country in financial services, and I think if we don't act, 
then we leave ourselves--others are not apt to follow. So while 
I raise these questions about cooperation, I think this is an 
important moment for the United States to demonstrate that it 
gets this and understands what needs to be done, and that by 
doing this or setting something like this in place, I think you 
raise significantly the possibility others will follow. If we 
don't act, I think you can almost make a similar prediction----
    Mr. Volcker. That is very important.
    Chairman Dodd.----see that, as well.
    Senator Shelby?
    Senator Shelby. Thank you, Mr. Chairman.
    Chairman Volcker, commercial banks did engage in activities 
considered to be investment banking prior to the repeal, 
including some proprietary trading. But there does not seem to 
be evidence that I have seen that proprietary trading created 
the losses that resulted in the rate need and race for 
bailouts. Some argue it is questionable how curtailment of 
proprietary trading will protect the financial system from 
future instabilities, what we are going after.
    In addition, there are notable examples of failed 
institutions, such as Bear Stearns, Lehman Brothers, among 
others, that were at the root of the recent crisis but did not 
engage in commercial banking and were more dangerous by being 
interconnected than by being large. And while AIG did have a 
small thrift--it was a very small thrift--the systemic threat 
from AIG did not emerge from that thrift.
    Would you just share with us what you believe are the top 
three institutions that were engaged in proprietary trading and 
discuss what it was about these institutions that contributed 
to the financial crisis that we are confronting now?
    Mr. Volcker. Well, in following the development of the 
financial crisis, which was the mother of all financial crises, 
it was quite clear, particularly in the American perspective, 
that the financial crisis, the panic, the defaults, were 
proceeding through proprietary trading-oriented institutions, 
beginning with Bear Stearns and losses in hedge funds, and they 
were a trading institution. Lehman was very much a trading 
institution, Merrill Lynch, so forth. Some of them got saved 
by----
    Senator Shelby. But none of these firms were banks, 
commercial banks, at that time, were they not?
    Mr. Volcker. Well, the commercial banks got in trouble, 
too, but----
    Senator Shelby. I know that, but these firms you just 
listed----
    Mr. Volcker. These firms I just listed----
    Senator Shelby. Yes, sir.
    Mr. Volcker.----were not commercial banks until they were 
given a commercial--a bank holding company in the midst of 
crisis.
    Senator Shelby. Right. Yes.
    Mr. Volcker. That is right. Now, all I am saying is that 
was a demonstration that proprietary trading can be risky. Now, 
how can we bring that to heel, so to speak, and what this 
program suggests is two things. They will have the oversight 
body, we call it the oversight body, who can intervene with any 
capital market institution that is both large or very 
interconnected and presenting a risk to the whole system and 
limit the leverage, which had not been limited prior to the 
crisis. And the capital and liquidity had not been overseen. 
They ran free.
    And very important, we want to set up a system, and this is 
the whole philosophy, that those institutions will not again be 
rescued.
    Senator Shelby. That is right.
    Mr. Volcker. If they get in trouble, they are going to 
fail, and that will make their own financing more difficult, or 
less easy, and presumably in itself tend to contain their 
leverage. So between the oversight and their natural self-
protective instincts, hopefully, knowing that they are not 
going to be saved, we reduce the chance of crisis.
    Senator Shelby. Dr. Volcker, one of the President's recent 
proposals is a limit on consolidation in the financial sector. 
In particular, the President proposal would, to quote from a 
White House press release, quote,

        place limits on the excessive growth of the market share of 
        liabilities at the largest financial firms to supplement 
        existing caps on the market share of deposits.

    Along those lines, I have three questions. First, could you 
elaborate on what constitutes excessive growth and on what 
particular liabilities restrictions will be imposed there? In 
other words, what would excessive growth be? This is important.
    Mr. Volcker. Well, I think the only answer I can give there 
is like pornography. You know when you see it.
    [Laughter.]
    Senator Shelby. You need to see it.
    Mr. Volcker. I think Deputy Secretary----
    Mr. Volcker. You might see it, but would the regulators see 
it?
    [Laughter.]
    Mr. Volcker. Well, the regulators won't see it unless you 
give them some instruction.
    Senator Shelby. Yes.
    Mr. Volcker. Let me give you a little bit of history on 
this point. I haven't been engaged in these discussions----
    Senator Shelby. Yes, sir.
    Mr. Volcker.----and Neal ought to say something to the 
point, but I have been around for a while and I proposed to 
this Committee at one point, and maybe it was the House 
committee, in the 1980s, when there wasn't any interstate 
banking, that we should have nationwide banking, but we didn't 
want it dominated by just a few institutions, and we modestly 
suggested perhaps a 5-percent limit ought to be appropriate for 
any one bank in terms of deposits. Well, when the Congress 
finally got around to acting, they made the limit 10 percent.
    Now, I don't know exactly what limit they are going to talk 
about now, but I am sure it is more than 10 percent in assets 
relative to the country. So let me say, it is a matter of 
judgment, but if you are talking 15 percent, I would say that 
is a pretty big institution in the United States.
    Senator Shelby. That is a huge institution.
    Mr. Volcker. A huge institution.
    Senator Shelby. Dr. Volcker, my second question along those 
lines would be, could you tell me, or tell the Committee, 
actually, what limits will be on a firm's share of similar 
liabilities in the U.S. banking system in the global market or 
in a market in each country in which a U.S. firm operates? Or, 
let us say it is a foreign firm operates in this country. We 
have a lot of banks domiciled overseas that operate here.
    Mr. Volcker. That is correct.
    Senator Shelby. How would that work? How----
    Mr. Volcker. Well, I would hope that those banks that are 
really major, domiciled overseas but operating here----
    Senator Shelby. Yes.
    Mr. Volcker.----or owned overseas, would be in countries 
that adopt a similar approach. The big banks are in the U.K., 
they are in Paris. There is one in Germany. There are some in 
Japan, but the Japanese banks don't do this sort of thing 
anyway, so they are no question. The Chinese banks suddenly 
aren't going to become big proprietary traders in our market, I 
don't think.
    When you take care of Europe and the U.K., there may be a 
dozen banks there, maybe 20 if you mix in Canadian banks, and 
they provide competition here, which I think is good, but the 
competition ideally ought to be on similar grounds and they 
follow the same general proscriptions.
    Senator Shelby. Dr. Volcker, it is my understanding from 
counsel that under existing laws and regulatory authorities--
existing laws--banks and holding companies can be limited with 
respect to trading activities, including proprietary trading, 
under the safety and soundness considerations. Could you 
explain why you believe current authority is not adequate, if 
you do, and why you believe regulator discretion should be 
eliminated by statutory prescription?
    Mr. Volcker. Well, this is another area that I have----
    Senator Shelby. Do you have the concerns we do with a lot 
of the regulations----
    Mr. Volcker. Pardon me?
    Senator Shelby.----the regulators?
    Mr. Volcker. I have been around a little while----
    Senator Shelby. I know.
    Mr. Volcker.----partly as a regulator, sometimes contesting 
with the regulators, and I will tell you, if you just have a 
general permission for a regulator to put on adequate controls, 
the regulator ends up in an impossible position during fair 
weather, because all the banks will say, what are you talking 
about? Nothing has happened. My trading is perfect. We haven't 
had any big losses. You can't restrict us. I am going to go 
down to the Banking Committee and tell them you are going to be 
unfair and unreasonable, and that tends to be a bit persuasive 
of the regulators.
    I think you need a hard legislative proscription rather 
than a kind of loose--the House bill has a voluntary kind of 
provision, and if you just take away the word ``voluntary'' in 
the House bill, I think you have got a better bill----
    Senator Shelby. Yes, sir.
    Mr. Volcker. and say it is prohibited, not voluntarily 
permitted.
    Senator Shelby. Secretary Wolin, do you want----
    Mr. Wolin. Senator, I just wonder whether I could add 
something on the questions that you raised with respect to the 
size constraints.
    Senator Shelby. Yes, sir.
    Mr. Wolin. We believe that an important piece of trying to 
put an end to too big to fail is to constrain the size of 
financial institutions. That is something, as I suggested 
earlier, that is already well embedded in law. The problem with 
the deposit cap, which, of course, is such a device, is that it 
only applies in the sense to the safest kinds of liabilities a 
financial firm can have, and, at least implicitly, causes firms 
that want to grow beyond the funding or liability base that 
deposits represent into other sorts of funding which are 
riskier, still.
    And so we believe that in order to update, in effect, and 
make useful in a world in which deposits are no longer really 
the only or even the core source of funding for these biggest 
firms, that you need to have a definition of size that is more 
broadly gauged.
    Senator Shelby. Quickly, Mr. Chairman, consensus on these 
proposals--Mr. Wolin, part of the uncertainty created by recent 
proposals from the Administration regarding banks stems from 
uncertainty about cohesion among members of the Administration 
and among regulators. Following the announcement of the Volcker 
Rule and size limits, for example, Reuters reported that 
Treasury Secretary Geithner may have expressed doubts about the 
utility of size limits. Reports from July of last year 
identified possible disagreement between FDIC Chairman Sheila 
Bair and Secretary Geithner concerning bans on proprietary 
trading by banks.
    According to Chairman Bernanke of the Federal Reserve, bans 
on proprietary trading for commercial banks may not be 
constructive. Dr. Summers, Chief Economic Advisor in the 
current Administration, in the past has been a vocal proponent 
of removing Glass-Steagall restrictions on banks.
    My question is this. Is there a consensus within the Obama 
administration and among the regulators concerning the Volcker 
Rule and restrictions on size? And if so, what process--what 
was expressed there?
    Mr. Wolin. Thank you, Senator Shelby. I think that is 
obviously a very important question. The proposals that the 
President articulated with respect to size and scope 2 weeks 
ago were ones that were based on a consensus recommendation of 
all his economic team. And I think you have heard Secretary 
Geithner and you see Director Summers now speak to that quite 
directly.
    I think, with respect to the regulators, they are, of 
course, independent, so I think I feel slightly less 
comfortable expressing their views. But I do think that in the 
main, they are also supportive of this and we will work 
together with them and obviously with this Committee to try to 
move these ideas forward as an important part, we think, of 
making sure that firms are not overly risky and that the system 
itself is not overly risky.
    Senator Shelby. Mr. Chairman, you are being generous. I 
just want to make one statement, quickly. I don't believe 
myself that being big is necessarily bad. But I do believe that 
being big and thinking the government is going to bail you out 
is bad. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Senator Merkley?
    Senator Merkley. Thank you very much, Mr. Chair, and thanks 
to both of you for your testimony.
    I wanted to start by going to this distinction between 
trading in a fashion that is related to your customers and 
trading on your own account. One person summarized this by 
saying, it is like a grocery store that puts peanut butter on 
its shelf for its customers versus buying a whole warehouse of 
customer because it wants to speculate on how much peanut 
butter will be worth next week.
    I think that in your testimony, Mr. Volcker, you referred 
to a volume rule, and I believe that goes to the heart of how 
you distinction between peanut butter on the shelf to service 
customers and a warehouse to speculate on the price. Could you 
give us any more details on how that might work, and how much 
needs to be done by this body and how much needs to be, if you 
will, delegated so the fine print can be worked out by experts 
in the field?
    Mr. Volcker. Well, I think the answer to your question, it 
is going to have to be worked out by the regulators and 
supervisors. But I think what is important is you give them 
very firm directions as to what the object is, that proprietary 
trading is out. Trading incidental to a customer relationship 
is OK. You be careful about how you define that, but you are 
going to have to delegate it.
    Senator Merkley. Mr. Wolin, do you wish to add anything to 
that?
    Mr. Wolin. No. I think that is our view.
    Senator Merkley. OK. In addition to such trading on your 
own account creating risk, there is also the reference to it 
creating a conflict of interest when you are also managing 
funds, asset management and so forth. Do we have examples of--
is that a theoretical problem----
    Mr. Volcker. No, I don't think it----
    Senator Merkley.----or have we seen real evidence of that 
in the field?
    Mr. Volcker. I don't think it is at all theoretical, and I 
don't know what else I can say. It is very real. There has been 
quite a lot of discussion in the press and elsewhere, in 
particular institutions or particular agencies. It is bound to 
be real, because you are bound to run into a conflict between 
dealing for your own account and a customer who may--in your 
dealing for your own account, you may go directly contrary to 
one of your customers' interests. It is inevitable.
    It is inevitable, maybe not quite so inevitable, but it is 
very real that if you are doing a big customer business, that 
may help you kind of have a feeling about which direction the 
market is going in and might help your proprietary trading. It 
is just human nature, I must say, when you put these things 
together.
    Senator Merkley. And so when firms respond by saying, and I 
think you referred to it in your testimony, they can create a 
Chinese wall within the firm, which I assume means the Great 
Wall of China, broad, large distinction, separation, your 
belief is we can't create--it is impossible due to human nature 
to create such a wall that would be effective.
    Mr. Volcker. Well, I will tell you, I hate to tell you this 
story, but when I was a young officer of a bank and there was 
considerable controversy in the Congress about whether banks 
should be in the trust business and whether there were a lot of 
conflicts of interest, and I was asked in this bank to go 
examine this situation so that they could report to the 
Congress. I was just a young fellow and they said, look at the 
Chinese Wall. I thought they said Chinese Wall because they 
thought it was so permeable. I thought the Chinese Wall hadn't 
kept out the Huns. But that was not the meaning they meant to 
convey. But that initial impression of mine has never left me 
as I examined the Chinese Wall in that particular institution.
    Senator Merkley. Thank you. I want to turn then to another 
piece of this, which is depository institutions have access to 
low-cost credit through the Fed, and one of my concerns is that 
our banks, our commercial banks do an effective job in fueling 
businesses in our economy, getting loans out the door. Is it a 
significant concern? Is it a legitimate concern that if you 
have proprietary trading, trading on your own account, that 
funds that might otherwise have gone out in the form of loans 
to fuel our economy might end up buying the inventory, if you 
will, the financial inventory?
    Mr. Volcker. Well, I don't know if that is a big problem. 
Neal may want to speak to it. I don't believe the other is--
sometimes you will the argument that they have to do 
proprietary trading to make a lot of money to support the 
lending business. I mean, I don't believe the banks think that, 
oh, I will make a lot of money in proprietary trading so I will 
go out and make more loans than I would otherwise make. They 
will make the loans if they think the loans are profitable, 
quite regardless of whether they are making or losing money in 
the proprietary trading, in my view.
    Senator Merkley. Mr. Wolin?
    Mr. Wolin. Senator Merkley, I think it is an incredibly 
important question. You know, to the extent that firms are 
tying up capital through proprietary trading or in hedge fund 
businesses and so forth, the kinds of things that we have said 
we think should not be allowable by banking firms, they do not 
have that capital to be used for things like commercial lending 
activity and so forth. And so we think that, among other 
things, is a reason why this is a good set of proposals.
    Senator Merkley. Could I ask you, Mr. Volcker, to expand a 
little bit on what the--or Mr. Wolin--on what the actual 
proposal would be for the 10 percent limit on other 
liabilities? What other liabilities might be included in that 
analysis?
    Mr. Wolin. So the answer, Senator, is we do not have the 
details of that fully nailed down. We want to make sure that we 
get it right. We want to work with the regulators, with this 
Committee in coming forward with a proposal. We don't think 
that it ought to be a limit that is currently binding. We have 
said that. But with respect to what exactly is the percentage 
and what is the, if you will, the denominator of this fraction, 
we have not yet landed. We are still working on that and would 
want to work with this Committee on that.
    Senator Merkley. OK. Finally, in 30 seconds, the Basel II 
approach of internal risk limits that allows somewhat unlimited 
leverage in investment banks, do we need to rethink that and 
have more of a concrete leverage limit?
    Mr. Volcker. If you want my response, I haven't been 
involved in those very complex discussions, but I think you do 
need to do some rethinking of Basel II with some more explicit 
overall leverage limit, I think is a good thing. But a lot of 
the Basel II stuff has to be clarified and made, I believe, 
more binding. It rested very heavily on banks' internal risk 
management procedures and on credit rating agencies. Both of 
those have been somewhat discredited in the past couple of 
years, so a lot of rethinking is involved there.
    And that is a place where you need, speaking of common 
international per capita requirements, I think you do need a 
common standard. And getting agreement among a lot of--this is 
now a lot of countries. It is not just the United States and 
United Kingdom and Europe, it is Japan and China and emerging 
countries. And getting them all to agree is a challenge.
    Mr. Wolin. Senator, if I could just add, we do want to go 
forward with the implementation of Basel II. We have made that 
clear to our counterparts in Europe. But we also have said in 
the context of our White Paper and in the G-20 discussions that 
we think there ought to be leverage constraints, as well. And 
so we feel like there is an appropriate role for that in terms 
of, again, answering this basic question about core prudential 
standards and making sure that we deal with the too big to fail 
set of issues, at least in part, through other things, as well, 
but in part through tough standards on the front end.
    Senator Merkley. Thank you both very much. Very helpful.
    Senator Johnson. [Presiding.] Senator Corker?
    Senator Corker. Thank you, Mr. Chairman, and thank you both 
for being here.
    Chairman Volcker, I thank you for the time in your office 
in New York and in here. There are very few people that could 
announce a policy, and we would have a hearing this quickly, 
and I think it shows a right respect we have for you as an 
inflation fighter.
    Mr. Volcker. Thank you.
    Senator Corker. Secretary Wolin, thank you also for the 
many conversations.
    Just to sort of put this in perspective, I know we have 
talked a lot about banks, but your proposal actually says that 
a financial holding company or bank holding company, a 
conglomerate that is a financial institution, that has a 
commercial bank as a component of it, could not engage in these 
activities that you have talked about.
    Mr. Volcker. Yes. Let me be perfectly clear on that part. 
When I say bank, a bank as an organization, I mean all holding 
companies.
    Senator Corker. I know. I just say that for the listening 
audience. You are not just talking about the bank, but you are 
talking about the entire bank holding company, the affiliates 
that operate all around the world.
    Mr. Volcker. Yes.
    Senator Corker. None of those could be involved in this.
    And I just want to point out that while Senator Shelby did 
a great job of this line in questioning, I know this last 
crisis is causing us to focus on reform, and certainly we do 
not want to focus on the past always, but it is true that not a 
single organization that was a bank holding company or a 
financial holding company that had a commercial bank had any 
material problems at all with proprietary trading. That is a 
fact. Unless you refute that, I assume that will stand.
    Mr. Volcker. Now wait a minute. I do not know how far back 
in history you want to go.
    Senator Corker. I am talking about this last crisis.
    Mr. Volcker. Pardon me?
    Senator Corker. The last crisis. I know we spoke----
    Mr. Volcker. On the last crisis, not going really far back 
in history, I recall at the beginning of the crisis there was a 
very large lawsuit on a French bank from a single rogue trader. 
It was one trader that went out and cost them hundreds of 
millions of dollars.
    Senator Corker. In the United States of America, there has 
not been a single institution. I just want to point that out. 
We can move on, but it is a fact.
    Mr. Volcker. A banking institution or a non-bank?
    Senator Corker. There is not a single bank holding company 
in this last crisis that had a commercial bank that had issues 
that were material to failure relating to proprietary trading, 
not one.
    Mr. Volcker. Well, I would have to go look and look at the 
proprietary trading, but there were certainly American banks 
that took substantial losses in their trading book.
    Senator Corker. Well, maybe we can get back on that. So let 
me just go a step further. I am going to say that that is a 
fact unless somebody tells me different.
    Mr. Wolin. I think obviously the causes of distress in 
these very big firms are multi-factorial, but I think there 
were plenty of bank holding companies that suffered losses in 
hedge funds that they owned or sponsored, or in their 
proprietary trading activities, that were part of the capital--
--
    Senator Corker. I am talking about material.
    Mr. Wolin. For even material that caused, were part of why 
taxpayer money was committed, and so you know to pinpoint a 
single reason why this or that firm, I would say this is 
clearly one of the reasons.
    Senator Corker. OK, let me move on. My point stands, and we 
can talk about that. I take your point.
    Let me also make another point, that the capital of a bank, 
a commercial bank within a bank holding company or financial 
holding company, cannot leave and go to any other part of that 
affiliate without reducing the capital of that commercial bank, 
which reduces their ability to make loans and do that sort of 
thing. You all acknowledge that.
    Mr. Wolin. There are firewalls, Senator, absolutely, 
between the activities or the relationships between the banks.
    Senator Corker. I am talking about the bank's capital 
cannot leave the commercial bank and go to the other parts of 
the bank holding company without taking a reduction in capital 
at that commercial institution. That is a fact.
    Mr. Wolin. Right, but, Senator, of course, to the extent 
that capital is fungible in some sense and----
    Senator Corker. Twenty-three A and B limit that.
    Mr. Volcker. Look, I do not understand that at all, 
Senator. I used to regulate bank holding companies. If you 
think they cannot find ways of moving capital from one part of 
the holding company to another over time----
    Senator Corker. No. I am talking about leaving the 
commercial banking operation. It cannot leave it without 
reducing the capital of that commercial bank.
    Mr. Volcker. It may be that there is a restriction at a 
particular point in time from taking a lump of capital out of 
the bank into another part of the holding company. Over time, 
they will reallocate that capital the way they want to.
    Senator Corker. And they have to take a reduction in the 
bank's capital when they do that, the commercial bank's 
capital.
    So let me just ask a couple questions. I am just making 
that point to say that there are firewalls that exist and that 
no bank holding company failed, that had a commercial bank, due 
to proprietary trading or hedge funds or any of the activity we 
are talking about, and this is just in recent times, in the 
United States.
    So let me ask a question. For client good, could one of 
these institutions or their affiliates make a market for a 
client? I think the answer is yes. Is that under your proposal?
    Mr. Volcker. They certainly deal in response to a client's 
need.
    Senator Corker. If they wanted to sponsor a hedge fund, so 
that a client would know that the Volcker bank was creating a 
hedge fund and was going to seed capital, could they do that 
just to know that the bank had an investment there and it was a 
good enough investment for their client to be involved in? 
Would that be illegal under this proposal?
    Mr. Volcker. It would not be legal, if I understand the 
question, for the bank to sponsor a hedge fund.
    Senator Corker. Even if they were just putting seed capital 
in it to show good faith?
    Mr. Volcker. Yes.
    Senator Corker. Could a community bank trade bonds or 
mortgage-backed securities within their portfolio to balance it 
out?
    Mr. Volcker. Yes.
    Senator Corker. But that is proprietary trading, right?
    Mr. Volcker. Well, you said, you put the important word 
there, to balance out. If they run into an occasion where they 
had too much of this and too little of that
    Senator Corker. So let me ask this question. If we have a 
bill that, as you used the word, ends a company, creates 
euthanasia, and I think we might end up having a bill like 
that. If we have a bill that stipulates capital requirements, 
that says that if you are going to be in these risky areas of 
activity, that higher capital is going to be required, and I 
have an idea that we might end up with a bill like that. Would 
a proposal like this, through that lens, if those two areas 
were dealt with, would a bill like this or this type of 
legislation even be necessary?
    Mr. Volcker. Well, I think it would certainly be very 
useful, and that is what the Administration has proposed, as I 
understand the question. I would not think the Congress is 
going to specify precisely what the capital requirement is, but 
they are going to give the supervisor the authority, direction, 
that yes, they can change that capital requirement depending 
upon the----
    Senator Corker. The risk.
    Mr. Volcker.----designation as the riskiness of the----
    Senator Corker. Sorry. But if you had a resolution 
mechanism that said that if an institution failed, there were 
not going to be bailouts. They were going to be resolved out of 
business. And if you had a piece of legislation that stipulated 
that if a bank holding company engaged in risky operations, 
capital had to be increased, would there be a need for an 
arbitrary restriction of the type that has been laid out?
    Mr. Volcker. Well, I think so for the reason that I 
suggested earlier, that without the Congress being very clear 
in law as to what kind of activity is restricted or eliminated, 
or not, over time in fair weather the restrictions will erode 
away because it is very hard to maintain very tough 
restrictions when nothing is happening.
    And I think you need a clear legislative direction beyond a 
general statement that you were able to change. Supervisors can 
already change the capital requirement. They do not need 
legislation to do that. What they need is a clear legislative 
intent as to the acceptability of proprietary activities, in my 
view.
    Senator Corker. Mr. Chairman, I know my time is up. First 
of all, again I want to thank both witnesses for being here.
    I think there has been a misnomer put upon the American 
people by many commentators who talk about the fact that we 
give money to these banks, and they use them in casino 
operations, when in essence there already are firewalls that 
exist. Capital cannot leave a commercial bank to other parts 
without a charge against capital, reducing the capital. That is 
just a fact.
    And the fact is that foreign affiliates, I assume, would 
just be having these operations taking place in Dubai and other 
places.
    It just seems to me that I appreciate very much the policy 
being forth, but it seems to me that it is being put forth 
without taking into account some of the other things that may 
be a part of this legislative process which would render it 
unnecessary.
    Chairman Dodd. [Presiding.] Go ahead. Do you want to 
comment?
    Mr. Wolin. Yes, sir, I just wanted to. Although the 
firewalls are obviously important, insofar as these banking 
firms get a lower cost of capital, a lower cost of funding 
because of their access to the safety net, the entire bank 
holding company gets the benefit of some of that benefit, 
meaning capital is fungible, and their overall costs on a 
systemwide, consolidated basis is lower on account of it. So 
what we are saying is that that advantage should not be put 
toward these higher risks, more volatile kinds of activities.
    We agree that a higher capital standard is very important. 
We agree that the resolution authority of which you speak, 
absolutely critically important. But we also think that in 
order to make sure that taxpayers are not exposed to extra risk 
in these banking firms, that these three kinds of activities 
which are uncustomer-related ought to be proscribed.
    Chairman Dodd. Thank you, Senator.
    Before I turn to Senator Warner, one of the things I wanted 
to make a point very briefly on is clearly we are looking back, 
and I think it is appropriate--where are the gaps we need to 
fill in, so we do not have a repetition of the problems that 
brought us to this point in crisis.
    But one of the things we have also talked about, at least I 
have over the last number of many months, is looking forward as 
well. Not only is it a question of trying to plug gaps but also 
what is the architecture we are creating for the 21st Century 
that allows this Country to lead in financial services 
worldwide and, second, protect against potential problems that 
can emerge.
    I do not want just the argument of fixing a problem that 
created the issues we are grappling with today, but also what 
do we need to be thinking about as a Committee and as a 
Congress that goes forward.
    Senator Warner.
    Senator Warner. Thank you, Mr. Chairman. I thank you and 
Senator Shelby for having this hearing.
    Echoing Senator Corker, I appreciate the chances I have had 
to visit with you, Mr. Volcker, on this issue. And I do think 
there are challenges around some of the definitions, but I want 
to come back to that in a moment.
    If we go back to, I think, your accurate recitation of how 
we kind of got here and acknowledging, as some of my other 
colleagues have said, that most of the initial folks who got us 
into this downward spiral were not the commercial banks but 
were investment banks, and that in the throes of the crisis 
that the Fed and others decided to allow these investment banks 
to convert into bank holding company status.
    If we were to adopt the Volcker rule, in effect the first 
action would be, of a Morgan and a Goldman, they would lose 
that bank holding company status? Would that not be the first 
action they would take?
    Mr. Volcker. Well, it would be their choice.
    Senator Warner. Recognizing how much of their book is based 
on proprietary, hedge funds.
    Mr. Volcker. If they were going to maintain--I think those 
two institutions are quite different. But if they wanted to 
maintain a heavy emphasis on proprietary trading, they would 
have to give up the banking license, yes. If they wanted to 
retain the banking license, they would have to live within the 
rules of a bank.
    Senator Warner. Again, the concept being that the ability 
to have that access to the lower capital with the Fed window, 
that was the tradeoff, correct?
    Mr. Volcker. Right.
    Senator Warner. You talk about three different areas: 
proprietary trading, private equity and hedge funds. I mean I 
know you have talked a little bit about definition on the 
proprietary trading act.
    I do wonder. I used to be in the private equity business. 
There are private equity, subordinated debt, different types of 
instruments that kind of fall along that continuum of what we 
now broadly define as private equity. Some of those 
traditionally had been kind of traditional banking functions.
    Mr. Volcker. I mean I think that is true. I was concerned 
about the opposite side of that, the fact that you could not 
prohibit something called an equity fund, and a bank that 
developed something that looked very much like an equity fund, 
but they did not call it an equity fund. And the false----
    Senator Warner. The same may be said about hedge funds, 
right?
    Mr. Volcker. Yes, the same thing you say about hedge funds 
which could become often a vehicle for just conducting 
proprietary trading operations. That is why the legislative 
language I think has to be pretty clear, to tell the 
supervisors that if somebody is getting around the obvious 
intent of the rule, the supervisor can do something about it.
    Senator Warner. Would you care, or Secretary Wolin, would 
you care to rank? The legislative process is always a little 
bit of give and take here.
    Is the primary aim here we want to try to prohibit the 
proprietary trading activities, and proprietary trading 
activities being remarked or remasked as a hedge fund or a 
private equity investment?
    Or would you say, no, we want to take--the first thing we 
want to get rid of is the private equity and then hedge funds 
and, last, proprietary trading? Is there a rank order of these 
three?
    Mr. Volcker. Not to me because I think to some degree they 
are substitutable, as you were saying. Some banker pointed out 
to me the other day my language is too limited. I should say 
something about real estate funds, which are really important 
to some banks. I kind of think of that as part of a private 
equity fund, but you could explicitly say real estate funds.
    But I think there is enough substitution. I do not see any 
reason to permit one and not permit the other.
    Senator Warner. Secretary Wolin, is that also----
    Mr. Wolin. It is. I think the core distinction, Senator 
Warner, was customer, non-customer. Obviously, there are, and 
the regulators will have to deal with some definitional issues 
as they implement the basic principle if it were to be lodged 
in statute.
    What we said is there are a whole lot of activities that 
traditionally have been in sort of the investment banking 
sphere, with respect to underwriting and asset management and 
so forth, which are OK. But as respects the three things that 
we think are not customer-facing and fundamentally more risky, 
riskier, I think I would avoid the opportunity to link within 
those.
    Senator Warner. I would concur with Secretary Volcker, that 
having been pitched by some of those firms along my career, 
those Chinese walls disappear oftentimes when you are being 
pitched as a potential client, the value of being able to kind 
of commingle and cross-mingle these different functions.
    One of the things about this, and I know everybody else has 
raised this as well, is I kind of struggle with this size cap 
approach. Clearly, the deposit cap approach, as you have seen, 
the ability to kind of lever up outside the depository 
institution, has not created the kind of diminution of 
accumulation of capital and system risk in a few top 
institutions. I know where you are heading, and I am saying I 
do not completely disagree with that, although again the 
challenge comes how do you write it out.
    From both the standpoint of putting American firms at a 
competitive disadvantage, I think the Chairman has raised that. 
If we do this and the rest of the world does not follow suit, 
and even if we are able to get some of our European friends to 
go along, could you see a migration to chartering some of these 
institutions in a kind of one-off company, country, that could 
avoid then this kind of restrictions even say the industrial 
world puts in place? But then we create a next generation of 
Cayman Island-based funds or firms.
    Then do we also have the problem that we do not want to 
give an undue competitive advantage, which they do have at this 
point in terms of cost of capital, to these large firms? But, 
at some point, do the best people leave these firms when they 
start bumping against this size cap?
    Mr. Wolin. Well, I would say, Senator, and I think those 
are all extremely important questions, I agree with Senator 
Shelby that size by itself is not the only thing. But we do 
believe that it is an important element of risk and that there 
is a meaningful correlation in general between size and risk, 
and it is part of what we are trying to constrain, not the only 
thing to be sure.
    I think on competitiveness U.S. banks are already 
relatively smaller than an awful lot of financial institutions 
in Europe and elsewhere in the world, and I think they compete 
awfully well as it stands. So I do not think that is liable to 
be a competitive problem.
    As I think Chairman Dodd said, at the end of the day, the 
most important thing for the competitiveness of our financial 
system is that it is safe and sound, and that people will see 
it as safe and sound. And that will, I think, be an awfully 
important thing going forward to make sure that we do maintain 
the strong competitive position of the U.S. financial services 
industry.
    So I think those are all considerations that we have for 
those questions.
    Senator Warner. But I think capital requirements, leverage 
restrictions, convertible debt requirements, funeral plans may 
also be other tools we could use----
    Mr. Wolin. Absolutely.
    Senator Warner.----that would not go at this plain, 
straight-out size.
    Mr. Wolin. No question, there are other tools. We think 
they are important other tools, but we believe that in the same 
way that the deposit cap is an important tool, but an 
insufficient tool, that we ought to also pay attention at some 
level, not in a way that binds currently. Some we are not 
talking about dismantling these firms, but that at some level 
size really does become an important element of systemic risk, 
and to be defined obviously together with you all and with the 
regulators.
    Senator Warner. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Senator Johanns.
    Senator Johanns. Thank you, Mr. Chairman.
    There are many things, as I think about where we are headed 
with financial reform, that I think there is consensus on. I 
think resolution authority. Gosh, I think most of us are there, 
if not all of us. Systemic risk and how we approach that, there 
may be some difference of opinion about how we approach it, but 
again I think we are there.
    This one, though, I must admit I have sat through this 
hearing, and I get more confused as you testify. You are not 
really clearing up for me what we are doing.
    So let me just ask a pretty straightforward, maybe a bit of 
a basic question to start out with. Tell me the evil that you 
are trying to wrestle out of the system by this rule. If we 
were just to say great, we are with you, we pass it the way you 
want it passed, what evil disappears?
    Mr. Volcker. Well, I don't know if you want call it evil. I 
feel that I have failed if you are more confused than you were 
before.
    Senator Johanns. That is all right.
    Mr. Volcker. What I want to get out of the system is 
taxpayer support for speculative activity, and I want to look 
ahead. If you do not bar that, it is going to become bigger and 
bigger, and it becomes, adds to what is already a risky 
business. And I do not want my taxpayer money going to support 
somebody's proprietary trading. I will make it as simple as 
that.
    Senator Johanns. But here is the problem, Mr. Chairman, and 
here is where I am struggling to follow your logic, and let me 
just give you some concrete examples. AIG, how would this have 
prevented all the taxpayer money going to AIG? If this rule had 
been in place, what would have been different? Anything?
    Mr. Volcker. Well, first of all, I think AIG is a big 
insurance company that should have been better supervised in 
the first place than it was. If it had an effective supervisor 
of AIG and it had not been an affiliate of, what, a small 
thrift?
    Mr. Wolin. Small thrift.
    Mr. Volcker. Somehow it was a bank because it had a small 
thrift appendix. Somebody should have been there and saying, 
what are you doing over there in London, with trillions of 
dollars of credit default swaps? You are jeopardizing your 
business.
    Senator Johanns. But, see, we can stipulate to that. I have 
said many times, I have never seen so many people paid so much 
money to do so many stupid things.
    Mr. Volcker. Right. Well, we want to shut off one area of 
stupid things.
    Senator Johanns. Yes, but let's say the Volcker rule had 
been in effect, would that have stopped AIG from doing this?
    Mr. Volcker. If it was in effect for insurance companies, 
it certainly would have stopped that.
    Senator Johanns. OK. So you are saying that if the Volcker 
rule had been in place, AIG would not have happened?
    Mr. Volcker. Well, you are assuming that the Volcker rule 
is in effect with an insurance company, which is not 
immediately at issue here.
    Senator Johanns. Right.
    Mr. Volcker. If it had been in effect on an insurance 
company----
    Senator Johanns. OK, so we can kind of set that one to the 
side, I think.
    Mr. Volcker.----and you had a particularly effective 
capital requirement alongside the complementary approach, I 
believe that we would not have had a trouble with AIG.
    Senator Johanns. Well, see, I think you are losing me 
again.
    Mr. Volcker. I mean I am puzzled why I am losing you.
    Senator Johanns. Here is why you are losing me. I do not 
think the Volcker rule would have stopped the behavior of AIG.
    Mr. Volcker. Why not?
    Senator Johanns. Because we are talking about banking 
institutions. They did not take deposits, right?
    Mr. Volcker. Yes, yes, the fact that an insurance company 
was not covered is a different problem.
    I think insurance companies. If you have the time, I would 
suggest that you enact a Federal supervisory agency for 
insurance companies too, but that is not right on the docket.
    Senator Johanns. Yes, but that is not what we are doing 
here today, and I am trying to figure out how----
    Chairman Dodd. Not only today, what about a limit? Thanks, 
Chairman Volcker, for another issue for me to grapple with.
    [Laughter.]
    Senator Johanns. What I am trying to figure out, Mr. 
Chairman, is this, how we are going to even deal with 
preventing what happened by doing what you are asking us to do, 
and I do not see how we are getting there.
    So AIG, I think your answer is saying we would even have to 
go further than what you are asking.
    Now let me go to Lehman. Would we have solved the problems 
with Lehman, had the Volcker rule been in place? Are they not 
yet another institution that was not taking deposits but were 
doing some----
    Mr. Volcker. The Volcker rule, much as I would like to say 
it solved all problems, does not solve all problems. It is part 
of a, I think, coherent reform of the financial system.
    Lehman, under not just this issue, they are not a bank. So 
the rule would not have applied.
    But under the general regulatory approach that has been 
proposed by the Administration, you would have had presumably a 
leverage restriction, a capital restriction on Lehman, and you 
would have had the resolution authority that you favor. I hope 
and believe that combination would have reduced a very good 
chance that Lehman would not have failed.
    Senator Johanns. Here is where I think we are getting to, 
though, based upon what you are saying to me, and I think it is 
now clear. You are saying I think, Mr. Chairman, that this is a 
great opportunity since we are doing financial reform anyway to 
put this rule in place. But it really would not have solved the 
problem with AIG. It really would not have solved the problem 
with Lehman.
    Mr. Volcker. It certainly would not have solved the problem 
at AIG or solved the problem with Lehman, alone. It was not 
designed to solve those particular problems.
    Senator Johanns. Exactly. That is the point. You know. This 
kind of reminds me of what the Chief of Staff said, never let a 
good crisis go to waste.
    What we are doing here is we are taking this financial 
reform, and we are expanding it beyond where we should be. And 
I just question the wisdom of that, unless somebody can make 
the case to me that had this been in place the world would have 
been differently.
    Mr. Secretary----
    Mr. Volcker. The Chairman made the point that I would 
emphasize, that the problem today is look ahead and try to 
anticipate the problems that may arise, that will give rise to 
the next crisis. And I tell you, sure as I am sitting here, 
that if banking institutions are protected by the taxpayer and 
they are given free rein to speculate, I may not live long 
enough to see the crisis, but my soul is going to come back and 
haunt you.
    Senator Johanns. That may be. There will be a lot of 
people. You would have to stand in line maybe.
    [Laughter.]
    Mr. Wolin. Senator, if I could just add, I think your 
question is obviously a critically important one. The Volcker 
rule, were it to have been in place, I think would not have 
solved all the problems and nor is it the only piece of what we 
think is a comprehensive package of proposals. But there were 
plenty of bank holding companies that did suffer losses in 
their hedge funds and in their proprietary trading activity, 
that had capital holes that were in part therefore filled by 
taxpayer funds.
    We think as we go forward the real goal here, at the end of 
the day, is to create a financial regulatory system in which 
firms do not pose undue risk and where the whole system in its 
entirety is well protected. Our view is that having banking 
firms that fundamentally subsidize their riskier activities in 
these areas because they have access to the safety net is 
something we can and should avoid as we construct a framework 
going forward.
    Senator Johanns. But here is the challenge that you have 
here today, I think, in trying to move this Committee in this 
direction. The challenge is this: When you say, well, I can 
find some places where they lost money, my response to you on 
that is and you know what, I can find some places where they 
lost money on mortgages, on commercial real estate, on 
residential real estate.
    So what are we getting to here?
    Mr. Volcker. Let me try that one. Commercial banking, as I 
said, is a risky business. Now the question is whether you want 
to, in effect, provide a subsidy or provide protection when 
they are lending to small business, when they are lending to 
medium-size business, when they are lending to homeowners, when 
they are transferring money around the Country. Those are 
important continuing functions of a commercial bank, in my 
view, and I do think it is deserving of some public support.
    I do not think speculative activity falls in that range. 
They are not lending to your constituents. They are out making 
money for themselves and making money with big bonuses. And why 
do we want to protect that activity?
    I want to encourage them to go into commercial lending 
activity.
    Senator Johanns. But, see, you are assuming something about 
what I am doing. I do not like the bailouts. I voted against 
TARP, the second tranche of TARP. Quite honestly, I do not 
think we should put the taxpayer in that position.
    But I also likewise think that if your goal is to try to 
wrestle risk out of the system, you get to a point where quite 
honestly you do not have a workable system anymore, and that is 
what worries me about where you are going here--is because you 
are using this opportunity to put into place something that has 
some pretty profound consequences, and I am not sure these 
circumstances justify that step. That is why I ask these 
questions.
    Mr. Volcker. Well, that is a reasonable question. I am 
sorry I apparently cannot get through with the answer, but I do 
not want to restrict commercial banks from doing commercial 
banking, traditional business. I do not want to. I want to 
encourage their lending. I do not want to encourage their 
speculative activities.
    Senator Johanns. Let me just wrap up. I am out of time, and 
I thank the Chairman.
    I really appreciate both of your being here. I really do. 
And we are wrestling with some very tough issues here, trying 
to figure them out, understand them, without damaging the 
economy.
    Mr. Volcker. I understand.
    Senator Johanns. So it is critically important that we ask 
these tough questions.
    Mr. Volcker. I am glad you asked them, because they have 
got to get answered.
    Senator Johanns. Thank you.
    Chairman Dodd. Thank you, Senator, very much.
    Senator Johnson.
    Senator Johnson. Thank you. Thank you, Chairman Volcker and 
Secretary Wolin.
    Chairman Volcker, one of the actions taken by the Fed 
during the crisis was transforming large non-banks into bank 
holding companies with access to the Fed's discount window. 
What should be done with investment banks that became bank 
holding companies if the Volcker rule is adopted?
    Mr. Volcker. Well, if the rule was adopted, they would not 
have been engaging, obviously, in some of these activities. But 
they could still get in trouble. Banks have had a history of 
centuries of getting in trouble. So that is one of the reasons 
we have a Federal Reserve. If they get in trouble and it seems 
to be a viable institution, a solvent institution, you have 
recourse to the Federal Reserve to handle even rather extreme 
liquidity needs, and I think that is totally appropriate. That 
is one form of Government support given to the banking system, 
and I do not see that changing. I think it is important to 
provide that backstop, and almost every country in the world 
provides that kind of backstop to its banking system. So that 
does not change.
    Senator Johnson. Secretary Wolin, if the proposal includes 
a provision that gives banks the explicit choice to exit the 
bank holding company regime, do you have any concerns that this 
would create new regulatory gaps? Are there concerns that 
American companies would go abroad where there are not 
proprietary trading restrictions?
    Mr. Wolin. Senator Johnson, I do not think that we are 
likely to see regulatory gaps. Our proposal would say whether 
you choose to be a bank holding company or a financial company 
that can do these other activities, you would still be subject 
to the overall consolidated supervisory regime that has strong 
capital standards, leverage requirements, liquidity 
requirements, and so forth. So from that perspective, there are 
other pieces of our proposal which we think are absolutely 
critical that would still apply to those firms that chose no 
longer to be bank holding companies.
    On the international dimension of your question, Senator, 
again, I think we are working closely with our G-20 partners to 
make sure that we get a regime that works worldwide so that we 
do not have new opportunities for arbitrage. I think as the 
Chairman said very eloquently, it is important for us to lead 
in that effort, and we are leading. And at the end of the day, 
again, I think that for us to have a strong regulatory regime 
is in some sense the most important competitive advantage that 
we could create because capital will want to flow where it is 
going to be protected and safe and where the overall framework 
is one that can be relied upon.
    Senator Johnson. Chairman Volcker or Secretary Wolin, it is 
my understanding that the Federal banking regulators already 
have the discretionary authority to impose activity 
restrictions right now very similar to what would be mandated 
by the Obama proposal. The Fed may require a bank holding 
company or a financial holding company to terminate any 
activity or divest control over any subsidiary that has a 
reasonable belief that constitutes serious risk to the 
financial safety, soundness, or stability of a subsidiary bank 
on a firm-by-firm basis.
    Do you believe that the Fed has this authority? Are there 
specific examples in the last 2 years where you think they 
failed to use this authority?
    Mr. Volcker. Well, I have no doubt that they need further 
instruction from the Congress, if I can put it that way. I do 
not know, I have been too far removed as to what authority the 
Federal Reserve would have to prohibit some activities. Some of 
these activities--most of them are provided for in law, and the 
law says a bank can do so-and-so. I do not think the Federal 
Reserve can lightly say, ``I do not care what the law says. You 
cannot do it.''
    They can have general concern about safety and soundness 
and, within limits, I think they can say, ``You are conducting 
a particular activity in a very risky way and do not do it.'' 
But I am not sure they can say you cannot do proprietary 
trading; the law permits it. I think they need further 
instruction.
    Senator Johnson. Mr. Wolin?
    Mr. Wolin. Senator, I think the Fed and the other 
regulators do have a broad set of regulatory authorities to act 
in circumstances where they think safety and soundness is at 
risk. Our proposals suggest those authorities ought to be 
clarified and strengthened. But in these three areas, we 
believe that it should not be left up to the discretion of the 
regulator; that if you are going to get the benefit of the 
safety net that banks and banking firms enjoy, you should not 
be allowed to do these three activities which are riskier and 
would get the subsidized benefit in effect of that access to 
the safety net.
    So we think it is important for the regulators to have even 
stronger authorities to act in a discretionary way to make sure 
that when they see something in a firm or that is broader, that 
they can take appropriate action. But this ought to be hard-
wired, in our view.
    Senator Johnson. What are the benefits of restrictions of 
activities on a wholesale basis instead of restrictions on a 
firm-by-firm basis?
    Mr. Volcker. I think you want some consistency over the 
industry, is all I would say about that. I do not think you 
want to say Firm A can deal in this business and Firm B cannot.
    Now, you might because of particular circumstances have 
some reason to think Firm B is taking extreme actions that are 
not creditworthy, and so you say, ``Stop it,'' because they are 
going overboard. But I do not think you can say they do not 
have the same authority to take action that another bank does.
    Senator Johnson. My time is up.
    Chairman Dodd. Thank you very much, Senator.
    Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman. Thank you both 
for being here. I appreciate it very much.
    In your written statement, Secretary Wolin, you said we 
should limit the ability of financial institutions to get 
bigger. That is in your written statement. But, Chairman 
Volcker, you do not address the size of firms in your 
statement. Do you agree with Secretary Wolin that we should 
limit the size of financial institutions? And if so, what 
limits would you put or should we set?
    Mr. Volcker. Well, I have not been involved with these 
discussions directly, but I think there is a kind of common-
sense feeling that at some point a financial institution, and 
particularly a bank, is so large in comparison to the whole 
market that it raises questions not just of stability and 
failure but of competition. And the United States is a very big 
market, and as I indicated earlier, at one point we thought a 
5-percent restriction might be appropriate, and then it became 
10 percent.
    Senator Bunning. I was on the Committee.
    Mr. Volcker. And now it is becoming higher, I suspect. You 
know, there is nothing magic about a particular number, but 
there is some point where it makes me feel uncomfortable if it 
got too big. Now, what that point is, I think you have got to 
decide.
    Senator Bunning. Would you like to respond?
    Mr. Wolin. Please, Senator Bunning. Thank you. I think this 
is an important question, and let me try to clarify what we are 
proposing and what we are not.
    We do think that there ought to be a limit on relative 
size, that is to say, in proportion to the overall size of the 
system.
    Senator Bunning. Overall.
    Mr. Wolin. What we do not want to do is constrain or have 
this bind on the current size of firms, that is to say, firms 
would not have to shrink, so it is from further growth. And it 
in our view does not and should not apply to organic growth, 
meaning like the 10-percent deposit cap, it ought to apply in 
circumstances where you jump over the size limit through 
acquisition. Again, we have to work on what that size limit 
should be, but at the end of the day, it is our view that there 
is important correlation between size and riskiness of firms. 
It is not the only thing, but at some point firms get to be so 
big that they do impose a risk on the system.
    Senator Bunning. Let me follow up on your statement because 
you said that we need to stop larger financial institutions 
from getting bigger, and then you just have said that we should 
not try to shrink them. Is that correct?
    Mr. Wolin. That is right.
    Senator Bunning. But these firms are already too big to 
fail, and the last 2 years have shown that at least in the 
judgment of the Federal Reserve and Treasury that is the case. 
Why should we not force them to get smaller in addition to 
stronger regulations? How does letting a firm that is already 
too big to fail stay big, how does it solve the problem?
    Mr. Wolin. Senator, I think that is an incredibly important 
question. I think two basic responses.
    We do have in our proposal a series of elements that we 
think create positive economic incentives for firms to shrink: 
heightened capital standards, leveraged constraints, liquidity 
requirements, all of which will create economic incentives in 
the direction that you are talking about. So this is, again, a 
set of proposals that build on one another and no one of them 
is the entire answer.
    So I think, you know, the other part of it, of course, is 
we do agree that it is critically important that resolution 
authority be adopted so that we do not have this horrible 
choice between having firms fail with tremendous knock-on 
consequences to the broader system on the one hand, or having 
to make the taxpayer foot the bill on the other, so that firms 
are essentially put out of their misery, or our misery, in ways 
that accomplish that goal but do so in an orderly fashion. I 
think those would be the basic answers.
    Senator Bunning. Senator Johnson brought this up on 
regulations. You know, the Congress has acted on regulations. 
In 1994, we, by regulation and by law, gave the Fed the 
authority to regulate banks and mortgage brokers. We gave them 
the power. We did not force them to use it. So for 14 years, 
they sat on their hands and did nothing.
    Now, how do you propose in your proposals to force the 
regulator to act?
    Mr. Wolin. Well, I think, Senator, that is obviously 
critically important. I think the statute should lay out that 
this is what the law should be and then----
    Senator Bunning. We did that.
    Mr. Wolin. Well, I think, you know, we have all learned a 
lot of lessons through this.
    Senator Bunning. I know, but 14 years is a long time before 
you rewrite one rule.
    Mr. Wolin. It is indeed.
    Senator Bunning. You know, and so all I am saying is that 
we can do those wonderful things that you are proposing. We 
cannot force the regulator to enforce it. And I want to make 
sure, if we do overhaul our financial regulatory regime that 
there is guts in what we do.
    Mr. Wolin. So I think, Senator, one of the ways in which 
you can have confidence that that would happen in the proposals 
that we have put forward and with which we are working with the 
Committee is to have a council, to have a group that has 
political accountability, including to the Congress, and, you 
know, I think that is the way to make sure that the will of the 
Committee and the will of the Congress overall is moved 
forward. We certainly take that very seriously.
    Senator Bunning. We also have to have really basic 
standards that the financial institutions have to meet. You 
know, we talked about all the things that are non-bank bank 
activities. Well, if they are non-bank bank activities, only 
non-bank banks should do them. And when we get into proprietary 
trading and we get into other--Chairman Volcker, you said that 
it is OK for banks to package mortgages. Wasn't that at the 
heart of our crisis? I know we are looking back, and I want to 
look forward to prevent it.
    Mr. Volcker. Well, certainly the whole mortgage market was 
an important problem here, and the banks were participating in 
that, and they were doing things that I think contributed to 
the problems of the mortgage market. But this gets into other 
areas. We do want a mortgage market. We do want to make 
mortgages available to the people so we are----
    Senator Bunning. We are having problems right now with 
that.
    Mr. Volcker. Absolutely. We do not want to prohibit people 
from making mortgages. I think one of the proposals within the 
Administration approach--and I think it is in the House bill--
is that when a bank or other institution packages securities, 
whether they are mortgages or otherwise, and sells them in a 
package, they keep part of the package themselves, which was a 
discipline, I think, that was missing----
    Senator Bunning. I think that is a great idea. Yes, then 
they share the risk.
    Mr. Volcker. Right.
    Senator Bunning. My time has expired. Thank you, Mr. 
Chairman.
    Chairman Dodd. Thank you very much, Senator.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman. I thank Chairman 
Volcker and Mr. Secretary.
    There are lots of institutions now at bank holding 
companies. The investment bank model would seem to be a 
footnote in history. But when you go on the street, very few of 
them are performing like banks, in the populist sense of a 
bank, which is to take deposits and provide safe return, and 
also to make commercial loans, residential loans, and consumer 
loans.
    My sense is that the essence of your proposal is not simply 
to prevent proprietary trading but, more importantly, to get 
them to start acting like banks again.
    Mr. Volcker. Yes.
    Senator Reed. Which is to make commercial loans, to make 
consumer loans, to make residential loans.
    Mr. Volcker. I do not want them to be diverted from those 
activities.
    Senator Reed. And I wonder, Mr. Chairman, can you--and you 
have, but can you once again sort of stress how this proposal 
would focus them on those activities?
    Mr. Volcker. Well, I think the only answer I have to that 
is it focuses on those activities by removing the temptation to 
get highly involved in more speculative type of activities 
where the immediate returns may seem to be very high and you 
have got some very highly paid people who want to keep that 
kind of activity going. I think commercial banks, I would like 
to understand their basic role in the scheme of things that you 
just outlined and concentrate on it.
    One thing I might just add, it is a complication at this 
time, I apologize, late in the afternoon, but there is a 
question about money market mutual funds, that they originated 
in a kind of regulatory arbitrage some years ago because they 
did not have to put up with some of the restrictions that banks 
put up with, and they have attracted trillions of dollars. And 
if more of those dollars were in the banking system, I think 
the incentive to lend, whether to businesses or homeowners or 
whatever, would be greater. That is an area where the 
Administration has made some proposals, and I think it ought to 
be taken seriously.
    Senator Reed. Well, I appreciate that point and it is well 
made. I think, again, returning to this issue, when I go and I 
think when my colleagues go back to their homes, people are 
saying, ``I cannot get a loan. I have got good credit.'' Or, 
``They have just cut my line of credit in half and raised the 
interest rates by 10 or 12 percent at the time the cost of 
funds is close to zero.'' And some of that is covering, as you 
suggest, Mr. Wolin, the losses in other types of activities, or 
I think some of it is because they can take that low-cost 
money, put it into these types of proprietary activities to 
make a much larger return. And if you are a business person, 
that is what you go. That is how you get a big, big bonus.
    Mr. Volcker. Of course, that reaction became extreme in the 
middle of the crisis a year or more ago, and nobody wanted to 
move any money anyplace. I hope that is changing some. There is 
a little evidence from some banker survey that the Federal 
Reserve made that they may be less tight than they were. But 
this is partly a matter of the severity of the economic crisis, 
and a lot of loans went bad and they are cautious. And we want 
to do what we can to increase confidence and get the money 
flowing.
    Senator Reed. Let me ask you if there is another way to 
approach this concept, which is to say to an institution if 
your traditional commercial banking activities are less than 75 
percent, then you do not have access to the Fed window. I mean, 
essentially what my colleagues have said time and time again, 
we do not want to subsidize the risk. We do not want the 
bailout. Well, the bailout comes, as we have seen, particularly 
in the context of bank holding companies, when the Federal 
Reserve walks up and takes whatever collateral they are willing 
to give them and gives them lots of money.
    Mr. Volcker. It is an interesting idea. I have not thought 
of it, I must confess. It is the reverse of many other ideas 
that you withdraw support if they do not lend enough. The 
Deputy Secretary mentioned some things that kind of discourage 
growth and would encourage, I hope, lending. But I would have 
to think pretty hard about the suggestion of removing, in 
effect, the safety net from banks that did not act like banks.
    Senator Reed. Well, food for thought.
    Mr. Volcker. OK. We will look at it.
    Senator Reed. Secretary Wolin, do you have any comments?
    Mr. Wolin. I think it is an interesting idea, Senator Reed. 
I think we want to be careful. Obviously, the safety net is 
incredibly important related to this utility function that 
banks play for individuals, for small businesses, for everyone, 
and so I think we want to be careful about unintended 
consequences on that, but it is something for us to work with 
you on and give additional thought to.
    Senator Reed. I mean, this has been described variously as 
the Fed put, which is basically we can go out, take some risk, 
and then we go to the--there is some way to put the risk off 
onto the Fed, which ultimately is the taxpayer. But I think, 
again, I think we have to think about a way that not only gets 
banks into what we think is the banking business--making loans 
and taking deposits--but also--and my colleagues have said this 
several time--is something that does not require a battalion of 
regulators constantly making judgments about is this a 
proprietary trade or is that a proprietary trade, et cetera.
    So, again, I think your proposal is something that deserves 
very thorough thought and also think of other ways that might 
be implemented. Thank you.
    Chairman Dodd. Senator Reed, thank you. That is a very 
creative idea. My experience has been over the years, as we 
have this debate and discussion about what is proprietary 
trading and how you define it and limit it, that there is 
probably some 22-year-old sitting in the bowels of some 
institution that has already figured six ways to get around 
anything we can write here. That has been my experience over 30 
years, and that we will end up passing a law, and we will turn 
around, and there is a whole new creative idea, using the 
genius of those creative ideas to create wealth and to expand 
opportunities, what we ought to be talking about, instead of 
trying to figure out how to get around a rule or a regulation. 
So, Jack, your idea, the beauty of it is that it achieves the 
goal without getting terribly complicated.
    Senator Reed. I grew up the where the rule was KISS, Keep 
it simple, stupid. And I think that is----
    Chairman Dodd. Not a bad rule for the Congress.
    Mike Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman. I want to 
follow up on that and a number of the other questions that have 
been asked in the hearing today, and that is the detail. The 
Administration submitted a significant proposal last summer 
about how to approach reform of issues in the financial world. 
The Volcker rule was not in that proposal last summer. I assume 
that part of the reason that we did not have it was because it 
was a legislative proposal that did not have--and that we do 
not have the detail yet for the legislation language as to how 
to actually make the definitions. And my question, Chairman 
Volcker, is: Drawing bright lights between the permissible and 
impermissible activities on market making or customer 
facilitation or proprietary trading is going to be very 
difficult, and some people say impossible or unworkable.
    If the Government makes it too difficult for banks to take 
positions, then there will be less liquidity in the market and 
the corresponding impacts on capital formation and robust 
economic activity.
    Do you expect that we will receive some specific 
legislation language so that we can understand specifically 
what we are talking about or what the proposal is with regard 
to proprietary trading and the other details of what is being 
discussed here?
    Mr. Volcker. I think that is Mr. Wolin's responsibility. I 
delegate----
    Senator Crapo. So you talk to us, you give us the theory, 
right, and Secretary Wolin will give us the detail?
    Mr. Wolin. Senator, I think an important question, 
obviously. Like the other proposals that we first articulated 
in June in the form of our White Paper, we will send draft 
legislative proposals to the Committee for your consideration. 
I think on these things, like on lots of other pieces of our 
proposal, we will want to embed in statute the principles that 
we have articulated with some detail. But, again, like an awful 
lot of banking law and a lot of the proposals, lots will be 
left to the regulators to implement in very detailed ways. So 
that is really the process forward.
    We are keen to work with you. We are currently working 
internally with the regulators to craft language that you can 
consider and that we would want to work with you on, obviously, 
as you move forward.
    And then inevitably on these kinds of things, making 
judgments at the margin, trying to figure out how to implement 
the principles in particular contexts is what regulators do in 
really the full range of banking laws that are on the books or 
that are being proposed in this current discussion.
    Senator Crapo. I understand the difference in role between 
policymaking and then the regulatory interpretation, although 
there is always a conflict there, a push and a pull or a tug in 
terms of what kind of specificity we need. But am I to 
understand you, Mr. Secretary, to be saying that you would 
expect Congress to pass legislation implementing the idea, but 
that we would not really have a good feel for what proprietary 
trading means when we pass this legislation?
    Mr. Wolin. No, no, Senator. I am sorry. I did not mean to 
leave that impression. I think we would want to specify it and 
have a role that is clear that regulators could then implement, 
but inevitably, in the same way that exists currently with 
respect to capital standards or a range of other questions that 
exist currently in Federal banking law or that would be enacted 
in Federal banking law in the proposals that the Committee is 
currently considering, certainly a lot of the detail would be 
left over to specific application in the rulemaking process or 
in the supervisory process.
    Senator Crapo. So we can expect some significant further 
detail from the Administration on exactly what it means by 
these proposals.
    Mr. Wolin. Senator, I expect that we would give you the 
same sort of language on these proposals as we have on the 
other proposals that we have put forward at the same level of 
detail and specificity. We really think of it as very similar 
in those regards.
    Mr. Volcker. If I may just interject, Senator.
    Senator Crapo. Yes, go ahead.
    Mr. Volcker. Bankers know what proprietary trading is and 
what it is not, and do not let them tell you anything 
different.
    Senator Crapo. Well, you know, I suspect that that may be 
true to some extent, although I also suspect we could find 
different points of view among bankers as to exactly what we 
are talking about. But I think the real question here is what 
the law says, and that is going to be pretty critical.
    Mr. Volcker. I agree, if your question is what the law 
says, and I do not think it is so hard to set forward the law 
that establishes the general principle, and that is going to 
have to be applied in difficult circumstances. The Chairman 
spoke about the banks are all going to have a lot of 26-year-
olds who have a lot of fancy mathematical training and all the 
rest. The supervisors need a few 28- year-olds that have had 
the same kind of training.
    Senator Crapo. Well, I can say--and I understand the point 
you are making, but I can also tell you that I think that this 
Committee and this Congress need some level of specificity on 
which to act with regard to these proposals because if we get 
them wrong, I think that we could be doing as much damage as 
good.
    Mr. Secretary, do you have any idea when we could get this 
detail?
    Mr. Wolin. We are working on it hard, Senator Crapo. I 
think, you know, in short order. I do not want to define 
exactly how many days or weeks, but it is going to be soon. We 
understand that you all are busy putting legislation together, 
and we want to make sure we get you language that can be timely 
in the context of the process that you have outlined.
    Senator Crapo. All right. Thank you. I would like to, in 
the short time I have remaining, just shift gears to our GSEs, 
Fannie and Freddie.
    In January of 2010--and this is probably mostly for you, 
Mr. Secretary--the CBO background paper on budgetary treatment 
of Fannie and Freddie states,

        CBO believes it is appropriate and useful to policymakers to 
        include their financial transactions alongside all other 
        Federal activities in the budget.

    The Administration, however, in its recent budget 
submission has not chosen to do that and has not chosen to 
bring the GSEs on budget.
    Could you explain to me why that is the case?
    Mr. Wolin. Senator, I think the GSEs are not owned by the 
U.S. Government. They are under the conservatorship of the 
FHFA. I think there is some amount of discretion that could be 
used. We tried to be transparent as we laid out the financial 
circumstances of the GSEs. Certainly the FHFA has been 
transparent. I understand they have sent a letter up to the 
Committee as recently as today laying that out. In our budget 
documents, I think there has been a high degree of 
transparency, and whether or not it was consolidated onto the 
balance sheet of the Federal Government.
    Senator Crapo. Well, I understand that, but we are talking 
about CBO's estimate of $291 billion, and that is a pretty big 
difference in the budget documents, depending on whether it is 
included or not. And the only thing the Administration said in 
the proposed budget was that the Administration continues to 
monitor the situation of GSEs closely and will continue to 
provide updates on considerations for longer-term reform of 
Fannie Mae and Freddie Mac as appropriate.
    So I guess a two-part question still: Is the Administration 
going to account for that $291 billion in its budget discussion 
this year? And, second, when will we get details on what the 
Administration's proposal for the GSE reform is going to be?
    Mr. Wolin. Senator, again, on the first question, we have 
laid out in our budget documents the transparency of the 
financial circumstances related to the GSEs. I think the 
question of consolidation is a question frankly of whether we 
own the GSEs or do not. We do not own them. The FHFA is a 
conservator of them. So I think that was the judgment made 
there.
    In respect of the policy with respect to the GSEs going 
forward, obviously we are very focused on the stability of the 
housing markets. We are looking at long-term options for the 
GSEs, and as we said in our White Paper, when we have that we 
will certainly bring forward our recommendation. It is clearly 
a critically important set of things for us to be focused on, 
but we want to do that in the context of stability in those 
markets and make sure that especially at this critical moment 
we do not do anything with respect to their long-term future 
that would perturb that stability.
    Senator Crapo. Well, thank you. I personally think that we 
need to see that $291 billion better reflected in the budget 
analysis that we are going through right now, and I do look 
forward to continuing this discussion on the details of 
proposed GSE reform.
    Thank you.
    Chairman Dodd. Thank you, Senator Crapo.
    Senator Schumer.
    Senator Schumer. Thank you, Mr. Chairman. Thank you for 
holding the hearing. I thank the witnesses. Sorry--I have been 
busy with a million different things--that I came in at the 
very end. Better late than never, I hope.
    I want to thank you, Mr. Volcker, for your thoughtful 
proposals, particularly relating to the too big to fail issue. 
I remain convinced that the steps the government took to save 
the financial system were absolutely necessary, but I suppose 
like everyone in the room would prefer we never be in that 
situation again and agree with the premise at the heart of your 
proposal: The safety net provided by the government put in 
place over the last century in response to multiple banking 
panics not be put at risk by financial activities that are 
outside the core function of the banking system. That would be 
a summation of what you----
    Mr. Volcker. That is the core.
    Senator Schumer. Yes. OK. So now I would like to ask a few 
questions to help us understand and probe it. From what I am 
told of the questions here, there is still a lot of trying to 
drill down as to what exactly we are talking about.
    I would like to talk a little bit about Canada and use it 
by way of contrast. They have a banking system, as you know, 
dominated by six large full-service banks, but it was the only 
G-7 country where the government didn't have to bail out its 
banking system in the recent crisis. Some people say it was 
cultural, arguing Canadians are simply more risk averse as a 
society than Americans and their bankers are no different. But 
others have argued the answer had more to do with their 
regulatory system. I tend to believe that. I don't know exactly 
how it works, but I know enough culture, maybe were the British 
more risky than the Canadians culturally? Who knows. But this 
regulatory system, and particularly its willingness to just say 
no to risky practices.
    So here are my specific questions and then general. 
Consumer protection--Canada has a separate Consumer Protection 
Agency, and despite home ownership levels higher than the 
United States, the percentage of Canadian mortgages that are 
subprime is less than half of that in the United States. The 
default rate is less than 1 percent in Canada compared to 10 
percent in the United States. What role do you think Canada's 
Consumer Protection Agency played in maintaining a safe and 
robust mortgage market and not allowing billions of dollars of 
no-doc loans to just be stamped, stamped, stamped, and 
securitized?
    Mr. Volcker. Well, I can't answer your question because we 
don't know. But one characteristic of the Canadian market is 
kind of interesting to me. It is essentially much more a 
privately owned market, so to speak, than the American market. 
They don't have the equivalent of Fannie Mae and Freddie Mac 
and the kind of volume that we have. They haven't had the 
pressure, frankly, from the government to push out very low 
downpayment mortgages. The market is pretty much dominated by 
commercial banks----
    Senator Schumer. Right.
    Mr. Volcker.----which is no longer true in the United 
States, and they have had, I think, an incentive to stay with 
more conservative practices in their own interest.
    Senator Schumer. What was the incentive? Why did their--let 
me put it another way. Why would their banks have the incentive 
and our banks not have the same incentive?
    Mr. Volcker. Because our banks were out of the mortgage 
market, basically. They were selling--all these mortgages were 
getting packaged and sold to Fannie Mae and Freddie Mac and 
there aren't so many mortgages left, residential mortgages left 
on American banks. That is----
    Senator Schumer. Right.
    Mr. Volcker. I think that whole thing deserves some kind of 
review, because the American mortgage market today is broken. 
There is no doubt about it.
    Senator Schumer. Right.
    Mr. Volcker. And you have got to rebuild a strong mortgage 
market, and I think looking at----
    Senator Schumer. You don't think the Consumer Protection 
Agency--I mean, I think if we had a Financial Consumer 
Protection Agency, it wouldn't have allowed a lot of the 
practices that we saw that, frankly, came initially not from 
banks, but from mortgage brokers.
    Mr. Volcker. I just am personally unfamiliar with that.
    Senator Schumer. I see. OK. So you are neutral on that 
issue.
    And what about securitization?
    Mr. Volcker. Well, I think----
    Senator Schumer. Twenty-seven percent of Canadian mortgages 
are securitized, compared with 67 percent of U.S. mortgages. 
Now, do you think that----
    Mr. Volcker. What percent in Canada?
    Senator Schumer. Twenty-seven in Canada, 67 in the United 
States.
    Mr. Volcker. Well, that is a reflection of what I said. The 
mortgage market in Canada is still in the kind of traditional 
banking market. Now, their mortgages are in shorter duration. 
They haven't got all the favorable arrangements for mortgage we 
do. They are not--they have no tax advantages.
    Senator Schumer. Right.
    Mr. Volcker. They have prepayment charges and that type of 
thing. So they are in a different mortgage market. We ought to 
learn from them, maybe--not maybe. I think we ought to. It is a 
different--it is a less government-dominated mortgage market.
    Senator Schumer. Do you think the securitization is also 
related to the Fannie and Freddie guarantees?
    Mr. Volcker. Oh, there is no question that Freddie and 
Fannie----
    Senator Schumer. Do you agree with that, Mr. Wolin?
    Mr. Wolin. Yes.
    Senator Schumer. So if we didn't guarantee as many 
mortgages, there would be less securitization. I don't know 
about that. We securitized everything here, not just federally 
guaranteed stuff, and not just mortgages. Everything got 
securitized. Credit card loans got securitized
    Mr. Volcker. That is right.
    Senator Schumer.----without any Federal guarantee.
    Mr. Volcker. That is correct, but I think it is fair to 
say----
    Senator Schumer. My guess is if you compared the Canadian 
banks on credit cards, their rate of securitization would also 
be considerably lower.
    Mr. Volcker. I suspect so. I don't know, but I suspect so.
    Senator Schumer. And that would have nothing to do with 
Fannie and Freddie.
    Mr. Volcker. There are a lot of differences between 
Canadian banks and American banks. As you said, they have only 
five or six major banks, heavily engaged in retail banking.
    Senator Schumer. Right.
    Mr. Volcker. Their life's work is retail banking. That is 
no longer true--it is true of some American banks, but none of 
the great big ones.
    Senator Schumer. It was a little true of B of A before 
they----
    Mr. Volcker. That is right.
    Senator Schumer.----before two or 3 years ago, right?
    Mr. Volcker. That is correct. And they have--because there 
are so few, the competitor situation is quite different because 
it is a stable oligopoly.
    Senator Schumer. Right. Any other lessons you might draw 
from the Canadian situation?
    Mr. Volcker. I think they have been more conservative in 
regulation. That is my impression of their supervision. But 
there, the central bank is not the chief regulator.
    Senator Schumer. Right.
    Mr. Volcker. It is like the British. But some years ago--
not recently, but some years ago, they got in trouble when two 
of their major regional banks did go bankrupt.
    Senator Schumer. Right.
    Mr. Volcker. At that point, people were not so proud of the 
regulatory system in Canada.
    Senator Schumer. Right. So another question, the inverse of 
this question. Here, you had Canada, big, big banks and 
relatively secure. Just because an institution is small doesn't 
mean it is not risky, and I would argue these days doesn't even 
mean they don't pose systemic risk. Maybe one hedge fund 
doesn't, but if 50 hedge funds do the same thing, together, 
they pose a problem of systemic risk if it is a risky activity. 
And with all of the counterparty risk and the intertwined 
spaghetti-like nature of the financial system, I mean, even 
back a while ago, whatever the place was in Greenwich, long-
term----
    Mr. Wolin. Capital Management?
    Senator Schumer.----Capital Management wasn't that large a 
company, but if the Fed didn't heavily intervene and get other 
people to prop it up, we might have had the whole system 
unraveling.
    And so I guess the question I am getting at on both ends of 
this, isn't it--or I don't want to even put it that way. It is 
the riskiness of the activities that the financial institutions 
do as much as their size that matters, or would you not argue 
that? In other words, because--just take my example, a risky 
activity done by one hedge fund or one small investment bank 
doesn't shake up the system, but if 50 of them are doing it, it 
does, particularly with counterparty risk. So that is my last 
question. Could you each comment? Neal?
    Mr. Wolin. I think it is mostly factoral. So size is 
clearly related. Interconnectedness is related. The riskiness 
of the activity is related. And so it is some combination. I 
think our proposals are meant to address each of those things 
in various combinations, but we do think that size at some 
level, above some threshold, is an important indicator of risk 
to the system, but it is absolutely true, Senator, that there 
are other elements to that equation.
    Senator Schumer. Yes, and you could clearly say one large 
institution doing risky things poses a greater systemic risk 
than one small institution doing----
    Mr. Wolin. Absolutely, Senator.
    Senator Schumer. Go ahead.
    Mr. Volcker. You are touching, I think, on a very big 
question of contagion, that institutions who are not in trouble 
necessarily and may be in a reasonably stable position are no 
longer stable if other people are failing and there is kind of 
a panic.
    Now, the answer to that in terms of hedge funds and equity 
funds and so forth is they are less likely because of the 
method of financing. You don't withdraw short-term money from 
hedge funds and equity funds because they typically don't take 
short-term money. They largely take equity money. And that is a 
very different situation when it comes to the effects of a kind 
of panic spreading around.
    Senator Schumer. Well, I know on that fateful week, and 
Chris was there, the worry was these people with short-term 
paper would just withdraw it from all these large institutions, 
and I guess that is right. It couldn't happen from most of the 
smaller institutions because their capital was longer-term.
    Mr. Volcker. It happens with the slow----
    Senator Schumer. A very interesting point. Thank you, Mr. 
Chairman.
    Chairman Dodd. Thank you, Senator.
    Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman, a great deal.
    Mr. Chairman, Mr. Secretary, thank you. Mr. Chairman, I 
want to reiterate, as you visited me earlier today and looking 
at the pictures of famous New Jerseans in my outer office, that 
I welcome you to send us a picture and we will hang it up in 
the outer office along with all the other famous----
    [Laughter.]
    Senator Menendez. Born in Cape May, New Jersey. Married a 
Jersey girl. That is about as Jersey as you get, so----
    Mr. Volcker. It depends upon how this legislation comes out 
as to whether I want my picture up----
    [Laughter.]
    Senator Schumer. Where did you live longer? In which State 
did you live longer?
    Mr. Volcker. Uh----
    Senator Menendez. Well, since he is eating up my time, you 
can take----
    [Laughter.]
    Mr. Volcker. I have lived longer in New York, I think.
    Chairman Dodd. But you wish you lived in Connecticut.
    [Laughter.]
    Mr. Volcker. I wish I lived in Connecticut. Exactly.
    [Laughter.]
    Senator Menendez. All right. Well, the offer still stands.
    I am reminded at the mantle of the Archives Building it 
says, ``What is past is prologue,'' and it seems to me that a 
lot of people want to dance around here, but at the end of the 
day, if we don't act, we are destined at some point in the 
future to relive a crisis, and that would be the worst 
situation perpetuated on the American people. So I think this 
is incredibly important.
    In the wake of the financial crisis, the surviving banks 
have actually grown bigger, not smaller, and the Volcker Rule 
doesn't force existing banks to downsize. So does that mean 
that you are comfortable with the current size of the banks 
that still exist?
    Mr. Volcker. Well, I am not terribly upset by it. I think 
there are limits. We discussed earlier common sense limits as 
to how much of a concentration you want in banking, and I have 
sympathy for what the Administration is trying to figure out, a 
sensible kind of limit that doesn't put a hard cap on organic 
growth of a bank but does say, look, if you are already very 
big, you can't combine with something else that is very big. I 
think these very big banks, they are able to take care of 
themselves.
    Senator Menendez. Isn't one of the risks here--I have posed 
this question throughout some time now of these hearings--that 
if you are too big to fail, haven't we failed already, because 
it presumes that your consequences to the economy are such that 
we can't let you fail. But that also produces the environment 
for risk taking that shouldn't take place.
    Mr. Wolin. Senator, I think it is important. I think from 
our perspective, the size cap is one of the two elements of 
what the President announced a few weeks back. It is not the 
only piece of our proposals that deal with size. By asking for 
higher capital standards, liquidity requirements, leverage 
standards, and so forth, we do create positive economic 
incentives for firms to shrink and believe that that is done in 
the context of making sure that all of those standards are 
really focused importantly on making sure that firms 
individually and the system in the aggregate is not overly 
risky, so that those things are tethered, the economic 
incentive to get smaller and the buffers, the cushions, the 
extent to which the firm can be more resilient at moments of 
distress are interlinked.
    Mr. Volcker. There is another point here, if I may add to 
that answer. With the resolution authority, which you haven't 
brought up, what seems too big to fail today may not be too big 
to fail tomorrow because you have a better arrangement for 
putting that institution to sleep without disturbing the whole 
market. That is the whole purpose of this resolution authority, 
to handle big failures.
    Senator Menendez. Now, it seems to me that one of the--
asking whether proprietary trading played a role in this crisis 
is missing the biggest lesson of this crisis, which is how do 
you avert the next one. And we know proprietary trading can be 
dangerous and contribute to the downfall of some investment 
banks. Mr. Chairman, you talked about not having taxpayer 
support for speculative activity. So it just seems to me that 
we should be attributing that to commercial banks, as well, so 
that we, at the end of the day, can ensure that customer 
deposits don't end up being part of the speculative nature that 
can create a crisis. So that is, in essence, what you are 
trying to do here.
    Mr. Volcker. But, in essence, that is what we are----
    Senator Menendez. Now, with that, if we pass a law 
preventing commercial banks from engaging in proprietary 
lending, one possibility is that a Goldman Sachs or a J.P. 
Morgan will simply drop their bank holding company status and 
continue to engage in proprietary trading, hedge fund, private 
equity activity. If they do that, will our financial system be 
less systemically at risk?
    Mr. Wolin. I think, Senator, whether they choose to be a 
bank holding company and engage in banking activities, or 
whether they choose instead to engage in these riskier 
activities, the full range of supervisory constraints and 
prudential standards that we think need to be tough and 
heightened will still apply. And so from that perspective, we 
will still be well covered in the proposals that we are putting 
forward.
    I think what we will have additionally is not having these 
risky activities be subsidized, in effect, in circumstances 
where a firm has, because of its access to the safety net, 
essentially a lower cost of funding and advantages that are in 
some sense helping them to focus on and engage in the 
activities that we are concerned about.
    Senator Menendez. So the Volcker Rule alone, if we are 
concerned about more broad systemic risk outside of even 
banking institutions, needs to have it be augmented by some of 
the other proposals----
    Mr. Volcker. Absolutely.
    Mr. Wolin. No question about it. Absolutely, Senator.
    Senator Menendez. And finally, Mr. Chairman, you have said, 
Mr. Chairman, that there is, quote, ``not a shred of evidence 
that financial innovation has improved our economy,'' and, in 
fact, that innovative financial products, quote, ``took us 
right to the brink of disaster.'' Why do you believe that 
financial innovation got so out of control, and can regulators, 
as the Chairman and the Committee deal with financial 
regulatory reform, can regulators ever be in a position to keep 
pace with innovation? And if not, are there steps we should 
take to make banking an innovation, you know, subject to the 
ability to ensure that it doesn't get out of control?
    Mr. Volcker. Look, there is no assurance in this area, but 
part of what I hope is the effect of what we are proposing is 
to reduce the capacity of the banks through imaginative 
financial engineering techniques to get way ahead of the 
regulators, because the most fertile field for this is in the 
area of hedge funds, equity funds, and proprietary trading. It 
doesn't mean they can't do a lot of complex things in the more 
traditional banking area. But at least you have cut down to 
some extent the risks of which you speak, quite rightly.
    And I do think the supervisory agencies are going to have 
to be better staffed. I think some of them are pretty well 
staffed now, but they are going to have to have the funds and 
the interest and the capacity to attract some of the brightest 
and best financial engineers, too. It takes a thief to catch a 
thief, so to speak. So there is a lot to be done in that area, 
I think.
    Senator Menendez. Mr. Secretary, do you want to comment on 
that?
    Mr. Wolin. Senator, thank you. You know, I think financial 
innovation is incredibly important to our economy and to people 
in businesses across the country. The critical question from 
our perspective is that that innovation happen within a robust 
framework of consumer protection, firstly, and that, second, 
that the taxpayer is not on the hook for when those innovations 
go sideways, that the funds themselves bear the downside risk 
of, in effect, failed innovation.
    So we want to make sure we have a system in which we have 
lots of innovation in this sector. That is hugely important, I 
think, to our entire country and to our economy, but incredibly 
important that it be done within those two critical frameworks.
    Senator Menendez. So innovation in which the innovator 
bears the risk?
    Mr. Wolin. Exactly, Senator.
    Senator Menendez. Thank you. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator.
    Just a couple of thoughts, if I can, picking up the 
question that Senator Menendez raised. Some have raised the 
issue that supposing an investment bank, using the examples 
where they would get rid of holding companies and so no longer 
at least would be defined accordingly, but since they were at 
least once covered by the safety net, should we worry that it 
would still be viewed as being protected, and as such, that it 
would act as if it were?
    Mr. Volcker. Absolutely. I think that is the big problem 
you face. Having been protected once, they will expect to be 
protected again. And more important, their creditors will 
expect them to be----
    Chairman Dodd. Well, that is what I am getting at here.
    Mr. Volcker.----protected. That is why I think you have got 
to be very tough in legislative language with this resolution 
authority, that the resolution authority is not a safety net.
    Chairman Dodd. No, I agree.
    Mr. Volcker. It is a----
    Chairman Dodd. I am not going to write--I mean, we are 
working on the bill, as you know and you have heard now for a 
number of months here, trying to pull this together. And I am 
hesitant to tell you what is going to be in the bill or not in 
the bill. But one thing that seems to be emerging you heard 
today is a very, very strong proposal dealing with resolution 
authority. And clearly, the notion of too big to fail, as I 
have said repeatedly, should become historic terms, and that 
bankruptcy receivership is the way these things will end up and 
will leave an opportunity for resolution, but that would be 
such a painful road to go down that there would be enough 
incentives to discourage people from opting for that solution.
    And the question, I guess, is, as you suggested, I think an 
awful lot of that will do an awful lot of what we are trying to 
achieve. That notion of being bailed out, if you will, is going 
to be absolutely off the charts, and to the maximum extent 
possible. So euthanasia, to use your word, Chairman Volcker, 
while that is not a legislative term, it is exactly what we are 
trying to achieve here. And that, I think, goes a long way.
    I am probably in a minority of one on this Committee, but 
I, for one, have been always attracted to the idea of the 
principle-based system rather than a rule-based system because 
I think it just gets to the heart of the matter in so many 
better ways than sitting to write specific rules all the time 
with the full knowledge that every time you write one, there is 
someone trying to figure out how to get around it. It is a game 
you never, ever catch up on, whereas a principle-based system, 
I think, gives a lot more leverage and authority to the 
regulators. But that is a separate debate for a later time.
    Let me just also suggest to you here, and I say this 
primarily to you, Secretary Wolin, and to a lesser degree to 
Chairman Volcker, we are in the process--we are going to get 
something done here now. I have gone--we have had over 52 
hearings this year. I can't tell you the countless meetings I 
have had with Members of this Committee. This represents one-
quarter of the U.S. Senate on this Committee. And I have had 
endless meetings with people on the various aspects of this 
bill. It is not a movable feast. It is not one that I can add 
ideas to it on a weekly basis and expect to get this done.
    And while I have certainly been familiar with the issue of 
dealing with proprietary trading and other issues, it does come 
up late, and the idea that the Administration made this such a 
major point a week or so ago seemed to many to be transparently 
political and not substantive and it is adding to the problems 
of trying to get a bill done.
    Now, there are other ideas that clearly should be a part of 
this, but there are tipping points. There is only so much that 
this institution will tolerate in a given point of time. I have 
been around it long enough to know what happens if you try and 
do more and bite off more than you can chew and we are getting 
precariously close to that. And I don't want to end up in a day 
here, well, because these ideas, many of them--and this is one, 
I said to you, I like the idea, either this variation of it or 
what Jack Reed suggested or something along these lines. But I 
don't want to be in a position where we end up doing nothing 
because we tried to do too much at a critical moment.
    So I want you to know that, because it is important from 
the Administration's standpoint. We are getting late in this 
game now. We need to do this right and do it carefully, and I 
have been trying to do that, and I want to do it if I can on a 
bipartisan basis. I don't want to go to the floor of the U.S. 
Senate begging for a 60th vote. I am not going to do that. So I 
want you to know that as we go forward. So if you have got more 
ideas, let me know.
    [Laughter.]
    Chairman Dodd. And let me know in a timely fashion. And 
also, when we call down and say, how does it work and 
specifically what do you have in mind, I expect answers to the 
questions. And we have made the calls and we are not getting 
good answers.
    Mr. Volcker. Well, let me just respond a little bit, if I 
can. And it is really important, I think, to get this right. 
And if you don't do it in the first round, God knows when the 
second round----
    Chairman Dodd. I don't know, either, but, you know, you 
can't add stuff every day to me on this----
    Mr. Volcker. It is important that we have a little chance, 
or you have a little chance, I think, to see what direction the 
British are going in and the French are going in and so forth. 
And the idea that this comes down to some party vote or 60 
votes or something, I don't think is right in this area because 
it is obviously not a partisan issue.
    Chairman Dodd. Yes.
    Mr. Volcker. But let me just say, for the record, I read 
all this stuff that the President's announcement was political. 
It came after Massachusetts. I know personally he decided this 
some weeks before and he had been discussing what day to 
announce it long before--before Massachusetts, and it was just 
a sheer coincidence that this thing came out on Thursday 
after----
    Chairman Dodd. You and I know that, and Members of the 
Committee know that.
    Mr. Volcker. I just want the public to know it.
    Chairman Dodd. But it doesn't--I mean, and we also--but 
also, as I say, it looks in a way--sometimes these things are 
announced don't help.
    Mr. Volcker. No, I understand.
    Chairman Dodd. And I make recommendations and so forth as 
to how to do this stuff and then it falls on deaf ears, and so 
we end up in the situation where I am grappling around here 
trying to convince people there is a substantive idea here that 
needs to be tangled with.
    Mr. Volcker. We will convince as many as you can to help 
you out.
    Chairman Dodd. I appreciate that.
    [Laughter.]
    Mr. Wolin. Mr. Chairman, let me just say, I hear you. We 
can obviously work with you as you work through what you are 
doing, as you say. This, we believe, is part and parcel to a 
lot of the things we put forward. We understand that adding it 
at this moment adds to your challenge and we hope to help you 
as you work through getting a bill from here to there.
    Chairman Dodd. I appreciate that.
    Senator Crapo asked that I include a statement he wanted 
for the record, that he wanted to put in for the Financial 
Services Roundtable, and I will ask consent that that be 
included in the record, as well.
    Chairman Dodd. We will have a continuation of this hearing 
on Thursday with others coming forward, and I appreciate, Mr. 
Wolin, your offer to continue to be helpful on this. But we are 
now going to begin moving fairly quickly.
    Mr. Wolin. Great.
    Chairman Dodd. The Committee will stand adjourned.
    Mr. Volcker. Thank you very much.
    Chairman Dodd. Thank you.
    [Whereupon, at 4:57 p.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional materials supplied for the record follow:]

               PREPARED STATEMENT OF SENATOR TIM JOHNSON

    As we all know all too well, the financial crisis revealed that our 
financial services marketplace is desperately in need of reform. We 
also learned that some financial firms were participating in high risk 
activities, and that a number of ``too-big-to fail'' institutions were 
so interconnected that their high risk actions essentially set a series 
of traps in our financial services marketplace that became a serious 
threat to consumers, investors and the economy as a whole.
    As Congress works on legislation to reform our financial system, 
this Committee has already identified two proposals that can help 
address this problem. First, better systemic risk regulation can help 
monitor risky activities by firms, and prevent and stop activities that 
could pose a threat to the economy as a whole. Second, Resolution 
Authority will provide a path forward if an institution fails without 
putting the taxpayer on the hook. These two steps are invaluable to 
decreasing risk in our nation's marketplace.
    In addition to these ongoing efforts, the Administration has 
proposed another idea to minimize economic threats to our system by 
prohibiting certain high-risk investment activities by banks and bank 
holding companies. I applaud the Chairman for holding two hearings on 
this proposal this week. I look forward to hearing more of the details 
from Chairman Volcker and Deputy Secretary Wolin today.
                                 ______
                                 
              PREPARED STATEMENT OF SENATOR SHERROD BROWN

    Thank you, Mr. Chairman, for holding this hearing on the 
Administration's plan to curb risky investment activities by banks. I 
also want to welcome the witnesses and thank them for their 
participation.
    Chairman Volcker made the point recently that that the ATM has been 
the biggest innovation in the financial services industry over the past 
20 years. The leading provider of ATM technology, NCR Corporation, 
started in Dayton, Ohio.
    I agree with Chairman Volcker that we should support the sorts of 
financial innovations that have value for working families.
    Unfortunately, instead of helping working families save and invest, 
the largest financial institutions ``innovated'' in ways that fueled 
the financial crisis.
    Despite the fact that these large, dangerously intertwined 
institutions recklessly underwrote exotic securities and gambled on 
toxic assets, they received a multibillion-dollar bailout from American 
taxpayers.
    It may have been necessary to prevent a complete financial 
collapse, but that doesn't make is any less noxious. Americans are 
disgusted that Wall Street can make or break our economy. So am I.
    And while the big banks got help, some of the smaller banks have 
not been so lucky, particularly in Ohio.
    National City Corp. was a vital part of the Cleveland community 
from 1845 until 2008. National City experienced severe difficulties 
caused by its involvement in the subprime market, but the Treasury 
Department denied its application for TARP funds. Instead, the 
government gave PNC Bank TARP money to purchase National City.
    This unfortunate development cost an untold number of jobs in Ohio. 
In response to this case, I sent a letter to Treasury letting them know 
of my concern about the TARP program being used to fund bank 
consolidation, rather than helping to rescue small, ailing banks.
    Over 1 year later, it appears that my concerns were justified. 
Large banks are bigger than ever, and they are reaping great benefits 
from their expansion and consolidation.
    A study by the Center for Economic and Policy Research found that 
the ``too big to fail'' banks that carry implicit government guarantees 
are able to borrow at a lower interest rate than other banks. According 
to their figures, this implicit ``too big to fail'' guarantee amounts 
to a government subsidy of $34.1 billion a year to the 18 banks with 
more than $100 billion in assets.
    Consolidation is also hurting community banks, thrifts and credit 
unions. According to the Kansas City Fed, the top four banks raised 
fees related to deposits by an average of 8 percent in the second 
quarter last year. To compete with the big banks, smaller banks lowered 
their fees by an average of 12 percent during the same period. This is 
the classic story of the big guys running the smaller guys out of town 
. . . at the expense of free market competition.
    These consolidations are not only undercutting community banks and 
their customers, but they are breeding the very environment that threw 
our financial system into chaos, creating a deep, deep recession.
    We don't want to bail out another set of ``too big to fail'' banks. 
We don't want to see risk multiplied a thousand fold by mega banks that 
have trillions of dollars in assets.
    We need regulatory reform because we need strict oversight of the 
major threats to our financial system posed by the size and activity of 
large, interconnected financial institutions. We need to tackle head-on 
the ``too big to fail'' problem. As you said in excellent your op-ed in 
Sunday's New York Times, Chairman Volcker, ``We need to face up to 
needed structural changes, and place them into law.''
    Thank you, Mr. Chairman. I look forward to hearing the witnesses' 
testimony.
                                 ______
                                 
                 PREPARED STATEMENT OF PAUL A. VOLCKER
         Chairman, President's Economic Recovery Advisory Board
                            February 2, 2010

    Mr. Chairman, Members of the Banking Committee:
    You have an important responsibility in considering and acting upon 
a range of issues relevant to needed reform of the financial system. 
That system, as you well know, broke down under pressure, posing 
unacceptable risks for an economy already in recession. I appreciate 
the opportunity today to discuss with you one key element in the reform 
effort that President Obama set out so forcibly a few days ago.
    That proposal, if enacted, would restrict commercial banking 
organizations from certain proprietary and more speculative activities. 
In itself, that would be a significant measure to reduce risk. However, 
the first point I want to emphasize is that the proposed restrictions 
should be understood as a part of the broader effort for structural 
reform. It is particularly designed to help deal with the problem of 
``too big to fail'' and the related moral hazard that looms so large as 
an aftermath of the emergency rescues of financial institutions, bank 
and non-bank, in the midst of crises.
    I have attached to this statement a short essay of mine outlining 
that larger perspective.
    The basic point is that there has been, and remains, a strong 
public interest in providing a ``safety net''--in particular, deposit 
insurance and the provision of liquidity in emergencies--for commercial 
banks carrying out essential services. There is not, however, a similar 
rationale for public funds--taxpayer funds--protecting and supporting 
essentially proprietary and speculative activities. Hedge funds, 
private equity funds, and trading activities unrelated to customer 
needs and continuing banking relationships should stand on their own, 
without the subsidies implied by public support for depository 
institutions.
    Those quintessential capital market activities have become part of 
the natural realm of investment banks. A number of the most prominent 
of those firms, each heavily engaged in trading and other proprietary 
activity, failed or were forced into publicly assisted mergers under 
the pressure of the crisis. It also became necessary to provide public 
support via the Federal Reserve, The Federal Deposit Insurance 
Corporation, or the Treasury to the largest remaining American 
investment banks, both of which assumed the cloak of a banking license 
to facilitate the assistance. The world's largest insurance company, 
caught up in a huge portfolio of credit default swaps quite apart from 
its basic business, was rescued only by the injection of many tens of 
billions of dollars of public loans and equity capital. Not so 
incidentally, the huge financial affiliate of one of our largest 
industrial companies was also extended the privilege of a banking 
license and granted large assistance contrary to long-standing public 
policy against combinations of banking and commerce.
    What we plainly need are authority and methods to minimize the 
occurrence of those failures that threaten the basic fabric of 
financial markets. The first line of defense, along the lines of 
Administration proposals and the provisions in the Bill passed by the 
House last year, must be authority to regulate certain characteristics 
of systemically important non-bank financial institutions. The 
essential need is to guard against excessive leverage and to insist 
upon adequate capital and liquidity.
    It is critically important that those institutions, its managers 
and its creditors, do not assume a public rescue will be forthcoming in 
time of pressure. To make that credible, there is a clear need for a 
new ``resolution authority'', an approach recommended by the 
Administration last year and included in the House bill. The concept is 
widely supported internationally. The idea is that, with procedural 
safeguards, a designated agency be provided authority to intervene and 
take control of a major financial institution on the brink of failure. 
The mandate is to arrange an orderly liquidation or merger. In other 
words, euthanasia not a rescue.
    Apart from the very limited number of such ``systemically 
significant'' non-bank institutions, there are literally thousands of 
hedge funds, private equity funds, and other private financial 
institutions actively competing in the capital markets. They are 
typically financed with substantial equity provided by their partners 
or by other sophisticated investors. They are, and should be, free to 
trade, to innovate, to invest--and to fail. Managements, stockholders 
or partners would be at risk, able to profit handsomely or to fail 
entirely, as appropriate in a competitive free enterprise system.
    Now, I want to deal as specifically as I can with questions that 
have arisen about the President's recent proposal.
    First, surely a strong international consensus on the proposed 
approach would be appropriate, particularly across those few nations 
hosting large multi-national banks and active financial markets. The 
needed consensus remains to be tested. However, judging from what we 
know and read about the attitude of a number of responsible officials 
and commentators, I believe there are substantial grounds to anticipate 
success as the approach is fully understood.
    Second, the functional definition of hedge funds and private equity 
funds that commercial banks would be forbidden to own or sponsor is not 
difficult. As with any new regulatory approach, authority provided to 
the appropriate supervisory agency should be carefully specified. It 
also needs to be broad enough to encompass efforts sure to come to 
circumvent the intent of the law. We do not need or want a new breed of 
bank-based funds that in all but name would function as hedge or equity 
funds.
    Similarly, every banker I speak with knows very well what 
``proprietary trading'' means and implies. My understanding is that 
only a handful of large commercial banks--maybe four or five in the 
United States and perhaps a couple of dozen worldwide--are now engaged 
in this activity in volume. In the past, they have sometimes explicitly 
labeled a trading affiliate or division as ``proprietary'', with the 
connotation that the activity is, or should be, insulated from customer 
relations.
    Most of those institutions and many others are engaged in meeting 
customer needs to buy or sell securities: stocks or bonds, derivatives, 
various commodities or other investments. Those activities may involve 
taking temporary positions. In the process, there will be temptations 
to speculate by aggressive, highly remunerated traders.
    Given strong legislative direction, bank supervisors should be able 
to appraise the nature of those trading activities and contain 
excesses. An analysis of volume relative to customer relationships and 
of the relative volatility of gains and losses would go a long way 
toward informing such judgments. For instance, patterns of 
exceptionally large gains and losses over a period of time in the 
``trading book'' should raise an examiner's eyebrows. Persisting over 
time, the result should be not just raised eyebrows but substantially 
raised capital requirements.
    Third, I want to note the strong conflicts of interest inherent in 
the participation of commercial banking organizations in proprietary or 
private investment activity. That is especially evident for banks 
conducting substantial investment management activities, in which they 
are acting explicitly or implicitly in a fiduciary capacity. When the 
bank itself is a ``customer'', i.e., it is trading for its own account, 
it will almost inevitably find itself, consciously or inadvertently, 
acting at cross purposes to the interests of an unrelated commercial 
customer of a bank. ``Inside'' hedge funds and equity funds with 
outside partners may generate generous fees for the bank without the 
test of market pricing, and those same ``inside'' funds may be favored 
over outside competition in placing funds for clients. More generally, 
proprietary trading activity should not be able to profit from 
knowledge of customer trades.
    I am not so naive as to think that all potential conflicts can or 
should be expunged from banking or other businesses. But neither am I 
so naive as to think that, even with the best efforts of boards and 
management, so-called Chinese Walls can remain impermeable against the 
pressures to seek maximum profit and personal remuneration.
    In concluding, it may be useful to remind you of the wide range of 
potentially profitable services that are within the province of 
commercial banks.

    First of all, basic payments services, local, national and 
        worldwide, ranging from the now ubiquitous automatic teller 
        machines to highly sophisticated cash balance management;

    Safe and liquid depository facilities, including especially 
        deposits contractually payable on demand;

    Credit for individuals, governments and businesses, large 
        and small, including credit guarantees and originating and 
        securitizing mortgages or other credits under appropriate 
        conditions;

    Analogous to commercial lending, underwriting of corporate 
        and government securities, with related market making;

    Brokerage accounts for individuals and businesses, 
        including ``prime brokerage'' for independent hedge and equity 
        funds;

    Investment management and investment advisory services, 
        including ``Funds of Funds'' providing customers with access to 
        independent hedge or equity funds;

    Trust and estate planning and Administration;

    Custody and safekeeping arrangements for securities and 
        valuables.

    Quite a list. More than enough, I submit to you, to provide the 
base for strong, competitive--and profitable--commercial banking 
organizations, able to stand on their own feet domestically and 
internationally in fair times and foul.
    What we can do, what we should do, is recognize that curbing the 
proprietary interests of commercial banks is in the interest of fair 
and open competition as well as protecting the provision of essential 
financial services. Recurrent pressures, volatility and uncertainties 
are inherent in our market-oriented, profit-seeking financial system. 
By appropriately defining the business of commercial banks, and by 
providing for the complementary resolution authority to deal with an 
impending failure of very large capital market institutions, we can go 
a long way toward promoting the combination of competition, innovation, 
and underlying stability that we seek.
                                 ______
                                 
                   HOW TO REFORM OUR FINANCIAL SYSTEM
                  The New York Times, January 30, 2010
                   By Paul Volcker, Op-Ed Contributor
     President Obama 10 days ago set out one important element in the 
needed structural reform of the financial system. No one can reasonably 
contest the need for such reform, in the United States and in other 
countries as well. We have after all a system that broke down in the 
most serious crisis in 75 years. The cost has been enormous in terms of 
unemployment and lost production. The repercussions have been 
international.
    Aggressive action by governments and central banks--really 
unprecedented in both magnitude and scope--has been necessary to revive 
and maintain market functions. Some of that support has continued to 
this day. Here in the United States as elsewhere, some of the largest 
and proudest financial institutions--including both investment and 
commercial banks--have been rescued or merged with the help of massive 
official funds. Those actions were taken out of well-justified concern 
that their outright failure would irreparably impair market functioning 
and further damage the real economy already in recession.
    Now the economy is recovering, if at a still modest pace. Funds are 
flowing more readily in financial markets, but still far from normally. 
Discussion is underway here and abroad about specific reforms, many of 
which have been set out by the United States administration: 
appropriate capital and liquidity requirements for banks; better 
official supervision on the one hand and on the other improved risk 
management and board oversight for private institutions; a review of 
accounting approaches toward financial institutions; and others.
    As President Obama has emphasized, some central structural issues 
have not yet been satisfactorily addressed.
    A large concern is the residue of moral hazard from the extensive 
and successful efforts of central banks and governments to rescue large 
failing and potentially failing financial institutions. The long-
established ``safety net'' undergirding the stability of commercial 
banks--deposit insurance and lender of last resort facilities--has been 
both reinforced and extended in a series of ad hoc decisions to support 
investment banks, mortgage providers and the world's largest insurance 
company. In the process, managements, creditors and to some extent 
stockholders of these non-banks have been protected.
    The phrase ``too big to fail'' has entered into our everyday 
vocabulary. It carries the implication that really large, complex and 
highly interconnected financial institutions can count on public 
support at critical times. The sense of public outrage over seemingly 
unfair treatment is palpable. Beyond the emotion, the result is to 
provide those institutions with a competitive advantage in their 
financing, in their size and in their ability to take and absorb risks.
    As things stand, the consequence will be to enhance incentives to 
risk-taking and leverage, with the implication of an even more fragile 
financial system. We need to find more effective fail-safe 
arrangements.
    In approaching that challenge, we need to recognize that the basic 
operations of commercial banks are integral to a well-functioning 
private financial system. It is those institutions, after all, that 
manage and protect the basic payments systems upon which we all depend. 
More broadly, they provide the essential intermediating function of 
matching the need for safe and readily available depositories for 
liquid funds with the need for reliable sources of credit for 
businesses, individuals and governments.
    Combining those essential functions unavoidably entails risk, 
sometimes substantial risk. That is why Adam Smith more than 200 years 
ago advocated keeping banks small. Then an individual failure would not 
be so destructive for the economy. That approach does not really seem 
feasible in today's world, not given the size of businesses, the 
substantial investment required in technology and the national and 
international reach required.
    Instead, governments have long provided commercial banks with the 
public ``safety net.'' The implied moral hazard has been balanced by 
close regulation and supervision. Improved capital requirements and 
leverage restrictions are now also under consideration in international 
forums as a key element of reform.
    The further proposal set out by the president recently to limit the 
proprietary activities of banks approaches the problem from a 
complementary direction. The point of departure is that adding further 
layers of risk to the inherent risks of essential commercial bank 
functions doesn't make sense, not when those risks arise from more 
speculative activities far better suited for other areas of the 
financial markets.
    The specific points at issue are ownership or sponsorship of hedge 
funds and private equity funds, and proprietary trading--that is, 
placing bank capital at risk in the search of speculative profit rather 
than in response to customer needs. Those activities are actively 
engaged in by only a handful of American mega-commercial banks, perhaps 
four or five. Only 25 or 30 may be significant internationally.
    Apart from the risks inherent in these activities, they also 
present virtually insolvable conflicts of interest with customer 
relationships, conflicts that simply cannot be escaped by an 
elaboration of so-called Chinese walls between different divisions of 
an institution. The further point is that the three activities at 
issue--which in themselves are legitimate and useful parts of our 
capital markets--are in no way dependent on commercial banks' 
ownership. These days there are literally thousands of independent 
hedge funds and equity funds of widely varying size perfectly capable 
of maintaining innovative competitive markets. Individually, such 
independent capital market institutions, typically financed privately, 
are heavily dependent like other businesses upon commercial bank 
services, including in their case prime brokerage. Commercial bank 
ownership only tilts a ``level playing field'' without clear value 
added.
    Very few of those capital market institutions, both because of 
their typically more limited size and more stable sources of finance, 
could present a credible claim to be ``too big'' or ``too 
interconnected'' to fail. In fact, sizable numbers of such institutions 
fail or voluntarily cease business in troubled times with no adverse 
consequences for the viability of markets.
    What we do need is protection against the outliers. There are a 
limited number of investment banks (or perhaps insurance companies or 
other firms) the failure of which would be so disturbing as to raise 
concern about a broader market disruption. In such cases, authority by 
a relevant supervisory agency to limit their capital and leverage would 
be important, as the president has proposed.
    To meet the possibility that failure of such institutions may 
nonetheless threaten the system, the reform proposals of the Obama 
administration and other governments point to the need for a new 
``resolution authority.'' Specifically, the appropriately designated 
agency should be authorized to intervene in the event that a 
systemically critical capital market institution is on the brink of 
failure. The agency would assume control for the sole purpose of 
arranging an orderly liquidation or merger. Limited funds would be made 
available to maintain continuity of operations while preparing for the 
demise of the organization.
    To help facilitate that process, the concept of a ``living will'' 
has been set forth by a number of governments. Stockholders and 
management would not be protected. Creditors would be at risk, and 
would suffer to the extent that the ultimate liquidation value of the 
firm would fall short of its debts.
    To put it simply, in no sense would these capital market 
institutions be deemed ``too big to fail.'' What they would be free to 
do is to innovate, to trade, to speculate, to manage private pools of 
capital--and as ordinary businesses in a capitalist economy, to fail.
    I do not deal here with other key issues of structural reform. 
Surely, effective arrangements for clearing and settlement and other 
restrictions in the now enormous market for derivatives should be 
agreed to as part of the present reform program. So should the need for 
a designated agency--preferably the Federal Reserve--charged with 
reviewing and appraising market developments, identifying sources of 
weakness and recommending action to deal with the emerging problems. 
Those and other matters are part of the Administration's program and 
now under international consideration.
    In this country, I believe regulation of large insurance companies 
operating over many states needs to be reviewed. We also face a large 
challenge in rebuilding an efficient, competitive private mortgage 
market, an area in which commercial bank participation is needed. Those 
are matters for another day.
    What is essential now is that we work with other nations hosting 
large financial markets to reach a broad consensus on an outline for 
the needed structural reforms, certainly including those that the 
president has recently set out. My clear sense is that relevant 
international and foreign authorities are prepared to engage in that 
effort. In the process, significant points of operational detail will 
need to be resolved, including clarifying the range of trading activity 
appropriate for commercial banks in support of customer relationships.
    I am well aware that there are interested parties that long to 
return to ``business as usual,'' even while retaining the comfort of 
remaining within the confines of the official safety net. They will 
argue that they themselves and intelligent regulators and supervisors, 
armed with recent experience, can maintain the needed surveillance, 
foresee the dangers and manage the risks.
    In contrast, I tell you that is no substitute for structural 
change, the point the president himself has set out so strongly.
    I've been there--as regulator, as central banker, as commercial 
bank official and director--for almost 60 years. I have observed how 
memories dim. Individuals change. Institutional and political pressures 
to ``lay off'' tough regulation will remain--most notably in the fair 
weather that inevitably precedes the storm.
    The implication is clear. We need to face up to needed structural 
changes, and place them into law. To do less will simply mean ultimate 
failure--failure to accept responsibility for learning from the lessons 
of the past and anticipating the needs of the future.
                                 ______
                                 
                  PREPARED STATEMENT OF NEAL S. WOLIN
              Deputy Secretary, Department of the Treasury
                            February 2, 2010

    Chairman Dodd, Ranking Member Shelby, thank you for the opportunity 
to testify before your Committee today about financial reform--and in 
particular about the Administration's recent proposals to prohibit 
certain risky financial activities at banks and bank holding companies 
and to prevent excessive concentration in the financial sector.
    The recent proposals complement the much broader set of reforms 
proposed by the Administration in June, passed by the House in 
December, and currently under consideration by this Committee. We have 
worked closely with you and with your staffs over the past year, and we 
look forward to working with you to incorporate these additional 
proposals into comprehensive legislation.
    Sixteen months from the height of the worst financial crisis in 
generations, no one should doubt the urgent need for financial reform. 
Our regulatory system is outdated and ineffective, and the weaknesses 
that contributed to the crisis still persist. Through a series of 
extraordinary actions over the last year and a half, we have made 
significant progress in stabilizing the financial system and putting 
our economy back on the path to growth. But the progress of recovery 
does not diminish the urgency of the task at hand. Indeed, our 
financial system will not be truly stable, and our recovery will not be 
complete, until we establish clear new rules of the road for the 
financial sector.
    The goals of financial reform are simple: to make the markets for 
consumers and investors fair and efficient; to lay the foundation for a 
safer, more stable financial system, less prone to panic and crisis; to 
safeguard American taxpayers from bearing risks that ought to be borne 
by shareholders and creditors; and to end, once and for all, the 
dangerous perception any financial institution is ``Too Big to Fail.''
    The ingredients of financial reform are clear:

    All large and interconnected financial firms, regardless of their 
legal form, must be subject to strong, consolidated supervision at the 
Federal level. The idea that investment banks like Bear Stearns or 
Lehman Brothers or other major financial firms could escape 
consolidated Federal supervision should be considered unthinkable from 
now on.
    The days when being large and substantially interconnected could be 
cost-free--let alone carry implicit subsidies--should be over. The 
largest, most interconnected firms should face significantly higher 
capital and liquidity requirements. Those requirements should be set at 
levels that compel the major financial firms to pay for the additional 
costs that they impose on the financial system, and give such firms 
positive incentives to reduce their size, risk profile, and 
interconnectedness.
    The core infrastructure of the financial markets must be 
strengthened. Critical payment, clearing, and settlement systems, as 
well as the derivatives and securitization markets, must be subject to 
thorough, consistent regulation to improve transparency, and to reduce 
bilateral counterparty credit risk among our major financial firms. We 
should never again face a situation--so devastating in the case of 
AIG--where a virtually unregulated major player can impose risks on the 
entire system.
    The government must have robust authority to unwind a failing major 
financial firm in an orderly manner--imposing losses on shareholders, 
managers, and creditors, but protecting the broader system and ensuring 
that taxpayers are not forced to pay the bill.
    The government must have appropriately constrained tools to provide 
liquidity to healthy parts of the financial sector in a crisis, in 
order to make the system safe for failure.
    And we must have a strong, accountable consumer financial 
protection agency to set and enforce clear rules of the road for 
providers of financial services--to ensure that customers have the 
information they need to make fully informed financial decisions.
    Throughout the financial reform process, the Administration has 
worked with Congress on reforms that will provide positive incentives 
for firms to shrink and to reduce their risk and to give regulators 
greater authorities to force such outcomes. The Administration's White 
Paper, released last June, emphasized the need to give regulators 
extensive authority to limit risky, destabilizing activities by 
financial firms. We worked closely with Chairman Frank and subcommittee 
Chairman Kanjorski in the House Financial Services Committee to give 
regulators explicit authority to require a firm to cease activities or 
divest businesses that could threaten the safety of the firm or the 
stability of the financial system.
    In addition, through tougher supervision, higher capital and 
liquidity requirements, the requirement that large firms develop and 
maintain rapid resolution plans--also known as ``living wills''--and 
the financial recovery fee which the President proposed at the 
beginning of January, we have sought indirectly to constrain the growth 
of large, complex financial firms.
    As we have continued our ongoing dialog, within the Administration 
and with outside advisors such as the Chairman of the President's 
Economic Recovery Advisory Board, former Federal Reserve Chairman Paul 
Volcker, whose counsel has been of tremendous value, we have come to 
the conclusion that further steps are needed: that rather than merely 
authorize regulators to take action, we should impose mandatory limits 
on proprietary trading by banks and bank holding companies, and related 
restrictions on owning or sponsoring hedge funds or private equity 
funds, as well as on the concentration of liabilities in the financial 
system. These two additional reforms represent a natural--and 
important--extension of the reforms already proposed.
    Commercial banks enjoy a Federal Government safety net in the form 
of access to Federal deposit insurance, the Federal Reserve discount 
window, and Federal Reserve payment systems. These protections, in 
place for generations, are justified by the critical role the banking 
system plays in serving the credit, payment and investment needs of 
consumers and businesses.
    To prevent the expansion of that safety net and to protect 
taxpayers from risk of loss, commercial banking firms have long been 
subject to statutory activity restrictions, and they remain subject to 
a comprehensive set of activity restrictions today. Activity 
restrictions are a hallowed part of this country's bank regulatory 
tradition, and our new scope proposals represent a natural evolution in 
this framework.
    The activities targeted by our proposal tend to be volatile and 
high risk. Major firms saw their hedge funds and proprietary trading 
operations suffer large losses in the financial crisis. Some of these 
firms ``bailed out'' their troubled hedge funds, depleting the firm's 
capital at precisely the moment it was needed most. The complexity of 
owning such entities has also made it more difficult for the market, 
investors, and regulators to understand risks in major financial firms, 
and for their managers to mitigate such risks. Exposing the taxpayer to 
potential risks from these activities is ill-advised.
    Moreover, proprietary trading, by definition, is not done for the 
benefit of customers or clients. Rather, it is conducted solely for the 
benefit of the bank itself. It is therefore difficult to justify an 
arrangement in which the Federal safety net redounds to the benefit of 
such activities.
    For all these reasons, we have concluded that proprietary trading, 
and the ownership or sponsorship or hedge funds and private equity 
funds, should be separated, to the fullest extent practicable, from the 
business of banking--and from the safety net that benefits the business 
of banking.
    While some details concerning the implementation of these proposals 
will appropriately be worked out through the regulatory process 
following enactment, it may be helpful if I take a moment to clarify 
the Administration's intentions on a few particularly salient issues.
    First, with respect to the application of the proposed scope 
limits: all banking firms would be covered. This means any FDIC-insured 
depository institution, as well as any firm that controls an FDIC-
insured depository institution. In addition, the proposal would apply 
to the U.S. operations of foreign banking organizations that have a 
U.S. branch or agency and are therefore treated under current U.S. law 
as bank holding companies. The prohibition also would generally apply 
to the foreign operations of U.S.-based banking firms.
    This proposal forces firms to choose between owning an insured 
depository institution and engaging in proprietary trading, hedge fund, 
or private equity activities. But--and this is very important to 
emphasize--it does not allow any major firm to escape strict government 
oversight. Under our regulatory reform proposals, all major financial 
firms, whether or not they own a depository institution, must be 
subject to robust consolidated supervision and regulation--including 
strong capital and liquidity requirements--by a fully accountable and 
fully empowered Federal regulator.
    Second, with respect to the types of activity that will be 
prohibited: this proposal will prohibit investments of a banking firm's 
capital in trading operations that are unrelated to client business. 
For instance, a firm will not be allowed to establish or maintain a 
separate trading desk, capitalized with the firm's own resources, and 
organized to speculate on the price of oil and gas or equity 
securities. Nor will a firm be allowed to evade this restriction by 
simply rolling such a separate proprietary trading desk into the firm's 
general market making operations.
    The proposal would not disrupt the core functions and activities of 
a banking firm: banking firms will be allowed to lend, to make markets 
for customers in financial assets, to provide financial advice to 
clients, and to conduct traditional asset management businesses, other 
than ownership or sponsorship of hedge funds and private equity funds. 
They will be allowed to hedge risks in connection with client-driven 
transactions. They will be allowed to establish and manage portfolios 
of short-term, high-quality assets to meet their liquidity risk 
management needs. Traditional merger and acquisition advisory, 
strategic advisory, and securities underwriting, and brokerage 
businesses will not be affected.
    In sum, the proposed limitations are not meant to disrupt a banking 
firm's ability to serve its clients and customers effectively. They are 
meant, instead, to prevent a banking firm from putting its clients, 
customers and the taxpayers at risk by conducting risky activities 
solely for its own enrichment.
    Let me now turn to the second of the President's recent proposals: 
the limit on the relative size of the largest financial firms.
    Since 1994, the United States has had a 10 percent concentration 
limit on bank deposits. The cap was designed to constrain future 
concentration in banking. Under this concentration limit, firms 
generally cannot engage in certain inter-state banking acquisitions if 
the acquisition would put them over the deposit cap.
    This deposit cap has helped constrain the growth in concentration 
among U.S. banking firms over the intervening years, and it has served 
the country well. But its narrow focus on deposit liabilities has 
limited its usefulness. Today, the largest U.S. financial firms 
generally fund themselves at significant scale with non-deposit 
liabilities. Moreover, the constraint on deposits has provided the 
largest U.S. financial firms with a perverse incentive to fund 
themselves through more volatile forms of wholesale funding. Given the 
increasing reliance on non-bank financial intermediaries and non-
deposit funding sources in the U.S. financial system, it is important 
to supplement the deposit cap with a broader restriction on the size of 
the largest firms in the financial sector.
    This new financial sector size limit should not require existing 
firms to divest operations. But it should serve as a constraint on 
future excessive consolidation among our major financial firms.
    The size limit should not impede the organic growth of financial 
firms--after all, we do not want to limit the growth of successful 
businesses. But it should constrain the capacity of our very largest 
financial firms to grow by acquisition.
    The new limit should supplement, not replace, the existing deposit 
cap. And it should at a minimum cover all firms that control one or 
more insured depository institutions, as well as all other major 
financial firms that are so large and interconnected that they will be 
brought into the system of consolidated, comprehensive supervision 
contemplated by our reforms.
    An updated size limit for financial firms will have a beneficial 
effect on the overall health of the financial system. Limiting the 
relative size of any single financial firm will reduce the adverse 
effects from the failure of any single firm. These proposals should 
strengthen our financial system's resiliency. It is true today that the 
financial systems of most other G7 countries are far more concentrated 
than ours. It is also true today that major financial firms in many 
other economies generally operate with fewer restrictions on their 
activities than do U.S. banking firms. These are strengths of our 
economy--strengths that we intend to preserve.
    Limits on the scale and scope of U.S. banking firms have not 
materially impaired the capacity of U.S. firms to compete in global 
financial markets against larger, foreign universal banks, nor have 
these variations stopped the United States from being the leading 
financial market in the world. The proposals I have discussed today 
preserve the core business of banking and serving clients, and preserve 
the ability of even our largest firms to grow organically. Therefore we 
are confident that we should not impact the competitiveness of our 
financial firms and our financial system.
    Before closing, I would like to again emphasize the importance of 
putting these new proposals in the broader context of financial reform. 
The proposals outlined above do not represent an ``alternative'' 
approach to reform. Rather, they are meant to supplement and complement 
the set of comprehensive reforms put forward by the Administration last 
summer and passed by the House of Representatives before the holidays.
    Added to the core elements of effective financial reform previously 
proposed, the activity restrictions and concentration cap that are the 
focus of today's hearing will play an important role in making the 
system safer and more stable. But like each of the other core elements 
of financial reform, the scale and scope proposals are not designed to 
stand alone.
    Members of this Committee have the opportunity--by passing a 
comprehensive financial reform bill--to help build a safer, more stable 
financial system. It is an opportunity that may not come again. We look 
forward to working with you to bring financial reform across the finish 
line--and to do all that we can to ensure that the American people are 
never again forced to suffer the consequences of a preventable 
financial catastrophe.
    Thank you.

 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM PAUL A. 
                            VOLCKER

Q.1. The government safety net for financial firms is larger 
than just deposit insurance. In particular, the Fed has made 
its lending available to all kinds of firms, including those 
that are not banks. Should firms that have access to any forms 
of Fed money be subject to these same limits on risk taking?

A.1. Yes.

Q.2. Under this proposal, would banks be allowed to continue 
their derivatives dealer business?

A.2. Yes, as long as they are originating these products on 
behalf of their customers, and are not trading them for their 
own account.

Q.3. Chairman Volker, in your New York Times piece you state 
that there are some investment banks and insurance companies 
that are too big to fail. What do you propose we do about them?

A.3. To be clear, I think I said that some of those firms 
present systemic risk, but in my view no firm is too big to 
fail. Their financial statements, business practices, and 
interconnectedness would be continuously reviewed by a 
``Systemic Overseer'', as well they would be subject to 
reasonable capital, leverage and liquidity requirements. These 
firms would also be operating under the auspices of a new 
resolution authority for non-banks.

Q.4.a. Chairman Volker, would you allow Goldman Sachs and 
Morgan Stanley, which became bank holding companies in order to 
get greater access to Fed money, to drop their bank charters so 
they could keep trading on their own account?

A.4.a. Yes, and then they would be operating outside the 
Federal safety net.

Q.4.b. If yes, how would that resolve any of the systemic risks 
posed by those firms?

A.4.b. They would be subject to the supervision outlined in my 
answer to Question 3. In the event of their failure, they would 
be liquidated or merged under a new resolution authority for 
nonbanks.

Q.5. Under this proposal, would banks be allowed to lend to 
hedge funds or private equity firms?

A.5. Yes, as these funds would be considered customers of the 
banks.

Q.6. What measurement do you propose we use to limit the size 
of financial institutions in the future?

A.6. I think the deposit and liability cap being contemplated 
by the Treasury is a reasonable means of limiting the size of 
financial institutions. I have not yet seen the percentage 
limit being proposed by Treasury, however I understand a new 
cap will be high enough so as not to require any existing firm 
to shrink. Size, though, is not the sole criteria for measuring 
the systemic risk of an institution. It is important to have an 
Overseer that is looking at the complexity and diversification 
of the institution's holdings, its interconnectedness with 
other institutions and markets, and other risk measures.

Q.7. If we put in place size limitations or trading 
limitations, who is going to be able to step in and buy other 
large firms that are in danger of failing? For example, what 
would happen to a transaction like the Bank of America-Merrill 
Lynch merger?

A.7. Again, I defer to Treasury with respect to the size 
criteria to be proposed. In the future, I hope that we will 
have a stable of strong financial institutions capable of 
executing such a transaction should a large bank or non-bank 
fail. If we do not have institutions that are capable and 
willing to acquire or merge with a competitor in trouble, then 
the failing firm will be liquidated under the auspices of the 
new resolution authority for non-banks.
                                ------                                

 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT FROM NEAL S. 
                             WOLIN

Q.1. As you know, many major banks and bank-holding companies 
in the United States offer prime brokerage services to their 
large institutional clients. In fact, prime brokerage is 
significant source of revenue for some of these banking 
entities. SEC Regulation SHO requires that, prior to executing 
a short sale, a prime broker need only ``locate'' shares on 
behalf of a client.
    It is possible to ``over-lend'' shares without ever firmly 
locating the shares. Under existing regulations prime brokers 
are compensated for lending the customers' shares for uses that 
are often contrary to their customers' investment strategies.
    What is the Administration doing to bring full disclosure 
and accountability to this process and do you think that the 
government should at least require the major banks and bank-
holding companies that offer prime brokerage services to obtain 
affirmative, knowing consent of the customer for the lending of 
their shares at the time the consumer signs the brokerage 
agreement?

A.1. Did not respond by publication deadline.
                                ------                                

 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM NEAL S. 
                             WOLIN

Q.1. In his testimony, Chairman Volker makes it clear that 
banks would continue to be allowed to package mortgages or 
other assets into securities and sell them off. That was an 
activity that was at the center of the credit bubble and the 
current crisis. Why should banks be allowed to continue that 
behavior?

A.1. Did not respond by publication deadline.

Q.2. The government safety net for financial firms is larger 
than just deposit insurance. In particular, the Fed has made 
its lending available to all kinds of firms, including those 
that are not banks. Should firms that have access to any forms 
of Fed money be subject to these same limits on risk taking?

A.2. Did not respond by publication deadline.

Q.3. Under this proposal, would banks be allowed to continue 
their derivatives dealer business?

A.3. Did not respond by publication deadline.

Q.4.a. Would you allow Goldman Sachs and Morgan Stanley, which 
became bank holding companies in order to get greater access to 
Fed money, to drop their bank charters so they could keep 
trading on their own account?

A.4.a. Did not respond by publication deadline.

Q.4.b. If yes, how would that resolve any of the systemic risks 
posed by those firms?

A.4.b. Did not respond by publication deadline.

Q.5. Under this proposal, would banks be allowed to lend to 
hedge funds or private equity firms?

A.5. Did not respond by publication deadline.

Q.6. Secretary Wolin, what measurement do you propose we use to 
limit the size of financial institutions in the future?

A.6. Did not respond by publication deadline.

Q.7. If we put in place size limitations or trading 
limitations, who is going to be able to step in and buy other 
large firms that are in danger of failing? For example, what 
would happen to a transaction like the Bank of America-Merrill 
Lynch merger?

A.7. Did not respond by publication deadline.
                                ------                                

 RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM NEAL S. 
                             WOLIN

Q.1. How would you define proprietary trading?

A.1. Did not respond by publication deadline.

Q.2. Will the restrictions on proprietary trading and hedge 
fund ownership apply to all bank holding companies--including 
Goldman Sachs and Morgan Stanley--or only to deposit taking 
institutions?

A.2. Did not respond by publication deadline.

Q.3. Do you think the failure of Lehman Brothers would have 
been less painful if these rules had been in place? If you do, 
please explain how.

A.3. Did not respond by publication deadline.

Q.4. Do you think it would have been easier to allow AIG or 
Bear Stearns to fail if these rules had been in place? If you 
do, please explain why.

A.4. Did not respond by publication deadline.

Q.5. It would also be instructive to hear from you how the 
largest bank failures in U.S. history. How would the Volker 
rule have impacted Washington Mutual and IndyMac? Please be 
specific to each institution and each aspect of the proposed 
limit in size and scope.

A.5. Did not respond by publication deadline.

Q.6. Do you think that it would be easier in the future to 
allow any large, interconnected non-bank financial institution 
to fail if these rules are in place? If so, why?

A.6. Did not respond by publication deadline.

Q.7. How does limiting the size and scope of an institution 
prevent banks from making too many risky home loans?

A.7. Did not respond by publication deadline.

Q.8. In your testimony you correctly say, ``Since 1994, the 
United States has had a 10 percent concentration limit on bank 
deposits. The cap was designed to constrain future 
concentration in banking. Under this concentration limit, firms 
generally cannot engage in certain inter-state banking 
acquisitions if the acquisition would put them over the deposit 
cap. This deposit cap has helped constrain the growth in 
concentration among U.S. banking firms over the intervening 
years, and it has served the country well.''
    Yet, you also say that the new size limit ``should not 
require existing firms to divest operations.''
    Why should we not consider this newly proposed rule as 
protecting the chosen few enormous institutions that are 
currently too big to fail?

A.8. Did not respond by publication deadline.

Q.9. Banking regulators have waived long standing rules in 
order to allow certain companies to hold more than 10 percent 
of the nation's deposits despite a rule barring such a 
practice. Do you support a continued waiver, or should the 
regulators enforce the statutory depository caps?

A.9. Did not respond by publication deadline.

Q.10. A sad truth of the sweeping government interventions and 
bailouts last year is that it has made the problem of ``too big 
to fail'' worse because it has increased the spread between the 
average cost of funds for smaller banks and the cost of funds 
for larger ``too big to fail'' institutions. A study done by 
the FDIC shows that it has become even more profitable.
    Do you believe that there are currently any financial 
companies that are too big and should be broken up?

A.10. Did not respond by publication deadline.

              Additional Material Supplied for the Record

            GONE FISHING: E. GERALD CORRIGAN AND THE ERA OF 
                            MANAGED MARKETS
               The Herbert Gold Society, February 1, 1993
                         By Christopher Whalen

    Financial markets and many foreign governments were taken by 
surprise in early January when New York Federal Reserve Bank President 
E. Gerald Corrigan suddenly resigned. In the unusual press conference 
called to announce his decision, Corrigan, who officially leaves the 
New York Fed in August, made a point of denying that there was any 
``hidden agenda'' in his departure from more than 20 years of public 
service.
    Yet a good part of his career was not public and, indeed, was 
deliberately concealed, along with much of the logic behind many far-
reaching decisions. Whether you agreed with him or not, Corrigan was 
responsible for making difficult choices during a period of increasing 
instability in the U.S. financial system and the global economy. During 
the Volcker era, as the Fed Chairman received the headlines, his 
intimate friend and latter day fishing buddy Corrigan did ``all the 
heavy lifting behind the scenes,'' one insider recalls.
    Because of his important, albeit behind-the-scenes role, Corrigan's 
sudden decision to step down is doubly wrapped in mystery. A Democrat 
politically associated with Establishment Liberal personalities, 
Corrigan under President Bill Clinton seemed likely to be at the head 
of the list of prospects to succeed Chairman Greenspan. Thus he sheds 
the limelight under circumstances and in such a way as will only 
intensify speculation about numerous pending issues, including his role 
in the Salomon Brothers scandal, the Iraq-Banco Nazionale del Lavoro 
affair, the BCCI collapse and widely rumored misconduct in the LDC debt 
market, to cite only part of a longer list of professional and personal 
concerns.
    One nationally known journalist who has closely followed Corrigan's 
career says that ``there is more to come'' on both the Salomon and BNL 
fronts, and also predicts that several lesser Fed officials close to 
Corrigan also may be implicated. In fact, it appears that the New York 
Fed chief decided to resign in the face of several ongoing 
congressional and grand jury investigations that when completed might, 
perhaps, embarrass the publicity shy central bank and compel Chairman 
Alan Greenspan and the board of directors of the New York Reserve Bank 
to force him out.
    The press statement from the Board of Governors in Washington, for 
example, stated that Corrigan had only just made his decision to 
resign, but why then the lengthy, 8-month period between the 
resignation and his departure? In fact, the search committee to find 
his replacement had begun its work days, perhaps weeks earlier. Even as 
Corrigan met the press, a personal emissary sent by Corrigan was 
completing a week-long swing through Europe to inform central bankers 
privately of the impending retirement, a final courtesy from the man 
who at first carried messages and later the weight of decisions during 
over 20 years surveying world financial markets.
    Many political observers lament the loss of the Fed's most senior 
crisis manager, yet there is in fact considerable relief inside much of 
the Federal Reserve System at Corrigan's departure. ``Break out the 
champagne,'' declared one former colleague. ``Stalin is dead.'' The 
unflattering nickname refers to Corrigan's often abrasive, dictatorial 
management style.
    But another 20-plus year Fed veteran, though no less critical of 
Corrigan's methods, worries that there is no financial official of real 
international stature at the central bank for the first time since Paul 
Volcker left New York to become Fed Chairman in 1979. ``Aside from the 
rather aloof Greenspan,'' he frets, ``there's no one in Washington or 
among the regional Reserve Bank presidents who is able to pick up the 
telephone and know which bankers to call in the event of a crisis. 
Greenspan knows everyone, but he is no banker.''
    Who will replace Gerry Corrigan? Candidates range from Fed Vice 
Chairman David Mullins, an Arkansas native, to economists and bankers 
from around the country. Yet to appreciate the scale of the task to 
select his replacement, it is first necessary to review Corrigan's long 
career. He probably will be best remembered in his last incarnations as 
both head of the Cooke bank supervisory committee and the chief U.S. 
financial liaison to the shaky government of Boris Yeltsin in Moscow, 
where he and the equally hard-drinking Russian leader often stayed up 
all night devising schemes to stave off a debt default. The Russian 
effort is perhaps most interesting to students of the Fed because of 
the combination of luck and divine providence that brought the New York 
Fed chief and the Russian leader together in the first place and also 
because it illustrates many aspects of a two-decade long career that 
has been largely obscured from public view. But now the age of Corrigan 
is revealed, indirectly, in the vacuum his departure leaves at the top 
of the American financial system.
The Russian Business
    Early in the summer of 1991, Treasury Secretary Nicholas Brady, Fed 
Chairman Greenspan, Corrigan, and several lesser western functionaries 
traveled to Russia to meet with then-Soviet President Mikhail 
Gorbachev. The Brady-led economic SWAT team went to Moscow to hear the 
besieged Soviet leader ask for an assessment of the economic reforms 
that would be required for eventual International Monetary Fund 
membership (and the release of billions of dollars in new loans from 
the IMF a year later).
    One evening during the visit, as Brady and Greenspan went off to 
dine with Gorbachev, an aide to Corrigan, who was not invited along for 
dinner, suggested that it would not be a bad idea to meet 
``discreetly'' with Yeltsin. The meeting with the Russian leader was 
quietly arranged. Yeltsin, it should be remembered, had just completed 
a disastrous tour of the United States, where he was ignored by the 
Bush Administration, which saw him as a dangerous, often drunken 
irresponsible on the fringe of Soviet politics.
    ``Yeltsin deeply appreciated the courtesy of Corrigan's visit,'' 
according to one senior Fed official familiar with the details of the 
trip. About a month later, when the attempted military coup against 
Gorbachev thrust Yeltsin to the forefront, the Russian President did 
not forget his new-found dining companion and billiard partner, Gerald 
Corrigan. In November 1991, the New York Fed chief began a series of 
``technical assistance'' trips, which usually included time for trips 
to the country and visits to such places as Stalin's country house or 
dacha. He made many of his Russian trips in the company of a female Fed 
official that one peer described as the central bank's answer to James 
Baker's Margaret Tutwiller.
    In January 1992, Corrigan hosted a dinner for 200 bankers and other 
close friends in Yeltsin's honor at the New York Fed's beautiful 
Italian-revival building at 33 Liberty Street in lower Manhattan, in 
the shadow of Chase Manhattan Bank and a stone's throw from the House 
of Morgan. The two now-intimate friends reportedly danced and tossed 
back shots of vodka till the wee hours of the morning in the bank's 
magnificent dining room.
    Through 1991, as the once stalwart communist Yeltsin became deeply 
committed to ``free market reform,'' Corrigan began to advise Russia's 
leader on economic matters. This role was formalized in February 1992, 
after the fact, when the Fed's Board of Governors in Washington 
effectively appointed Corrigan ``czar'' to oversee American technical 
assistance to Moscow. Corrigan assembled a team of high-level financial 
experts from the New York financial community and led them to Russia at 
Yeltsin's request, to study and recommend further financial reforms.
    In May 1992, this team became part of a formal network called the 
``Russia-U.S. Forum,'' of which Corrigan is co-chair and which includes 
such establishment fixtures as David Rockefeller and Cyrus Vance as 
directors. Significantly, Vance is a two-term member of the board of 
directors of the New York Fed and part of the search committee to find 
a replacement for Corrigan.
    Thus the New York Fed chief, who was already the senior U.S. bank 
regulator, also assumed the role of financial liaison to the Yeltsin 
regime. Together with Corrigan's long-time mentor, former Fed Chairman 
Volcker, who ironically acted as adviser to the Russian government 
after years of steering the world through the international debt 
crisis, Corrigan has been perhaps the most influential Western 
financial expert on the scene in Russia, particularly after James Baker 
moved to the White House in August 1992 to direct the abortive Bush 
reelection effort.
    Yet were helping Russia move toward a market-based economy really 
Washington's first priority, the fate that brought Yeltsin and Corrigan 
together would have to be seen as one of those crazy events in history 
when the wrong person was in the right place at the wrong time. ``The 
oddest thing that is going on right now is that Gerry Corrigan is 
taking to Moscow a bunch of people from the big money center banks to 
tell them how to run a banking system,'' financial author Martin Mayer 
noted during a seminar on banking at Ohio State University last summer. 
``The Russians don't need that kind of help.''
    Perhaps it is just a coincidence, but Corrigan's resignation comes 
as Mayer is about to publish a new book later this year on the Salomon 
Brothers scandal that reveals the New York Fed's central role in the 
debacle. Yet Corrigan's willingness to tolerate Salomon's market 
shenanigans is not surprising. By his own admission, Corrigan has never 
entirely or even partially trusted in free markets, and the Fed's 
conduct in the Salomon affair was an illustration of this viewpoint put 
into practice. The New York Fed knew that something was afoot in the 
government bond market but turned a blind eye to Salomon's machinations 
rather than risk the ``stability'' of the sales of Treasury paper.
    Corrigan is a classic interventionist who sees the seemingly random 
workings of a truly free market as dangerously unpredictable. The 
intellectual author and sponsor of such uniquely modernist financial 
terms such as ``too big to fail,'' which refers to the unwritten 
government policy to bail out the depositors of big banks, and 
``systemic risk,'' which refers to the potential for market disruption 
arising from inter-bank claims when a major financial institutions 
fails, Corrigan's career at the Fed was devoted to thwarting the 
extreme variations of the marketplace in order to ``manage'' various 
financial and political crises, a role that he learned and gradually 
inherited from former Chairman Volcker.
    At a July 1, 1991 conference on restructuring financial markets, 
Corrigan said that relying entirely on market forces actually posed a 
risk to the world financial system. ``There is a tendency to think that 
market forces must be good,'' he opined, and said also that the 
``challenge'' for regulators will be how to ``balance free market 
forces'' with the ``dictates of stability in the financial structure.'' 
And as Salomon and a host of other examples illustrate, Corrigan worked 
very hard to ensure that stability, regardless of the secondary impact 
on markets or the long-term cost.
    A career of almost day-to-day crisis control stretched back to the 
Hunt Brothers silver debacle in 1980, but especially to the collapse of 
Drysdale Government Securities in 1982, the Mexican debt crisis (1982-
1990) and the October 1987 market crash. Russia was Corrigan's greatest 
and last test, yet despite claims of fostering private sector activity 
in Russia or stability in domestic financial markets, in fact his first 
and most important priority over two decades of service was 
consistently bureaucratic: to help heavily indebted countries and their 
creditor banks navigate a financial minefield that was neither of his 
making nor within his power to remove. Like Volcker before him, Gerald 
Corrigan cleaned up the messes left behind by the big banks and 
politicians in Washington, and tried to keep a bad situation from 
getting any worse.
Volcker's Apprentice
    Corrigan's unlikely rise to the top of the American financial 
system started in 1976 when as corporate secretary of the N.Y. Fed he 
was befriended by then-President Volcker. At the time, other senior 
officers of the New York Reserve Bank still were a bit stand-offish 
toward Volcker because of policy disagreements, most notably after 
America's abandonment of gold for international settlements at Camp 
David in August 1971, a move Volcker supported (he actually 
participated in the drafting of the plan). But Corrigan extended 
himself for the new president and quickly became his trusted adviser 
and friend, and the man doing the difficult jobs behind the scenes as 
Volcker attracted the limelight as the crisis manager.
    When Volcker was appointed Fed Chairman late in the summer of 1979, 
Corrigan followed him to Washington as the chairman's aide and hands-on 
situation manager (although he remained on the New York Fed's payroll 
and was subsequently promoted). He was quickly thrown into the crisis 
control fray when Bunker and Herbert Hunt's attempt to manipulate the 
silver market blew up into a $1.3 billion disaster the following year. 
Corrigan managed the unwinding of silver positions, providing the moral 
suasion necessary to convince reluctant banks to furnish credit to 
brokers who made bad loans to the Hunts to finance their silver 
purchases.
    In 1982, when Drysdale Government Securities collapsed, Corrigan 
was again the man on the scene to do the cleanup job, working to avoid 
the worst effects of one of the ugliest financial debacles in the post 
war period. Drysdale was the first in a series of shocks that year 
which included the Mexican debt default and the collapse of Penn Square 
Bank.
    Drysdale threatened not only the workings of the government 
securities market, but the stability of a major money center bank, 
Chase Manhattan, which saw its stock plummet when rumors began to fly 
as to the magnitude of losses. Corrigan fashioned a combination of Fed 
loans of cash and collateral, and other expedients, to make the crisis 
slowly disappear, even as Volcker again received public credit for 
meeting the crisis.
    It was about this time that Corrigan, who had never shown any 
inclination toward outdoor sports (although he is an avid pro-football 
fan), discovered a love for fly fishing, a favorite pastime of Volcker. 
He joined a select group of cronies such as current New York Fed 
foreign adviser and former Morgan Stanley partner Ed Yeo and then-IMF 
managing director Jacques de Larosiere, who would go on long fishing 
trips.
    We may never know what was discussed while this select group let 
their lines dangle into the water, but fishing no doubt took up far 
less than most of the time. Later in 1982 Volcker, who was by then 
supervising the unfolding Penn Square situation, pushed for Corrigan to 
take the open presidency of the Minneapolis Fed. (Volcker later 
admitted wanting to keep the badly insolvent Penn Square open for fear 
of wider market effects, but the FDIC closed down the now infamous 
Oklahoma bank, paying out only on insured deposits.)
    Significantly, as Volcker promoted Corrigan's career within the 
Fed, he took extraordinary measures to prevent the nomination or 
appointment of respected economists and free market advocates like W. 
Lee Hoskins and Jerry L. Jordan to head other Reserve Banks (both 
Hoskins and later Jordan were appointed to the Cleveland Reserve Bank's 
presidency after Volcker's departure in 1987). Hoskins in particular 
was the antithesis of Volcker, an unrepentant exponent of conservative, 
sound money theory who advocated making zero inflation a national goal. 
He left the Cleveland Fed last year to become president of the solid 
Huntington Bank in Columbus (which interestingly was among the last 
institutions to approve new bank loans for Chrysler in 1992).
    Hoskins and other free market exponents believe that ill-managed 
banks should be allowed to fail and that Federal deposit insurance 
hurts rather than protects the financial system by allowing banks to 
take excessive risks that are, in effect, subsidized by the American 
taxpayer. But this free market perspective, which represented 
mainstream American economic thought before the New Deal, is at odds 
with the Volcker-Corrigan view of avoiding ``systemic risk'' via public 
sops for large banks and other, more generalized types of government 
intervention in the ``private'' marketplace.
    Volcker moved to protect his bureaucratic flank in 1984 when he 
nominated Corrigan as a replacement for Anthony Solomon as president at 
the New York Fed, an event that required almost as much lobbying as was 
latter needed to block the appointment of Hoskins to head the St. Louis 
Fed in 1986. The cigar chomping Fed chairman got on a plane to call a 
rare Sunday meeting of the Reserve Bank's board, where he reportedly 
pounded the table and warned of being outnumbered by Reagan-era free 
market-zealots. The St. Louis Fed's board caved in to Volcker's demands 
and Hoskins was passed-over, although he would be appointed President 
of the Cleveland Fed in late 1987, after Volcker no longer was Federal 
Reserve Board Chairman.
    Significantly, Corrigan's impending selection in 1984 caused 
several more conservative line officers and research officials to flee 
the New York Reserve Bank. Roger Kubarych, one of the deputy heads of 
research in New York and a widely respected economist on Wall Street 
(he's Henry Kaufman's chief economist), actually resigned the day 
Corrigan's appointment was formally announced, fulfilling an earlier 
vow not to serve under Volcker's apprentice that symbolized earlier 
internal Fed disputes.
The Neverending Crisis
    From the first day he took over as head of the New York Fed in 
1985, Corrigan's chief priority was ``managing'' the LDC debt crisis 
and in particular its devastating effects on the New York money center 
banks. Even in the late 1980s, when most scholars and government 
officials admitted that loans to countries like Brazil, Argentina and 
Mexico would have to be written off, as J.P. Morgan did in 1989, 
Corrigan continued to push for new lending to indebted countries in an 
effort to bolster the fiction that loans made earlier could still be 
carried at par or book value, 100 cents on the dollar. Even today, when 
some analysts declare the debt crisis to be over, the secondary market 
bid prices for LDC debt range from 65 cents for Mexico to 45 cents for 
Argentina and 25 cents for Brazil.
    ``Anything approaching a `forced' write down of even a part of the 
debt--no matter how well dressed up--seems to me to run the risks of 
inevitably and fatally crushing the prospects for fresh money financing 
that is so central to growth prospects of the troubled LDCs and to the 
ultimate restoration of their credit standing,'' Corrigan wrote in the 
New York Fed quarterly review in 1988. ``A debt strategy that cannot 
hold out the hope of renewed debtor access to market sources of 
external finance is no strategy at all.''
    And of course, in the case of Mexico, debt relief has been followed 
by massive new lending and short-term investment, albeit to finance a 
growing external trade imbalance ($15 billion in deficit during the 
first 9 months of 1992 alone) that is strikingly similar to the import 
surge which preceded the 1982 debt default. Likewise bankrupt Russia, 
which is supposedly cutoff from new Western credit, has received almost 
$18 billion in new western loans over the past 12 months--loans 
guaranteed by the taxpayers of the G-7 countries.
    But in addition to pressing for new loans to LDC countries, 
Corrigan worked hard at home to manage the debt crisis, bending 
accounting rules, delaying and even intervening in the closing of bank 
examinations, resisting regulatory initiatives such as market value 
accounting for banks' investment securities portfolios and initially 
promoting the growth of the interbank loans, swaps and other designer 
``derivative'' assets now traded for short-term profit in the growing 
secondary market. In particular, Corrigan played a leading role in 
affording regulatory forbearance to a number of large banks with fatal 
levels of exposure to heavily indebted countries in Latin America. But 
no member of the New York Clearing House has received more special 
treatment than Citibank, the lead bank of the $216 billion total asset 
Citicorp organization.
    When former Citicorp chairman Walter Wriston said that sovereign 
nations don't go bankrupt, this in response to questions about his 
bank's extensive financial risk exposure because of lending in Latin 
America, his supreme confidence in the eventual outcome of the LDC debt 
crisis was credible because he and other financiers knew that senior 
Fed officials like Volcker and Corrigan would do their best to blunt 
the impact of bad LDC loans on the balance sheets and income statements 
of major banking institutions. In 1989, for example, as Wriston's 
successor, John Reed, was in Buenos Aires negotiating a debt-for-equity 
swap to reduce his bank's credit exposure in Argentina, Corrigan 
pressured bank examiners in New York to keep open the bank's 
examination for 14 months. This unprecedented intervention in a 
regularly scheduled audit contradicted the Fed's own policy statements 
in 1987 to the effect that large banks would be examined every 6 
months, with a full-scope examination every year.
    Corrigan's decision (he and other Fed officials refuse to discuss 
regulatory issues as a matter of standing policy) probably was made in 
order to avoid charges against earnings by forcing the bank to post 
higher reserves against its illiquid Third World loan portfolio, an 
action that would later be taken anyway as Argentina slid further down 
the slope of inflation and political chaos.
    Yet in a recent internal memo, Corrigan declared the debt crisis 
``resolved,'' even as LDC debt continues to grow, both in nominally and 
in real, inflation-adjusted terms. Public sector debt has fallen in 
Mexico, for example, accumulation of new private loans and short-term 
investment has driven total foreign debt over $120 billion, not-
withstanding the abortive Brady Plan, while real wages in Mexico 
continue to deteriorate. This is about $30 billion more than Mexico's 
total debt level following the Brady Plan debt exchange in 1989.
    It is significant to note that while Corrigan and other officials 
pushed the Baker plan after 1985 (essentially a new money lending 
program) to help ``buy time'' for commercial banks, as Volcker did 
before him, there remain literally thousands of unsecured commercial 
creditors of Mexico, Brazil and other LDCs who have little hope of ever 
seeing even the meager benefits such as World Bank guarantees on 
interest payments accorded to commercial banks under the Brady scheme. 
Indeed, because of its debt reduction aspects there remains doubt as to 
whether Corrigan even fully endorsed the abortive Brady Plan.
Systemic Risk & Fiat Money
    As vice chairman of the Federal Open Market Committee, a position 
by law held by the New York Fed chief, Corrigan consistently supported 
the forces pushing for easy money in recent years in order to reflate 
the domestic economy and eastern real estate markets, and thereby to 
bolster the sagging balance sheets of insolvent money center behemoths.
    In fairness, it must be said that Mr. Corrigan, for the most part, 
was merely following Chairman Greenspan's lead on those monetary policy 
votes. Since becoming a Reserve Bank president in 1982, he never 
dissented in an FOMC vote against the chairman's position under either 
Volcker or Greenspan. Yet as Bill Clinton seems destined to discover, 
embracing inflationism today in order to accommodate Federal deficits, 
and bail out badly managed commercial banks and real estate developers, 
has its price tomorrow in terms of maintaining long-term price and 
financial market stability.
    Several of the nation's largest commercial banks, which are 
headquartered in Corrigan's second Fed district, are or until recently 
have been by any rational, market-oriented measure insolvent and should 
have been closed or merged away years ago. Concern about the threat to 
the financial markets of ``systemic risk'' is used to keep big banks 
alive, and also as a broad justification for all types of market 
intervention.
    The reasoning behind ``systemic risk'' goes something like this: If 
Russia defaults on its debts, large banks (mostly in Europe) will fail, 
causing other banks and companies to lose money and also fail. 
Therefore, new money must keep flowing to countries like Russia, 
Mexico, Brazil and Argentina so that they may remain current on private 
debts to commercial lenders, essentially the old-style pyramid or Ponzi 
scheme on an international scale, funded by taxpayers in America, 
Europe and Japan via inflation and public sector debt.
    When Corrigan gave a speech earlier this year warning about the 
risks inherent in derivative, off-balance sheet instruments such as 
interest rate swaps, many market participants wondered aloud if the New 
York Fed chief really understands the market he once promoted but now 
so fears. ``Off-balance sheet activities have a role, but they must be 
managed and controlled carefully,'' he told a mystified audience at the 
New York State Bankers Association in February. ``And they must be 
understood by top management as well as traders and rocket 
scientists.''
    Swap market mavens were right to wonder about Corrigan's grasp of 
derivative securities, but they might better ask whether Corrigan 
appreciates the connection between embracing easy money and inflation 
to bail out the big banks, and the expansion of derivative markets. In 
fact, the growth of the swaps market in particular and financial 
innovation generally, is fueled by paper dollars created by monetary 
expansion, credit growth that Corrigan has long and repeatedly 
advocated within the FOMC's closed councils.
    From $2 trillion in 1990, the derivatives market grew to $3.8 
trillion at the end of last year (Citicorp is one quarter of the total 
swaps market) and may double again before the end of 1994. And yet in 
basic, purely financial terms, there is no difference between an 
interest rate swap with a counterparty incapable of understanding the 
risk, a loan to Brazil, and the commercial real estate loans that 
fueled the Olympia & York disaster; all are simply vehicles for 
marketing credit in a market awash in paper, legal tender greenbacks 
created by an increasingly politicized Federal Reserve Board.
    In addition to the exponential growth in markets such as interest 
rate swaps, another side effect of expansionary monetary policy has 
been an increase in market volatility generally. When the great 
mountain of dollars created by the Fed during the previous decade 
suddenly moved out of U.S. equities on Black Monday, October 19, 1987, 
the New York Fed under Corrigan reportedly urged private banks to 
purchase stock index futures to stabilize cash prices on the New York 
Stock Exchange. Corrigan bluntly told commercial banks to lend to 
brokers in order to help prop the market up, and dealers were even 
allowed to borrow collateral directly from the Fed in order to 
alleviate a short-squeeze. Orchestrating such a financial rescue is 
still intervention in the free market, albeit of an indirect nature.
    In October 1987, banks in Europe and Japan had refused to lend 
Treasury paper to counterparties in New York, many of whom had been 
taken short by customers and other dealers during the frenzied flight 
to quality that occurred, from stocks into AAA-rated U.S. Government 
debt. The Fed saved may dealers from grave losses by lending securities 
they could not otherwise obtain, but this seemingly legitimate response 
to a market upheaval still represents government inspired meddling in 
the workings of a supposedly private market. Traders who sell short a 
stock or bond that they cannot immediately buy back in the market at a 
lower price are no better than gamblers who have none to blame save 
themselves for such stupidity and should seek the counsel of a priest 
or bartender.
    But in an illustration of the broadly corporativist evolution of 
Fed policy, as manifested in the government bond market, Corrigan 
sought broader powers to support the dealer community. In fact, in the 
wake of the bond market collateral squeeze in 1987 (and again during 
the ``mini crash'' in October 1989), the New York Fed chief pushed for 
and late last year obtained authority from Congress to lend directly to 
broker-dealers in ``emergencies,'' thus allowing the central bank to 
provide direct liquidity support to the U.S. stock market the next time 
sellers badly outnumber buyers.
    When it came time to explain the 1987 debacle to the Congress and 
the American people, Corrigan was more than willing to help the private 
citizen drafted to oversee the task, former New Jersey Senator Nicholas 
Brady, who after being appointed to the Presidential commission created 
to study the crash, became Treasury Secretary in 1988 when James Baker 
left the government to run the Bush election campaign.
    Yet Corrigan assisted the work of Brady's hand-picked assistants, 
Harvard professor Robert Glauber, who later became under secretary of 
the Treasury for Finance, and David Mullins, who also joined Brady's 
Treasury and is now a Bush-appointee as Vice Chairman of the Fed Board 
of Governors. Mullins and Glauber worked on the Brady report in offices 
provided by the New York Fed and reportedly dined regularly with 
Corrigan, who offered them his informed view of how financial markets 
work.
    When the Salomon scandal erupted in the Spring and Summer of 1991, 
Corrigan was again the key man on the scene to manage the fallout from 
a debacle that has still been only partially unveiled. Following 1986, 
when regulatory responsibility for the government bond market had been 
explicitly given to the SEC, the Fed, at Corrigan's instruction, had 
largely curtailed its surveillance of the market for Treasury debt, 
particularly the informal ``when-issued'' market in Treasury paper 
before each auction.
    And yet when the Salomon scandal broke open, it was apparent that 
the hands-on ``management'' of markets prescribed by Corrigan had 
failed to prevent one of the great financial scandals of the century. 
``Neither in Washington nor in New York did the Fed seem aware that the 
dangers of failure to supervise this market had grown exponentially in 
1991,'' Mayer notes in an early draft of his upcoming book on the 
Salomon debacle. ``Like the Federal Home Loan Bank Board in its pursuit 
of making the S&Ls look solvent in 1981-82, the Fed had adopted tunnel-
vision policies to save the nation's banks. And just as excessive 
kindness to S&Ls in the early 1980s had drawn to the trough people who 
should not have been in the thrift business, Fed monetary policies in 
the early 1990s created a carnival in the government bond business.''
    The Salomon crisis was not the only bogie on the scope in 1991. 
During December 1990, the Federal Reserve Bank of New York, working in 
concert with several private institutions, fashioned a secret rescue 
package for Chase Manhattan Bank when markets refused to lend money to 
the troubled banking giant. While Chase officials vociferously deny 
that any bailout occurred, the pattern of discount window loans during 
the period and off-the-record statements by officials at the Fed and 
several private banks suggest very strongly that Corrigan's personal 
intervention prevented a major banking crisis at the end of 1990.
    Rational observers would agree that the collapse of a major banking 
institution is not a desirable outcome, but the larger, more 
fundamental issue is whether any private bank, large or small, should 
be subject to the discipline of the marketplace. In the case of 
Citibank, Chase and numerous other smaller institutions, Corrigan, like 
Volcker before him, answered this question with a resounding ``no.'' 
The corporativist tendencies of this extra-legal arrangement amounts to 
the privatization of profits and the socialization of losses.
A Question Of Principles
    The real issue raised by Corrigan and his supporters within the Fed 
bureaucracy has been not what they believe, but the fact that they did 
not seem to have any basic core beliefs with which to guide regulatory 
actions and policy recommendations during years of difficult domestic 
and international crises. Other than seeking to avoid a market-based 
resolution to bank insolvencies and other random events in the 
marketplace, for example, there is no discernible logic to ``too big to 
fail.''
    While this attitude may be useful to elected officials, appointed 
higher ups and the CEOs of large banks, it cannot help confusing an 
American public that still believes that concepts like free markets and 
the rule of law matter. There is not, for example, any explicit 
statutory authority supporting the doctrine of ``too big to fail,'' nor 
has Congress given the Fed authority to support the market for 
government bonds or even private equity via surreptitious purchases of 
stock index futures, as was alleged in 1987 and on several occasions 
since.
    In the case of the conflict between monetary accommodation for big 
money center banks and complaining about the explosive growth of 
derivative products, for example, or warning about banking capital 
levels while allowing regulatory forbearance and financial 
accommodation for brain dead money center institutions, Corrigan's 
positions are riven with logical inconsistencies and interventionist 
prescriptives that, as the Salomon scandal also illustrates, fail to 
address the underlying problems. But it may be unfair to place all or 
even part of the blame for this incongruity at his feet alone.
    Since beginning his work under Volcker in 1976, Corrigan has met 
and at least temporarily resolved each foreign and domestic crisis with 
various types of short-term expedients designed to maintain financial 
and frequently political stability. The rarefied atmosphere of crisis 
management leaves small time for recourse to first principles. In this 
respect, Corrigan must be seen as a pathetic figure, an errand boy 
doing difficult jobs for politicians and servile Fed Chairmen in 
Washington who have been unwilling to take the hard decisions needed to 
truly end the multiple crises that affected the American-centered world 
financial system since the 1960s abroad and the 1970s at home.
    By at once advocating new lending to LDCs while softening 
regulatory treatment for heavily exposed money center institutions, 
Corrigan was at the forefront of efforts to forestall the day of 
financial reckoning for the big banks, whether from Third World loans, 
domestic crises arising from real estate loans, or highly leveraged 
transactions. However, if Russia, Mexico or some other financial 
trouble spot boils over after next summer, Gerry Corrigan will have 
gone fishing. And he will leave behind a very large pair of much-
traveled boots that Alan Greenspan and the Clinton Administration 
quickly must fill.
                                 ______
                                 
              THE VOLCKER RULE & AIG: HEDGE FUNDS AND PROP
                       DESKS ARE NOT THE PROBLEM
                            January 25, 2010
                         By Christopher Whalen
        There are certain basic things that the investor must realize 
        today. In the first place, he must recognize the weakness of 
        his individual position . . . [T]he growth of investors from 
        the comparative few of a generation ago to the millions of the 
        present day has made it a practical impossibility for the 
        individual investor to know what is occurring in the affairs of 
        the corporation in which he has an interest. He has been forced 
        to relegate his rights to a controlling class whose interests 
        are often not identical to his own. Even the bondholder who has 
        superior rights finds in many cases that these rights have been 
        taken away from him by some clause buried in a complicated 
        indenture . . . The second fact that the investor must face is 
        that the banker whom tradition has considered the guardian of 
        the investors' interests is first and foremost a dealer in 
        securities; and no matter how prominent the name, the investor 
        must not forget that the banker, like every other merchant, is 
        primarily interested in his own greatest profit.

    --False Security: The Betrayal of the American Investor, Bernard J. 
Reis and John T. Flynn, Equinox Cooperative Press, NY (1937).

    This is an expanded version of a comment we posted last week on 
ZeroHedge.

    Watching the President announcing the proposal championed by former 
Fed Chairman Paul Volcker to forbid commercial banks from engaging in 
proprietary trading or growing market share beyond a certain size, we 
are reminded of the reaction by Washington a decade ago in response to 
the Enron and WorldCom accounting scandals, namely the Sarbanes-Oxley 
law. The final solution had nothing to do with the actual problem and 
everything to do with the strange political relationship between the 
national Congress, the central bank and the Wall Street dealer 
community. We call it the ``Alliance of Convenience.''
    The basic problems illustrated by the Enron/WorldCom scandals were 
old fashioned financial fraud and the equally old use of off-balance 
sheet vehicles to commit same. By responding with more stringent 
corporate governance requirements, the Congress was seen to be 
responsive--but without harming Wall Street's basic business model, 
which was described beautifully by Bernard J. Reis and John T. Flynn 
some eighty years ago in the book False Security.
    A decade since the Enron-WorldCom scandals, we still have the same 
basic problems, namely the use of OBS vehicles and OTC structured 
securities and derivatives to commit securities fraud via deceptive 
instruments and poor or no disclosure. Author Martin Mayer teaches us 
that another name for OTC markets is ``bucket shop,'' thus the focus on 
prop trading today in the Volcker Rule seems entirely off target--and 
deliberately so. The Volcker Rule, at least as articulated so far, does 
not solve the problem nor is it intended to. And what is the problem?
    Not a single major securities firm or bank failed due to prop 
trading during the past several years. Instead, it was the securities 
origination and sales process, that is, the customer side of the 
business of originating and selling securities that was the real source 
of systemic risk. The Volcker Rule conveniently ignores the securities 
sales and underwriting side of the business and instead talks about 
hedge funds and proprietary trading desks operated inside large dealer 
banks. But this is no surprise. Note that former SEC chairman Bill 
Donaldson was standing next to President Obama on the dais last week 
when the President unveiled his reform, along with Paul Volcker and 
Treasury Secretary Tim Geithner.
    Donaldson is the latest, greatest guardian of Wall Street and was 
at the White House to reassure the major Sell Side firms that the Obama 
reforms would do no harm. But frankly Chairman Volcker poses little 
more threat to Wall Street's largest banks than does Donaldson. After 
all, Chairman Volcker made his reputation as an inflation fighter and 
not in bank supervision. Chairman Volcker was never known as a hawk on 
bank regulatory matters and, quite the contrary, was always attentive 
to the needs of the largest banks.
    Volcker's protege, never forget, was E. Gerald Corrigan, former 
President of the Federal Reserve Bank of New York and the intellectual 
author of the ``Too Big To Fail'' (TBTF) doctrine for large banks and 
the related economist nonsense of ``systemic risk.'' But Corrigan, who 
now hangs his hat at Goldman Sachs (GS), did not originate these ideas. 
Corrigan was never anything more than the wizard's apprentice. As 
members of the Herbert Gold Society wrote in the 1993 paper ``Gone 
Fishing: E. Gerald Corrigan and the Era of Managed Markets'':

        Yet a good part of his career was not public and, indeed, was 
        deliberately concealed, along with much of the logic behind 
        many far-reaching decisions. Whether you agreed with him or 
        not, Corrigan was responsible for making difficult choices 
        during a period of increasing instability in the U.S. financial 
        system and the global economy. During the Volcker era, as the 
        Fed Chairman received the headlines, his intimate friend and 
        latter day fishing buddy Corrigan did `all the heavy lifting 
        behind the scenes,' one insider recalls.

    The lesson to take from the Volcker-Corrigan relationship is don't 
look for any reform proposals out of Chairman Volcker that will truly 
inconvenience the large, TBTF dealer banks. The Fed, after all, has for 
several decades been the chief proponent of unregulated OTC markets and 
the notion that banks and investors could ever manage the risks from 
these opaque and unpredictable instruments. Again to quote from the 
``Gone Fishing'' paper:

        Corrigan is a classic interventionist who sees the seemingly 
        random workings of a truly free market as dangerously 
        unpredictable. The intellectual author and sponsor of such 
        uniquely modernist financial terms such as `too big to fail,' 
        which refers to the unwritten government policy to bail out the 
        depositors of big banks, and `systemic risk,' which refers to 
        the potential for market disruption arising from inter-bank 
        claims when a major financial institutions fails. Corrigan's 
        career at the Fed was devoted to thwarting the extreme 
        variations of the marketplace in order to `manage' various 
        financial and political crises, a role that he learned and 
        gradually inherited from former Chairman Volcker.

    As Wall Street's normally selfish behavior spun completely out of 
control, Volcker has become an advocate of reform, but only focused on 
those areas that do not threaten Wall Street's core business, namely 
creating toxic waste in the form of OTC derivatives such as credit 
default swaps and unregistered, complex assets such as collateralized 
debt obligations, and stuffing same down the throats of institutional 
investors, smaller banks and insurance companies. Securities 
underwriting and sales is the one area that you will most certainly not 
hear President Obama or Bill Donaldson or Chairman Volcker or HFS 
Committee Chairman Barney Frank mention. You can torment prop traders 
and hedge funds, but please leave the syndicate and sales desks alone.
    Readers of The IRA will recall a comment we published half a decade 
ago (``Complex Structured Assets: Feds Propose New House Rules,'' May 
24, 2004), wherein we described how the SEC and other regulators knew 
that a problem existed regarding the underwriting and sale of complex 
structured assets, but did almost nothing. The major Sell Side firms 
pushed back and forced regulators to retreat from their original 
intention of imposing retail standards such as suitability and know 
your customer on institutional underwriting and sales. Before Enron, 
don't forget, there had been dozens of instances of OTC derivatives and 
structured assets causing losses to institutional investors, public 
pensions and corporations, but Washington's political class and the 
various regulators did nothing.
    Ultimately, the ``Interagency Statement on Sound Practices 
Concerning Complex Structured Finance Activities'' was adopted, but as 
guidance only; and even then, the guidance was focused mostly on 
protecting the large dealers from reputational risk as and when they 
cause losses to one of their less than savvy clients. The proposal read 
in part:

        The events associated with Enron Corp. demonstrate the 
        potential for the abusive use of complex structured finance 
        transactions, as well as the substantial legal and reputational 
        risks that financial institutions face when they participate in 
        complex structured finance transactions that are designed or 
        used for improper purposes.

    The need for focus on the securities underwriting and sales process 
is illustrated by American International Group (AIG), the latest poster 
child/victim for this round of rape and pillage by the large Sell Side 
dealer banks. Do you remember Procter & Gamble (PG)? How about Gibson 
Greetings? AIG, along with many, many other public and private Buy Side 
investors, was defrauded by the dealers who executed trades with the 
giant insurer. The FDIC and the Deposit Insurance Fund is another 
large, perhaps the largest, victim of the structured finance shell 
game, but Chairman Volcker and President Obama also are silent on this 
issue. Proprietary trading was not the problem with AIG nor the cause 
of the financial crisis, but instead the sales, origination and 
securities underwriting side of the Sell Side banking business.
    The major OTC dealers, starting with Merrill Lynch, Citigroup (C), 
GS and Deutsche Bank (DB) were sucking AIG's blood for years, one 
reason why the latest ``reform'' proposal by Washington has nothing to 
do with either OTC derivatives, complex structured assets or OBS 
financial vehicles. And this is why, IOHO, the continuing inquiry into 
the AIG mess presents a terrible risk to Merrill, now owned by Bank of 
America (BCA), GS, C, DB and the other dealers--especially when you 
recall that the AIG insurance underwriting units were lending 
collateral to support some of the derivatives trades and were also 
writing naked credit default swaps with these same dealers.
    Deliberately causing a loss to a regulated insurance underwriter is 
a felony in New York and most other states in the United States. Thus 
the necessity of the bailout--but that was only the obvious reason. 
Indeed, the dirty little secret that nobody dares to explore in the AIG 
mess is that the Federal bailout represents the complete failure of 
state-law regulation of the U.S. insurance industry. One of the great 
things about the Reis and Flynn book excerpted above is the description 
of the assorted types of complex structured assets that Wall Street was 
creating in the 1920s. Many of these fraudulent securities were created 
and sold by insurance and mortgage title companies. That is why after 
the Great Depression, insurers were strictly limited to operations in a 
given state and were prohibited from operating on a national basis and 
from any involvement in securities underwriting.
    The arrival of AIG into the high-beta world of Wall Street finance 
in the 1990s represented a completion of the historical circle and also 
the evolution of AIG and other U.S. insurers far beyond the reach of 
state law regulation. Let us say that again. The bailout of AIG was not 
merely about the counterparty financial exposure of the large dealer 
banks, but was also about the political exposure of the insurance 
industry and the state insurance regulators, who literally missed the 
biggest act of financial fraud in U.S. history. But you won't hear 
Chairman Volcker or President Obama talking about Federal regulation of 
the insurance industry.
    And AIG is hardly the only global insurer that is part of the 
problem in the insurance industry. In case you missed it, last week the 
Securities and Exchange Commission charged General Re for its 
involvement in separate schemes by AIG and Prudential Financial (PRU) 
to manipulate and falsify their reported financial results. General Re, 
a subsidiary of Berkshire Hathaway (BRK), is a holding company for 
global reinsurance and related operations.
    As we wrote last year (``AIG: Before Credit Default Swaps, There 
Was Reinsurance,'' April 2, 2009), Warren Buffett's GenRe was actively 
involved in helping AIG to falsify its financial statements and thereby 
mislead investors using reinsurance, the functional equivalent of 
credit default swaps. Yet somehow the insurance industry has been 
almost untouched by official inquiries into the crisis. Notice that in 
settling the SEC action, General Re agreed to pay $92.2 million and 
dissolve a Dublin subsidiary to resolve Federal charges relating to 
sham finite reinsurance contracts with AIG and PRU's former property/
casualty division. Now why do you suppose a U.S. insurance entity would 
run a finite insurance scheme through an affiliate located in Dublin? 
Perhaps for the same reason that AIG located a thrift subsidiary in the 
EU, namely to escape disclosure and regulation.
    If you accept that situations such as AIG and other cases where Buy 
Side investors (and, indirectly, the U.S. taxpayer) were defrauded 
through the use of OTC derivatives and/or structured assets as the 
archetype ``problems'' that require a public policy response, then the 
Volcker Rule does not address the problem. The basic issue that still 
has not been addressed by Congress and most Federal regulators (other 
than the FDIC with its proposed rule on bank securitizations) is how to 
fix the markets for OTC derivatives and structured finance vehicles 
that caused losses to AIG and other investors.
    Neither prop trading nor the size of the largest banks are the 
causes of the financial crisis. Instead, opaque OTC markets, 
deliberately deceptive structured financial instruments and a general 
lack of disclosure are the real problems. Bring the closed, bilateral 
world of OTC markets into the sunlight of multilateral, public price 
discovery and require SEC registration for all securitizations, and you 
start down the path to a practical solution. But don't hold your breath 
waiting for President Obama or the Congress or former Fed chairmen to 
start that conversation.
                                 ______
                                 
        PREPARED STATEMENT OF THE FINANCIAL SERVICES ROUNDTABLE
                            February 2, 2010

    The Financial Services Roundtable (``Roundtable'') respectfully 
offers this statement for the record on ``Prohibiting Certain High-Risk 
Investment Activities by Banks and Bank Holding Companies.''
    The Financial Services Roundtable represents 100 of the largest 
integrated financial services companies providing banking, insurance, 
and investment products and services to the American consumer.
    The Roundtable supports the goals of the Administration and of 
Congress in building a stronger economy, and rebuilding a regulatory 
framework that is modern, effective, and encourages economic growth. We 
are concerned, however, that recent proposals outlined by President 
Obama and Paul Volcker, Chairman of President's Economic Recovery 
Advisory Board, are a step in the wrong direction. The proposed 
``Volcker rule'' would prohibit U.S. banks and their non-bank 
affiliates from owning, investing in or sponsoring hedge funds, private 
equity funds and proprietary trading operations for their own profit, 
``unrelated to serving customers.'' While limited in detail, the 
``Volcker rule'' could be interpreted as limiting the growth of small 
businesses; curtailing the ability of financial institutions to manage 
risk; increasing the cost of capital for businesses; and putting U.S. 
financial institutions at a competitive disadvantage to their European 
and Asian counterparts.
    For example, proprietary trading, most broadly, is where a 
financial services company is putting their own capital at risk. By 
current regulation, bank-holding companies cannot acquire more than5 
percent of the shares of a company. Securities firms that are 
affiliated with banks can exceed the 5 percent limit under their 
merchant banking authority. This permits them to acquire shares in on-
going firms, but they cannot operate those firms, and cannot hold the 
investment for more than a certain period of time. Many additional 
rules apply to ensure safety across the board.
    To be clear, excessive risk can, and should, be curtailed. We are 
committed to sound risk management practices that benefit the long-
term, sustained health of our financial institutions and economy at-
large.
    The Roundtable is committed to protecting consumers from 
irresponsible loans, trades and excessive risks. We will continue to 
work with both Congress and the Administration to ensure that these 
goals are met.
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