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52–966 PDF 2009

S. HRG. 111–141 

LESSONS LEARNED IN RISK MANAGEMENT 

OVERSIGHT AT FEDERAL FINANCIAL REGULATORS 

HEARING 

BEFORE THE

SUBCOMMITTE ON SECURITIES, INSURANCE, 

AND INVESTMENT 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

ON 

DISCUSSING THE ROLE OF FEDERAL FINANCIAL REGULATORS IN THE 

FINANCIAL CRISIS IN THE UNITED STATES AND REFORMING REGULATION TO ENSURE A STRONG FINANCIAL SYSTEM 

MARCH 18, 2009 

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

( 

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

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

MEL MARTINEZ, Florida 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

KAY BAILEY HUTCHISON, Texas 

COLIN MCGINNIS, Acting Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director and Counsel 

DAWN RATLIFF, Chief Clerk 

DEVIN HARTLEY, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT

JACK REED, Rhode Island, Chairman 

JIM BUNNING, Kentucky, Ranking Member 

TIM JOHNSON, South Dakota 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

MARK R. WARNER, Virginia 

MICHAEL F. BENNET, Colorado 

CHRISTOPHER J. DODD, Connecticut 

MEL MARTINEZ, Florida 

ROBERT F. BENNETT, Utah 

MIKE CRAPO, Idaho 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

BOB CORKER, Tennessee 

DIDEM NISANCI, Staff Director 

WILLIAM HENDERSON, Republican Staff Director 

ROB LEE, GAO Detailee 

RANDY FASNACHT, GAO Detailee 

(II)

C O N T E N T S 

WEDNESDAY, MARCH 18, 2009 

Page 

Opening statement of Senator Reed ...................................................................... 1 

Opening statements, comments, or prepared statements of: 

Senator Bunning ............................................................................................... 3 

WITNESSES 

Orice M. Williams, Director, Financial Markets and Community Investment, 

Government Accountability Office ...................................................................... 4 

Prepared statement .......................................................................................... 30 

Roger T. Cole, Director, Division of Banking Supervision and Regulation, 

Board of Governors of the Federal Reserve System .......................................... 6 

Prepared statement .......................................................................................... 63 

Response to written questions of Senator Vitter ........................................... 94 

Timothy W. Long, Senior Deputy Comptroller, Bank Supervision Policy and 

Chief National Bank Examiner, Office of the Comptroller of the Currency ... 8 

Prepared statement .......................................................................................... 70 

Response to written questions of Senator Vitter ........................................... 98 

Scott M. Polakoff, Acting Director, Office of Thrift Supervision .......................... 9 

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

Response to written questions of Senator Vitter ........................................... 101 

Erik Sirri, Director, Division of Trading and Markets, Securities and Exchange Commission .............................................................................................. 11 

Prepared statement .......................................................................................... 87 

Response to written questions of Senator Vitter ........................................... 175 

(III)

(1) 

LESSONS LEARNED IN RISK MANAGEMENT 

OVERSIGHT AT FEDERAL FINANCIAL 

REGULATORS 

WEDNESDAY, MARCH 18, 2009 

U.S. SENATE, 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND

INVESTMENT, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Subcommittee met at 3:34 p.m., in room SD–538, Dirksen 

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

OPENING STATEMENT OF SENATOR JACK REED 

Senator REED. Let me call the hearing to order. Let me first 

apologize for the extra delay. We were engaged in voting, and these 

things take longer than we usually expect, but thank you very 

much. 

I want to thank you all for joining us here today. This financial 

crisis has demonstrated that, contrary to the presumption of many, 

financial institutions were unprepared and in many cases incapable 

of adequately assessing the risks that they were bearing on their 

books. The governance structures, the firm managers, and sophisticated models all failed to capture the magnitude of the risks that 

were building. Now the mistakes and poor risk management by 

these financial institutions and their regulators have become the 

taxpayers’ problems, with the effects spiraling through the broader 

global economy. 

The trillions of dollars in losses stand as witness to the many 

failures of risk management at these firms. Blame must primarily 

be placed at the feet of these financial institutions which gambled 

and then cashed in on exorbitant transaction fees for creating exotic new financial products. 

The guiding presumption of many, including former Federal Reserve Chairman Alan Greenspan, was that self-interest would keep 

these firms from engaging in overly risky behavior; and if that was 

not sufficient, then surely market discipline would rein in excesses. 

But, in reality, both proved inadequate to constrain excessive risk 

taking. The drive for short-term profits led to irrational behavior 

that affected many, not just a few firms. 

When self-interest and market discipline break down, we hope 

that the safety net of regulators will guide us out of the storm. 

However, if the people engaging in these complex transactions did 

2 

not understand the risk, the regulators, it appears, based upon the 

report we have been given today, might have known even less. The 

capacity to conduct oversight of the risk management function at 

these firms was in many cases lacking. 

During the good times, when all the excesses were building up, 

the regulators did not press hard enough. Yet it is during these 

times that it is most important, as excesses encourage a sense of 

fearlessness about risk taking, that the regulators act promptly to 

constrain the exuberance. 

Perhaps more fundamentally, the regulators should be asking 

hard questions. When new financial products are drawing in unprecedented profits, they should be asking pointed questions about 

the cash-flows and how the products work, including how they perform in good times and bad. Reverse engineering these products is 

critical if regulators are to understand how they operate and know 

their embedded risk. 

Regulators also need a firm-view on risk. As we heard in testimony last week concerning AIG, the firm stopped offering credit 

default swaps on CDOs and mortgage-backed securities in one area 

of the firm, at the same time it started risky securities lending in 

another area of the firm. 

Another bank claimed it was never involved in subprime lending, 

yet it was buying mortgage lenders engaged in the practice and 

securitizing such products. 

Last June, I called a similar hearing to discuss risk management 

and its implications for systemic risk. Unfortunately, further 

variances in risk management have taken place since that time. 

The purpose of this hearing is to bring to light the specific problems and to find a positive way forward. This hearing is particularly important given the need for swift and yet deliberate regulatory reform. 

GAO at my request, after last June’s risk management hearing, 

undertook a study of the risk management function of those regulators responsible for large financial institutions. GAO reviewed a 

sample of large, complex financial institutions to determine what 

the regulators knew, when they knew it, and what changes were 

requested as a result of the regulatory examinations and inquiries. 

While GAO will be sharing this in testimony, I wanted to highlight 

a few findings that I found particularly troubling. 

Regulators found problems as early as 2005, 4 years ago, with 

the risk management systems at large, complex financial institutions, but often were not aggressive in insisting on changes at 

firms until market events made the problem self-evident. 

A Federal Reserve review conducted in 2006 concludes that no 

large, complex financial institutions they reviewed had sufficient 

enterprise-wide stress tests to determine what economic or other 

scenarios might render the entire company insolvent. Moreover, 

many large, complex financial institutions could not sufficiently 

measure or manage all of their risk at a consolidated level; rather, 

they focused on risk within various subsidiaries without looking at 

the health of the entire holding company. Even knowing this, regulators did not significantly change their ratings of such firms until 

the crisis emerged. 

3 

Because of the sensitive nature of the information, I would ask 

that my colleagues avoid asking about any currently ongoing financial institution by name. Instead, I think the focus here is on the 

performance of the regulator and also in general the performance 

of these regulated entities. 

The GAO’s review comes at an important time in our history. It 

is the kind of deep analysis that should guide us forward as we 

take up questions on regulatory reform that will serve as the foundation for financial oversight as we go forward. In short, major regulatory reform is coming. I hope that we can learn from what has 

transpired, move forward with a stronger safety net, and build a 

strong financial system. 

At this time, I would like to recognize the Ranking Member, Senator Bunning. Senator. 

STATEMENT OF SENATOR JIM BUNNING 

Senator BUNNING. Thank you, Chairman Reed. This is my first 

hearing working with you on this Subcommittee. I am glad to be 

here, and I look forward to working with you for years to come. 

I think what we are going to hear today from our witnesses is 

that failures in risk management that contributed to our current 

economic crisis were not just the result of problems with our laws 

or poor decisions by firms. No, there was also a failure by regulators to recognize the dangers and, even worse, a lack of will to 

do something about the problems that they did find. 

Mr. Chairman, I find that deeply troubling. I also find the example of the 2006 Federal Reserve study mentioned in the report to 

be extremely troubling. The Fed found that none of the institutions 

it looked at had stress tests that covered the entire company and 

none of the tests to see what would make them insolvent. That is 

bad and shows the irresponsibility of the firms. But as far as I can 

tell, the Fed also did little or nothing about it. That is worse and 

should throw cold water on the idea of some that the Fed should 

be the new risk regulator. 

I find the admission by some regulators to GAO that they did not 

understand the real risk or the importance of contributing factors 

to be refreshing, but still very troubling. Those admissions should 

raise questions about whether we can ever create a risk regulator 

that will understand and act to stop systemwide risk. In a system 

of ‘‘too big too fail’’ when market discipline has been removed by 

bailouts, we have to rely on regulators to make sure firms do not 

get into trouble. 

But if our regulators are unable to find problems and unwilling 

to do something about them, we are in real trouble, and maybe we 

need to reconsider the whole concept of relying on regulators to be 

the last line of defense against all problems. 

Why should we think a few changes in the law will magically 

make them more effective the next time around? We can try to fix 

problems with our current system, but we cannot legislate will or 

competency. Instead, we need to build a system where everyone is 

accountable and has incentives to perform due diligence, a sort of 

check-and-balance, so if any one party does not do so, it will not 

lead to an overall failure. 

4 

The system also needs to be robust enough to handle the failure 

of individual firms, and we should assume that firms will fail, because they do. To handle that, we need to improve the authority 

of regulators to take control of and shut down failing firms through 

some type of orderly bankruptcy. We also need to hold directors 

and executives accountable. If everyone knows they will face the 

consequences of their actions, they will be more careful in the future. I think that will go a long way in the future to creating a stable financial system than rearranging the furniture downtown at 

various regulators. 

Again, thank you, Mr. Chairman. I am looking forward to hearing from the witnesses. 

Senator REED. Thank you, Senator Bunning. I, too, look forward 

not only to hearing from the witnesses, but working with you on 

this Subcommittee. Thank you very much. 

Let me introduce our panel. Ms. Orice Williams is the Director 

of the Financial Markets and Community Investment group at the 

Government Accountability Office. 

Mr. Roger Cole is Director of the Division of Banking Supervision 

and Regulation, Federal Reserve Board. 

Mr. Timothy Long is the Senior Deputy Comptroller, Bank Supervision Policy and Chief National Bank Examiner for the Office 

of the Comptroller of the Currency. 

Mr. Scott Polakoff is the Acting Director of the Office of Thrift 

Supervision. 

And Dr. Erik Sirri is the Director, Division of Trading and Markets, U.S. Securities and Exchange Commission. 

All of your testimony will be made part of the record. You may 

summarize if you wish. In fact, that is encouraged. And I understand both Ms. Williams and Mr. Polakoff have had a long day of 

testimony, so thank you particularly for waiting and being with us 

today. 

Ms. Williams, would you please begin? 

STATEMENT OF ORICE M. WILLIAMS, DIRECTOR, FINANCIAL 

MARKETS AND COMMUNITY INVESTMENT, GOVERNMENT 

ACCOUNTABILITY OFFICE 

Ms. WILLIAMS. Mr. Chairman and Ranking Member Bunning, I 

am pleased to be here today to discuss lessons learned from risk 

management oversight at large, complex institutions. At your request, we initiated work in December to review the risk management oversight of large institutions by the banking and securities 

regulators, namely, the Federal Reserve, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Securities and Exchange Commission, and FINRA. 

Our objectives were to: one, identify how regulators oversee risk 

management at large institutions; two, identify the extent to which 

regulators identified shortcomings in risk management at selected 

institutions prior to the financial crisis; and, three, how some aspects of the regulatory system may have contributed to or hindered 

their oversight. 

However, I need to note that Section 714 of the Federal Banking 

Agency Audit Act generally prohibits GAO from disclosing nonpublic information about an open bank. Therefore, I will not disVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 S:\DOCS\52966.TXT SHERYL
5 

close the banking institutions included in our sample or provide detailed information obtained from the examinations or interviews 

with examination staff. 

First, we found the regulators generally maintained continuous 

contact with large complex institutions using a risk-based examination approach that aims to identify areas of risk and assess these 

institutions’ risk management systems. But the approaches of the 

banking and securities regulators varies somewhat. 

Likewise, the regulators generally use a combination of tools and 

activities to assess the quality of risk management. For example, 

bank examiners review the activities, products, and services that 

an institution engaged in to identify risk and then, through continuous monitoring and targeted examinations, assess how the institution manages those risks. When regulators identify weaknesses 

in risk management at an institution, they have a number of formal and/or informal supervisory tools they can use for enforcement 

and to effect change. 

For the examinations we reviewed, we found that regulators had 

identified numerous weaknesses in institutions’ risk management 

systems prior to the beginning of the financial crisis. However, regulators did not effectively address the weaknesses or in some cases 

fully understand their magnitude until the institutions were 

stressed. In hindsight, the regulators told us that they had not 

fully appreciated the risks to the institutions or the implications of 

the identified weaknesses for the stability of the overall financial 

system. 

We also found that some aspects of the regulatory system may 

have hindered regulators’ oversight of risk management. For example, no regulator systematically and effectively looks across all 

large, complex institutions to identify factors that could have a destabilizing effect on the overall financial system. 

In closing, I will share a few observations. 

First, while an institution’s risk managers directors, and auditors, all have key roles to play in effective corporate governance, 

regulators, as outside assessors of the overall adequacy of the system of risk management, also have an important role in assessing 

risk management. Yet the current financial crisis has revealed that 

many institutions had not adequately identified, measured, and 

managed all core components of sound risk management. We also 

found that for the limited number of large, complex institutions we 

reviewed, the regulators failed to identify the magnitude of these 

weaknesses, and that when weaknesses were identified, they generally did not take forceful action to prompt these institutions to 

address them. 

Second, while our recent work is based on a limited number of 

institutions, these examples highlight the significant challenges 

regulators face in assessing risk management systems at large, 

complex institutions. While the painful lessons learned during the 

current crisis bolster market discipline and regulatory authority in 

the short term, effective regulation requires that regulators critically assess their regulatory approaches, especially during good 

times, to ensure that they are aware of potential regulatory blind 

spots. This means constantly re-evaluating regulatory and superVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 S:\DOCS\52966.TXT SHERYL
6 

visory approaches and understanding inherent biases in regulatory 

assumptions. 

While we commend recent supervisory efforts to respond to the 

current crisis, the new guidance we have seen tends to focus on 

issues specific to this crisis rather than on broader lessons learned 

about the need for more forward-looking assessments and on the 

reasons that regulation failed. 

Finally, the current institution-centric approach has resulted in 

regulators all too often focusing on the risks of individual institutions and regulators looking at how institutions are managing individual risks, while missing the implications of the collective strategy which is premised on the institution having little liquidity risk 

and adequate capital. Whether the failures of some institutions ultimately come about because of a failure to manage a particular 

risk, such as liquidity or credit risk, these institutions often lack 

some of the basic components of good risk management, for example, having boards of directors and senior managers set the tone for 

proper risk management across the enterprise. 

Mr. Chairman, Ranking Member, this concludes my oral statement, and I would be happy to answer any questions at the appropriate time. 

Senator REED. Thank you, Ms. Williams. 

Mr. Cole, please. Is your microphone on, Mr. Cole? 

Senator BUNNING. Would you put your microphone up to your 

mouth a little closer? 

Senator REED. Thank you. 

STATEMENT OF ROGER T. COLE, DIRECTOR, DIVISION OF 

BANKING SUPERVISION AND REGULATION, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 

Mr. COLE. Chairman Reed, Ranking Member Bunning, it is my 

pleasure today to discuss the state of risk management in the 

banking industry and the steps taken by supervisors to address 

risk management shortcomings. 

The Federal Reserve continues to take vigorous and concerted 

steps to correct the risk management weaknesses at banking organizations revealed by the current financial crisis. In addition, we 

are taking actions internally to improve supervisory practices addressing issues identified by our own internal review. 

The U.S. financial system is experiencing unprecedented disruptions that have emerged with unusual speed. Financial institutions 

have been adversely affected by the financial crisis itself, as well 

as by the ensuing economic downturn. 

In the period leading up to the crisis, the Federal Reserve and 

other U.S. banking supervisors took several important steps to improve the safety and soundness of banking organizations and the 

resilience of the financial system, such as improving banks’ business continuity plans and the compliance with the Bank Secrecy 

Act and anti-money-laundering requirements after the September 

11 terrorist attacks. 

In addition, the Federal Reserve, working with the other U.S. 

banking agencies, issued several pieces of supervisory guidance before the onset of the crisis such as for nontraditional mortgages, 

commercial real estate, and subprime lending, and this was to 

7 

highlight the emerging risks and point bankers to prudential risk 

management practices they should follow. 

We are continuing and expanding the supervisory actions mentioned by Vice Chairman Kohn last June before this Subcommittee 

to improve risk management at banking organizations. While additional work is necessary, supervised institutions are making 

progress. Where we do not see sufficient progress, we demand corrective action from senior management and boards of directors. 

Bankers are being required to look not just at risks from the 

past, but also to have a good understanding of their risks going forward. For instance, we are monitoring the major firms’ liquidity positions on a daily basis, discussing key market developments with 

senior management and requiring strong contingency funding 

plans. We are conducting similar activities for capital planning and 

capital adequacy, requiring banking organizations to maintain 

strong capital buffers over regulatory minimums. 

Supervised institutions are being required to improve their risk 

identification practices. Counterparty credit risk is also receiving 

considerable focus. In all of our areas of review, we are requiring 

banks to consider the impact of prolonged, stressful environments. 

The Federal Reserve continues to play a leading role in the work 

of the Senior Supervisors Group whose report on risk management 

practices at major U.S. and international firms has provided a tool 

for benchmarking current progress. Importantly, our evaluation of 

banks’ progress in this regard is being incorporated into the supervisory exam process going forward to make sure that they are complying and are making the improvements we are expecting. 

In addition to the steps taken to improve banks’ practices, we are 

taking concrete steps to enhance our own supervisory practices. 

The current crisis has helped us recognize areas in which we can 

improve. Vice Chairman Kohn is leading a systematic internal 

process to identify lessons learned and develop recommendations. 

As you know, we are also meeting with Members of Congress and 

other Government bodies, including the Government Accountability 

Office, to consult on lessons learned and to hear additional suggestions for improving supervisory practices. 

We have already augmented our internal process to disseminate 

information to examination staff about emerging risks within the 

industry. Additionally, with the recent Federal Reserve issuance of 

supervisory guidance on consolidated supervision, we are not only 

enhancing the examination of large, complex firms with multiple 

legal entities, but also improving our understanding of markets 

and counterparties, contributing to our broader financial stability 

efforts. 

Looking forward, we see opportunity to improve our communication of supervisory expectations to firms we regulate to ensure 

those expectations are understood and heeded. We realize now 

more than ever that when times are good and when bankers are 

particularly confident, we must have even firmer resolve to hold 

firms accountable for prudent risk management practices. 

Finally, despite our good relationship with fellow U.S. regulators, 

there are gaps and operational challenges in the regulation and supervision of the overall U.S. financial system that should be addressed in an effective manner. 

8 

I would like to thank you and the Subcommittee for holding this 

second hearing on risk management, a crucially important issue in 

understanding the failures that have contributed to the current crisis. Our actions with the support of Congress will help strengthen 

institutions’ risk management practices and the supervisory and 

regulatory process itself—which should, in turn, greatly strengthen 

the banking system and the broader economy as we recover from 

the current difficulties. 

I look forward to answering your questions. 

Senator REED. Mr. Long. 

STATEMENT OF TIMOTHY W. LONG, SENIOR DEPUTY COMPTROLLER, BANK SUPERVISION POLICY AND CHIEF NATIONAL BANK EXAMINER, OFFICE OF THE COMPTROLLER 

OF THE CURRENCY 

Mr. LONG. Chairman Reed, Ranking Member Bunning, my name 

is Tim Long. I am the Senior Deputy Comptroller for Bank Supervision Policy at the OCC. I appreciate this opportunity to discuss 

the OCC’s views on risk management and the role it plays in banks 

we supervise, the weaknesses and gaps that we have identified in 

risk management practices and the steps we are taking to address 

those issues, and how we supervise risk management at the largest 

national banks. 

Recent events have revealed a number of weaknesses in banks’ 

risk management processes that we in the industry must address, 

and we are taking steps to ensure this happens. More importantly, 

these events have reinforced that even the best policy manuals and 

risk models are not a substitute for a strong corporate governance 

and risk management culture, a tone and approach to business 

that must be set at the top of the organization and instilled 

throughout the company. 

While risk management practices are legitimately the focus of 

much current attention, risk management is hardest when times 

are good and problems are scarce. It is in those times when bank 

management and supervisors have the difficult job of determining 

when accumulating risks are getting too high and that the foot 

needs to come off the accelerator. These are never popular calls to 

make, but in retrospect, we and bankers erred in not being more 

aggressive in addressing our concerns. 

However, we must also not lose sight that banks are in the business of managing financial risks. Banks must be allowed to compete and innovate, and this may at times result in a bank incurring losses. The job of risk management is not to eliminate risk, 

but to ensure that those risks are identified and understood so that 

bank management can make informed choices. 

Among the lessons we have learned are: Underwriting standards 

matter, regardless of whether the loans are held or sold. Risk concentrations can excessively accumulate across products and business lines. Asset-based liquidity is critical. Back-room operations 

and strong infrastructure matters. And robust capital and capital 

planning are essential. 

As described in my written testimony, we are taking steps to address all of these issues. Because the current problems are global 

in nature, we are working closely with my colleagues here and 

9 

internationally. Critical areas of focus are on improved liquidity 

risk management, stronger enterprise-wide risk management, including rigorous stress testing, and further strengthening the Basel 

II capital framework. 

Risk management is a key focus of our large bank supervision 

program. Our program is organized with a national perspective. It 

is centralized and headquartered in Washington and structured to 

promote consistent and uniform supervision across the banking organizations. We establish core strategic objectives annually based 

on emerging risks. These objectives are incorporated into the supervisory strategies for each bank and carried out by our resident onsite staff with assistance from specialists in our Policy and Economics Unit. 

Examination activities within a bank are often supplemented 

with horizontal reviews across a set of banks. This allows us to 

look at trends not only within but across the industry. 

Throughout our resident staff, we maintain an ongoing program 

of risk assessment and communication with bank management and 

the board of directors. Where we find weaknesses, we direct management to take corrective action. For example, we have directed 

banks to make changes in personnel and organizational structures 

to ensure that risk managers have sufficient stature and ability to 

constrain business activities when warranted. 

Through our examinations and reviews, we have directed banks 

to be more realistic about recognizing credit risks, to improve their 

valuation techniques for certain complex transactions, to aggressively build loan loss reserves, to correct various risk management 

weaknesses, and to raise capital as market opportunities permit. 

Finally, the Subcommittee requested the OCC’s views on the 

findings that Ms. Williams from the GAO will be discussing with 

you today. Because we only recently received the GAO’s summary 

statement of findings, we have not had an opportunity to review 

and assess their full report. We take the findings from GAO very 

seriously, and we would be happy to provide the Subcommittee 

with a written response to this report once we receive it. 

My preliminary assessment based on the summary we were provided is that the GAO raised a number of legitimate issues, some 

of which I believe we are already addressing; and others, as they 

pertain to the OCC, may require further action on our part. 

Thank you, and I will be happy to answer questions you may 

have. 

Senator REED. Thank you. 

Mr. Polakoff, please. 

STATEMENT OF SCOTT M. POLAKOFF, ACTING DIRECTOR, 

OFFICE OF THRIFT SUPERVISION 

Mr. POLAKOFF. Good afternoon, Chairman Reed, Ranking Member Bunning. Thank you for inviting me to testify on behalf of OTS 

on the lessons the current economic crisis has taught us about risk 

management. 

The topic is timely and important because, as you know, the 

heart of bank supervision is in monitoring for risks, to help prevent 

them from endangering the health of regulated financial institutions. Some of the risks I will discuss today not only endangered 

10 

institutions during this crisis, but played major roles in some failures. 

The financial crisis has had serious consequences for our economy and for public confidence in the safety of their bank accounts 

and investments. This confidence and the trust it engenders are 

necessary for both the smooth operation of our financial system 

and the larger economy. Restoring confidence is essential to achieving full economic recovery. 

In my comments today, I will focus on three risks that I think 

are most significant: concentration risk, liquidity risk, and the risk 

to the financial system from unevenly regulated companies, individuals, and products. Shortcomings in responding to each of these 

risks have significant consequences. 

Let me start with concentration risk, which is basically the risk 

of a financial institution having too many of its eggs in one basket. 

If something bad happens to that basket, the institution is in trouble. Although concentration risk is one of the main risks that our 

examiners traditionally watch closely, the current crisis exposed a 

new twist to concentration risk, and the OTS has acted to address 

that risk. 

The new twist was the risk of a business model heavily reliant 

on originating mortgage loans for sale into the private label secondary market. The freeze-up in this market for private label mortgage-backed securities in the fall of 2007 exposed this risk for institutions with an originate-to-sell business model. Their warehouse 

and pipeline loans could no longer be sold and had to be kept on 

their books, causing severe strain. 

To prevent this problem in the future, the OTS reviewed all of 

its institutions for exposure to this risk, updated its examination 

handbook in September 2008, and distributed a letter to the chief 

executive officers of OTS-regulated thrifts on best practices for 

monitoring and managing this type of risk. 

The financial crisis also taught us lessons about liquidity risk 

when some of our institutions experienced old-fashioned runs on 

the bank by panicked customers. In some cases, the size and speed 

of the deposit withdrawals were staggering. The event showed that 

the prompt corrective action tool created to prevent a gradual erosion of capital during the financial crisis of the late 1980s and early 

1990s is inadequate to address a rapidly accelerating liquidity crisis. Rather than seeking a new type of prompt corrective action for 

liquidity, Federal banking regulators plan to issue guidance to examiners and financial institutions to incorporate lessons learned on 

managing liquidity risk. 

Finally, I would like to discuss the risk to the financial system 

and the larger economy by companies, individuals, and products 

that are not regulated at the Federal level or, in some cases, at any 

level. These gaps in regulation are, in my mind, the root cause of 

the crisis. If you could distill the cause to a single sentence, I think 

it would be this: Too much money was loaned to too many people 

who could not afford to pay it back. 

The simple lesson is that all financial products and services 

should be regulated in the same manner, whether they are offered 

by a mortgage broker, a State-licensed mortgage company, or a federally regulated depository institution. To protect American conVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 S:\DOCS\52966.TXT SHERYL
11 

sumers and safeguard our economy, consistent regulation across 

the financial services landscape is essential. 

Thank you again, Mr. Chairman, for having us here today. I look 

forward to answering your questions. 

Senator REED. Thank you, Mr. Polakoff. 

Dr. Sirri? 

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

Mr. SIRRI. Chairman Reed, Ranking Member Bunning, and members of the Subcommittee, I am pleased to have the opportunity 

today to testify concerning insights gained from the SEC’s administration of the Consolidated Supervised Entities, or CSE, program, 

as well as the SEC’s long history of regulating the financial operation of broker-dealers and protecting customer funds and securities. 

The turmoil in the global financial system is unprecedented and 

has tested the resiliency of financial institutions and the assumptions underpinning many financial regulatory programs. I believe 

that hearings such as this, where supervisors reflect on and share 

their experiences from this past year, will enhance our collective efforts to improve risk management oversight of complex financial institutions. 

A registered broker-dealer entity within the CSE group was supervised by an extensive staff of folks at the SEC and at FINRA, 

the broker SRO. All U.S. broker-dealers are subject to the SEC’s 

rigorous financial responsibility rules, including the net capital 

rules, the customer protection rules, and other rules designed to 

ensure that firms operate in a manner that permit them to meet 

all obligations to customers, counterparties, and market participants. 

The CSE program was designed to be broadly consistent with the 

Federal Reserve oversight of bank holding companies. Broker-dealers have to maintain the minimum of $5 billion of tentative net 

capital to qualify for the program and no firm fell below this requirement. 

The CSE regime was also tailored to reflect two fundamental differences between investment bank and commercial bank holding 

companies. First, the CSE regime reflected the resilience of securities firms on mark-to-market—the reliance of securities firms on 

mark-to-market accounting as a critical risk and governance control. 

Second, the CSE firms were required to engage in liquidity stress 

testing and hold substantial liquidity pools at the holding company. 

We also required firm-wide stress testing as a prerequisite to 

being allowed to enter the program, a requirement that was put in 

place well before the crisis started. For most firms, the stress testing comprised a series of historical or hypothetical scenarios that 

were applied across all positions, not just across one product or 

business line. While the set of scenarios did not cover every plausible scenario, they included major financial shocks or stresses to 

the market, such as the fall 1988 failure of long-term capital in the 

Russian default as well as the 1987 stock market crash. The CSE 

12 

firms later expanded these scenarios or created others to stress 

their hedge fund counterparty credit risk exposures. 

I, too, appreciate the work that GAO did to review the supervision of financial institutions’ risk management programs across 

the various regulators and find their observations on these programs very helpful. We are reviewing the recommendations and 

findings and we look forward to working with GAO as we fully consider their report. 

The SEC’s supervision of investment banks has always recognized that capital is not synonymous with liquidity and the ability 

of a securities firm to withstand stress events depends on having 

sufficient liquid assets, cash and high-quality instruments, such as 

U.S. Treasuries, that can be used as collateral to meet their financial obligations as they arise. For this reason, the CSE program required stress testing of liquidity and substantial liquidity pools at 

the holding company to allow firms to continue to operate normally 

in stressed market environments. But what the CSE regulatory approach did not anticipate was the possibility that secured funding, 

even that funding backed by high-quality collateral, such as U.S. 

Treasury and agency securities, would become unavailable. 

Thus, one lesson of the SEC’s oversight of CSEs, Bear Stearns 

in particular, is that no parent company liquidity pool can withstand a run on the bank. Such a liquidity pool would not suffice 

in an extended financial crisis of the magnitude we are now experiencing. In addition, these liquidity constraints are exacerbated 

when clearing agencies’ sizable amounts of capital for clearing deposits to protect themselves against intraday exposures to the firm. 

Another lesson relates to the need for supervisory focus on the 

concentration of illiquid assets held by financial firms, particularly 

in entities other than a U.S.-registered broker-dealer. Such monitoring is relatively straightforward with larger U.S. broker-dealers, 

which must disclose illiquid assets on a monthly basis in financial 

reports that are filed with their regulators. For the consolidated entities, supervisors must be well acquainted with the quality of assets on a group-wide basis and monitor the amount of illiquid assets and drill down on their relative quality. 

Leverage tests are not accurate measures of financial strength 

for investment banks, in particular due to their sizable matchbook 

or derivatives business. Leverage tests do not account for the quality or liquidity of assets. Rather, they rely on overly simplistic 

measures of risk, such as leverage ratios. Regulators of financial 

firms have gone to a great deal of effort to develop and continue 

to refine capital rules that are risk sensitive and act as limiters on 

the amount of risk that can be taken by a firm. 

Finally, any regulator must have the ability to get information 

about the holding company and other affiliates, particularly about 

issues and transactions that impact capital and liquidity. As we 

have witnessed with Lehman Brothers, the bankruptcy filing of a 

material affiliate had a cascading effect that can bring down the 

other entities in the group. 

For these reasons and to protect the broker and its customer assets, the SEC would want not only to be consulted before any such 

liquidity drain occurs at the parent, but to have a say, likely in coordination with other interested regulators, in the risk, capital, and 

13 

liquidity standards that the holding company must maintain. Our 

experience last year with the failure of Lehman’s U.K. broker and 

the fact that the U.S.-registered broker-dealers were well capitalized and liquid throughout the turmoil has redoubled our belief 

that we must rely on and protect going forward the soundness and 

the regulatory regime of the principal subsidiaries. 

Thank you for this opportunity to discuss these important issues 

and I am happy to take your questions. 

Senator REED. Thank you very much. 

Senator Bunning had to step out. He will rejoin us for his questioning, but let me begin. 

I want to address a question to all the regulators. first, let me 

say that I thought the GAO did a very responsible and thorough 

examination. Thank you and your colleagues Ms. Williams. But the 

basic questions are, and I will begin with Mr. Cole, just as you happen to be sitting next to Ms. Williams, but when did you first institutionally become aware of the significance of the risk difficulties 

in your supervised entities, and how did you communicate these 

concerns both to your supervisors, to your fellow regulators, and to 

a broader audience, and when did that communication become public? Mr. Cole? 

Mr. COLE. Well, I really need to go back somewhat in time in answering that, but in 1995, we issued a supervisory letter to our examiners directing them in terms of taking a systematic approach 

to assessing the risk management, including the major risk categories of credit risk, market risk, operational risk, liquidity, 

reputational, and legal risk, and then that became part of the formal exam process and rating process. 

Kind of fast forwarding to the 9/11-type situation, as I mentioned 

in my testimony, we focused on some significant risk issues there 

that we thought needed to be addressed, and some of them tended 

to focus on, say, operational risks, such as payments and settlements, others on contingency planning, locating backup facilities at 

appropriate different distances, and then very importantly on BSA/ 

AML, Bank Secrecy/Anti-Money Laundering. In that regard, with 

regard to one of the institutions in question, we took very strong 

action to require a significant change in their business risk management and that was accomplished with a very forceful hand in 

terms of requiring them to make those changes. So I think that is 

a good example of where, when we see a significant problem, we 

do act. 

Senator REED. Let me be more specific. The issue, I think, that 

the GAO has revealed is a lack of the capacity of large complex financial institutions, which all of you regulate, to assess adequately 

all of the risks they face, not so much a particular risk—— 

Mr. COLE. OK. 

Senator REED.——but the fact that they did not have systems in 

place to adequately assess the risk, which I think is a fair conclusion of the report of the GAO. At what point did this fact or this 

observation become resonant with the Fed and how was it communicated to the banking community, to the regulating community, 

and on to the broader audience, the Congress, for one? 

Mr. COLE. We have been engaged consistently, I think, since— 

just going back, say, to the 1995 letter, in terms of working with 

14 

institutions to enhance the risk management process. Now, in 

terms of moving right to the current situation, this stress testing 

example is a good example because we believe going into that 

stress test that there was a significant opportunity to put pressure 

on the big firms to improve their ability to pull positions together 

on a firm-wide basis and develop a really robust stress test. 

The horizontal review that we did provided very significant information for us on a peer basis that they were not able to do that, 

that the stress that they typically came up with was one quarter’s 

worth of earnings, and that was based on a fairly flawed system 

of not being able to comprehensively pull the positions together on 

an integrated firm-wide basis. 

Senator REED. That was—— 

Mr. COLE. We used that as a major tool in terms of pushing on 

those firms. It was feedback from that exercise and saying, look, 

you need to do more here, and that is one of the main tools that 

we have, is that type of horizontal review. So that occurred, say, 

in June 2007, that kind of feedback with the firms on the findings 

from that stress testing. 

Then I would move just a little bit further—— 

Senator REED. Can I just clarify? Is it June 2007 or 2006? 

Mr. COLE. The actual exercise was in 2006. We did the report in 

2007 and then the feedback to the firms, I think was in June of 

2007. 

Senator REED. It raises an issue, which is that in 2006, you had 

at least had serious concerns because of the stress testing that 

these firms could not handle or have systems in place to deal with 

the risk The whole point, I think, of the report of the GAO is that 

having that knowledge of those suspicions, it didn’t seem to 

produce a timely, rapid response—— 

Mr. COLE. Well, Senator, I think that at the same time that we 

were doing the stress testing, we were also reviewing and having 

very significant interactions with these firms in terms of various 

aspects of their risk process—— 

Senator REED. Let me just ask. Did you communicate in 2006 

with other supervisors, OTS, Comptroller, SEC, your concerns that 

some of the institutions that you were the overall supervisor had 

these deficiencies in risk assessment? 

Mr. COLE. Well, we have very frequent conversations with—— 

Senator REED. Would you say fairly that you communicated 

these concerns to the other regulators, or you heard similar concerns from them? 

Mr. COLE. I would say fairly that, as we are working on, for example, infrastructure requirements for the use of models and so on, 

we have had consistent communications with the other regulators 

that there are significant deficiencies in risk management. 

Senator REED. And let me just ask a final question, because I do 

want your colleagues to respond, too. What broader audience did 

you communicate these concerns about the lack of adequate systems in place? 

Mr. COLE. We have throughout the development, for example, of 

qualifying criteria for the use of Basel II and the so-called Pillar 

2 criteria indicated the need for improvement to the firms we have 

been working with. 

15 

Senator REED. Mr. Long, similar questions. When did you, not 

personally, but the organization, become aware, if you did, of 

failings in the management of risk by entities you supervised? Did 

you communicate them to your fellow supervisors? Did they communicate with you, and then what broader audience? 

Mr. LONG. Yes, I do think we began to communicate pretty well 

in the 2006 range, as my colleague says, but let me back up to answer you. I want to make sure I answer your question. 

As I stated in my written testimony—it is difficult at times to 

strike that balance of letting a bank keep competitive and innovative at the same time and order a bank to constrain a certain business activity because we believe they are taking on too much risk. 

It is always a delicate balance and it is something we work hard 

to do. 

But I think we did, going back to 2004. I know at the OCC and 

amongst other regulators, we did begin to see this buildup of risk 

and this buildup of excessive aggregation of risk. We issued guidance going back to 2004. We had the interagency credit card guidance. We issued guidance on home equity lending, on non-traditional mortgage products, on commercial real estate lending, and 

then most recently some interagency guidance on complex structured products. As we issued guidance to the industry, our examiners were in the banks and they were examining for this. We frequently cited matters requiring attention and began taking actions, 

various types of actions, surrounding these guidance. 

So from 2004 up to 2007, I think we all saw the accumulation 

of risk. At the OCC, we looked vertically very well into those companies. If there were lessons learned by us, it was probably in two 

things. Number one, we underestimated the magnitude of the effects of the global shut-down beginning in August of 2007, and we 

did not rein in the excesses driven by the market. 

So a real lesson learned, and I think you have heard it in some 

of the statements and in the GAO report, the ability to look 

vertically into these companies is good. The ability to look across 

the companies in terms of the firms we supervise, we need to get 

better at that, and looking horizontally across the system is something I think we all need to do. 

A good example of that is in the firms that we supervise, we underestimated the amount of subprime exposure they had. We basically kicked the subprime lenders out of the national banking system. Our banks were underwriting very little of the subprime 

loans. What we didn’t realize is that affiliates and subsidiaries of 

the banks that we supervised were turning around, buying those 

loans, structuring them, and bringing that risk back in in another 

division in the bank, and that is a good example of being able to 

look horizontally across a company and see that coming. 

Senator REED. What inhibited you from looking across these 

other subsidiaries? 

Mr. LONG. Well, Senator, there are two things. You know, internally, from the OCC’s standpoint, we need to get better at doing 

more horizontal work, and I think we have. I think we started 

doing that probably a year and a half ago, where we have networking groups. We do more horizontal-type exams to where REICs 

can share information amongst themselves. 

16 

Where we are continuing to work with our other colleagues with 

the other agencies is making sure that we try to gather the risk 

in the entire system. But obviously all of us are constrained somewhat by GLBA. 

Senator REED. Let me, Mr. Polakoff can I finish this line of questioning and then I will recognize you, Jim. 

Senator BUNNING. I will stay as long as you want. 

Senator REED. Thank you. 

Mr. POLAKOFF. Senator, thank you. I don’t want to embellish on 

what my colleagues have said. It is a consistent message. 

I would say a trip-wire date for us was June of 2007 when the 

liquidity market shut down. What it proved to us and probably all 

of us at this table is we did not stress test models sufficiently for 

that kind of catastrophic event. So risk management turned upside 

down at that point in time. When any of these models predicted a 

stress scenario, and even a more stress scenario, none of us, none 

of the entities still predicted or had a model that stressed a scenario for what ultimately we saw starting in June of 2007 forward. 

That is a critical lesson learned for all of us. 

Senator REED. Dr. Sirri? 

Mr. SIRRI. The one thing I would point out that is slightly different with the CSEs that reentered this business in a different 

manner, the firms that we regulated under the CSE program came 

to us because of the European Union Financial Conglomerates Directive for that purpose. They needed a consolidated holding company supervisor and they didn’t have one for that purpose. 

So we came at this from rule, not by statute. We crafted the regime where in exchange for certain capital treatment we would be 

given a limited amount of access to the holding company. What we 

focused on and what that access related to were financial and operational risk controls, and in that sense, I think that was very helpful, informed broker-dealer oversight issues as well as certain 

issues of the holding company. 

But, for example, as my colleagues have pointed out, GrammLeach-Bliley limits the way we touch upon other regulated entities. 

We defer to the functional regulator in that sense. And so our 

knowledge there was more limited. 

So I think what you are really asking is a point which was made 

in the GAO report which says, if an enterprise, if a modern firm 

manages risk at an enterprise level, how can you as a regulator 

that is in many ways functionally based replicate that in your own 

regulatory program, and I acknowledge that is a challenge. 

Senator REED. Let me follow up with a very quick question because I want to recognize Senator Bunning. Given the fact that you 

had to rely upon other regulatory agencies, what was the level of 

communication? If, in fact, by 2004 or 2005 the OCC was aware of 

buildup of risk, at 2006 the Federal Reserve was aware of risk, I 

would presume that in that same—so did anyone sort of, in a systematic way, say, you know, you should be aware that we are concerned about risk assessment, about the ability to manage this enterprise risk? Did that ever become part of the discussion? 

Mr. SIRRI. I think we all—I won’t speak for others. I think we 

understood, and my impression was all of these regulators understood, that we were limited in part. We had dialog amongst ourVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 S:\DOCS\52966.TXT SHERYL
17 

selves. Staff on the ground talked to staff from other regulators. In 

addition, the firm—it is not like the firms drew up walls and said, 

we won’t give you information on that bank, or we won’t give you 

information on that thrift. They would provide such information. 

But in the sense of integrated enterprise risk management, I think 

it was not what it could be. 

Senator REED. Senator Bunning, and take as much time as you 

want. 

Senator BUNNING. Thank you, Mr. Chairman. 

Welcome back from your vacations that you have been on for the 

last 5 years, and I say that not kiddingly. I say that as meaningful 

as I can, because if we would have had good regulators, we 

wouldn’t be in the crisis we are in right now. 

Ms. Williams, at the bottom of page 24, you said the Fed did not 

identify many of the issues that led to the failure of some large institutions. Can you tell us what some of these issues that they are, 

what they missed? 

Ms. WILLIAMS. Absolutely. I would direct your attention to a couple of pages later, on page 26. We note that the Fed began to issue 

risk committee reports, and in February of 2007 they issued perspectives on risk, and we list a number of issues that we pulled 

from that report. For example—the report stated that there were 

no substantial issues of supervisory concern for large financial institutions; that asset quality across the systemically important institutions remains strong; in spite of predictions of a market crash, 

the housing market correction has been relatively mild and while 

price appreciation and home sales have slowed, inventories remain 

high and most analysts expect the housing boom to bottom out in 

mid-2007. 

Overall, the impact on a national level will likely be moderate. 

However, in certain areas, housing prices have dropped significantly. They also noted that the volume of mortgages being held by 

institutions or warehouse pipelines had grown rapidly to support 

collateralized mortgage-backed securities and CDOs and noted that 

the surging investor demand for high-yield bonds and leveraged 

loans, largely through structured products such as CDOs, was providing a continuing strong liquidity that resulted in continued access to funding for lower-rated firms at relatively modest borrowing 

costs. So those are some of the—— 

Senator BUNNING. Would you like to comment on counterparty 

exposures, particularly to hedge funds? 

Ms. WILLIAMS. This was another area that was identified. The 

regulators had focused on counterparty exposures, particularly to 

hedge funds. 

Senator BUNNING. Mr. Cole, would you like to respond? 

Mr. COLE. I would indeed, and thank you for the opportunity, 

Senator. First of all, I would say that my understanding is that the 

report that the GAO has done is really based on review of one institution. 

Senator BUNNING. That is incorrect, but that is fine. 

Mr. COLE. OK, and that we received this report with reference 

to perspectives on risk just in the last couple days. So we would 

like an opportunity to go over these findings with the GAO, as we 

typically do in GAO reviews. We have not had that opportunity. 

18 

But I will say this, that I think that what Ms. Williams quoted 

from is in the report, but unfortunately, there are other parts that 

were not quoted, and one in particular is, quote: 

The effects of a long period of easy liquidity and benign credit conditions 

have continued to weaken underwriting standards across all major credit 

portfolios. Finally, we note that investor demands appear to be encouraging 

large financial institutions to originate more assets and even greater volumes of low-quality assets, and in order to distribute them through the capital markets. 

In response to that, we took very firm actions, and that—— 

Senator BUNNING. When? 

Mr. COLE. That included—— 

Senator BUNNING. When? When did you take firm actions? 

Mr. COLE. Let me see. A perspectives of risk report was issued 

in February 2007—— 

Senator BUNNING. Two-thousand-and-seven? 

Mr. COLE. And we initiated major analysis of subprime mortgage 

markets in March and published an interim report in June of that 

year. 

Senator BUNNING. Two-thousand-and-seven? 

Mr. COLE. That is correct. 

Senator BUNNING. OK. That is about 5 years after the—— 

Mr. COLE. Well, that is—— 

Senator BUNNING. That is about 5 years after the subprime and 

the mortgage mess hit the fan. Two-thousand-and-two and 2003 is 

when it hit. 

Mr. COLE. Yes. 

Senator BUNNING. OK. 

Mr. COLE. But could I also—— 

Senator BUNNING. No, you can’t. 

Mr. COLE. OK. 

Senator BUNNING. What did the Fed do about the 2006 review 

that showed institutions did not have overall stress testing for 

their own enterprise? Did you require your regulated firms to fix 

those problems? 

Mr. COLE. Yes. I actually touched upon that in a prior response, 

that we did follow up with the institutions, that a very critical part 

of this type of horizontal peer review is going back to the institutions, which we did in June of 2007. The report was actually issued 

in February of 2007 and had communications with those firms indicating that there was significant need for improvement. 

We also, I am told, communicated to the primary regulator—— 

Senator BUNNING. You were told or you know? 

Mr. COLE. No, I know. I was informed in the interim of my last 

question that the primary regulators of these institutions were informed of the deficiencies we observed, as well as the President’s 

Working Group. So it was—— 

Senator BUNNING. Well, that is all well and good if you followed 

up and made sure that they weren’t going to repeat the same mistakes in the immediate future and subject the country to the recession that we are now in. 

Mr. COLE. Right, and—— 

Senator BUNNING. If you sat on your hands, which the Fed did 

in overseeing mortgages and mortgage lenders and banks that were 

19 

under your jurisdiction, then I think that the Fed is a failure in 

doing what they are supposed to do. 

For anyone, did the board of directors understand the risk their 

firms were taking? 

Mr. POLAKOFF. Senator, I would say they understood the risk for 

the period of time that they were operating in, but failed to—— 

Senator BUNNING. In other words, what I am trying to get at, 

there is a reasonable rate of return on equity that everybody expected at a given point in time. Somehow, that got out of kilter, 

and instead of being happy with a 7 or 8 percent return on equity, 

people were leveraging from—and I don’t blame anybody, but regulators ought to be looking at the rate of return on equity and not 

giving permission for these firms to get into mischief, and that is 

what happened. That is why we are here today asking you these 

questions. The regulators should have stopped the risk takers taking undue risk with taxpayers’ money or with equity that has been 

invested. Now the taxpayers are paying the price. 

So go ahead, finish your answer. 

Mr. POLAKOFF. I agree with what you said, Senator. 

Senator BUNNING. And how do we improve senior management 

and boards’ understanding of an accountability for risk? How do we 

get that regulated? 

Mr. POLAKOFF. Well, across the spectrum, all of the boards, I believe, are held accountable for the risk and—— 

Senator BUNNING. Is that right? Is that why we are paying bonuses to each and every one at AIG for—they were the board, they 

were the people that were supposed to regulate AIG. So we are 

paying them bonuses for taking $160 billion in taxpayers’ money. 

Are you kidding me? Explain that to the American people. 

Mr. POLAKOFF. AIG right now is not a regulated company. I—— 

Senator BUNNING. It is. It is owned by the Federal Government, 

so the Federal Government is the regulator. It is owned by the Federal Government. The contracts that have been paid out were 

OKed by the Federal Government. So it is regulated. 

Mr. POLAKOFF. Yes, sir. I was speaking only from an OTS perspective. 

Senator BUNNING. OK. It is not yours. It is ours. 

How did you miss the risk and possibility of liquidity drying up? 

How did you miss it? 

Mr. SIRRI. I can speak for the firms that we regulate. For a trading firm, for a securities firm, they do not take deposits as a commercial bank or a thrift does. Their primary means of funding is 

through the capital markets, especially through a market known as 

the repurchase market. 

Senator BUNNING. I am familiar. 

Mr. SIRRI. What a firm does is it takes the security it has, it 

gives it someone who lends it out—— 

Senator BUNNING. I am familiar. 

Mr. SIRRI.——it comes back. Because that is a secured lending 

market, the lenders were thought to be not sensitive to the health 

of the firm, but sensitive to the quality of the collateral they got. 

So our thought was always that if you as a firm gave someone a 

Treasury bill or gave them an agency security, they would take 

that and fund you, even if you as a firm were in trouble. That was 

20 

an assumption we made, and that is, I think, many in the financial 

community made. And we were wrong. 

When firms got in trouble, other funding counterparties—money 

market funds, people with cash to lend—would not take Treasury’s 

to fund, and that was something we had never seen before. 

Senator BUNNING. Mr. Long, what changes in law do you suggest 

to protect against future failures like we are in right now? 

Mr. LONG. Senator, I do not know if I can think of a change in 

law that we need. We need to continue to have rigorous supervision 

around these companies. As I said in my written statement, you 

need a strong corporate culture, and it needs to start at the top of 

the organization, and it needs to be led by the Chairman and put 

down into the company. It is a simple—— 

Senator BUNNING. That, unfortunately, is not an answer. 

Ms. Williams, do you have any changes in law that we can get 

a hold of as we are looking for as Members of Congress to prevent 

any more of the debacle that is going on right now? 

Ms. WILLIAMS. I would just touch on a couple of issues. In January, GAO issued a framework for reforming the current financial 

regulatory system, and we point out a couple of issues. One would 

be clearly articulated goals; that is, Congress needs to be very clear 

about the goals that they expect regulators to achieve. There also 

needs to be a systemwide focus in the structure. And—— 

Senator BUNNING. In other words, A watching B and B watching 

C? 

Ms. WILLIAMS. Not necessarily, but systemwide from the perspective of not focusing on particular institutions and getting caught up 

in the institution or type of product; but having a regulator that 

can focus attention on anything that poses a risk to the overall system. 

Senator BUNNING. Then we would need one for about 25 major 

market banks, money market banks in New York City, one regulator each for each one, because those are the ones that are too big 

to fail. That is what we have been told by our Chairman of the Fed, 

in fact. And we have also been told that by the Secretary of the 

Treasury. So if that is the case, we need an awful lot of regulators. 

Scott, do you have some suggestions? 

Mr. POLAKOFF. Senator, I would offer that we need to ensure 

that there is a level playing field. We have had some products— 

80 percent of subprime loans were underwritten by mortgage brokers. There is no Federal oversight for that. 

Senator BUNNING. Well, I am sorry, but the Federal Reserve got 

that job in 1994. That was their job. I mean, we wrote a law that 

gave them that job. Whether they did it or not is another question, 

but we handed that over to the Fed. 

SEC? 

Mr. SIRRI. Our charge is the broker-dealer, primarily, and so I 

am going to translate your question as: What do you need to make 

sure that we keep safe the customer’s—— 

Senator BUNNING. No. What would give the SEC the ability to 

discover this situation that we are in now before or as it is happening and do something about it? 

Mr. SIRRI. Drexel, Lehman Brothers taught us the same lesson. 

The lesson is that the health of a broker-dealer could be affected 

21 

by entities outside the broker-dealer—commercial banks, thrifts, 

unregulated affiliates that deal in derivatives. We need to touch on 

those entities. We need to have a say-so on risk. 

Senator BUNNING. In other words, we should take all manners of 

dealing with a broker-dealer, whether it be securities, whether it 

be bonds. You mentioned some other things that they are dealing 

with now. But we should have someone watching the store for all 

entities. 

Mr. SIRRI. I think, again, I was focusing on the broker-dealer, but 

I know that our charge is affected by risks that are taken outside 

the broker-dealer. You do not hold derivatives in a broker-dealer, 

because we haircut the capital—we haircut you, we charge you capital. So firms respond by moving the risk outside the broker-dealer, 

by moving illiquid instruments outside the broker-dealer. That still 

imperils the broker-dealer. We need to touch on those. We need—— 

Senator BUNNING. Well, then you need regulations over those 

people that are dealing in the entities. 

Mr. SIRRI. For preserving the broker-dealer, that would be very 

helpful. 

Senator BUNNING. Thank you very much, Mr. Chairman. 

Senator REED. Thank you, Senator Bunning. 

Let me raise a few questions. You mentioned, Dr. Sirri, that really what happened, in your view, was a run on the bank. And I 

think that begs the question: What caused the run on the bank? 

There are some people that suggest the huge amount of leverage 

which the market became aware of just undercut any sort of willingness to accept even Treasury securities. And that leverage ratio 

was something that was approved by the SEC—at least not effectively disapproved—and I think you had the authority to do that. 

Can you comment on that? 

Mr. SIRRI. Sure. The question of a ‘‘run on the bank,’’ which is 

the term I used, is always a difficult one because it implicitly depends on confidence in the institution. Of course, we did not have 

a bank, and the run was different. It was not deposits. But, nonetheless, it was funding with certain kinds of securities through the 

repo market. 

You know, it is hard to know why something like that starts. The 

instruments became the instruments in these firms, in some of the 

firms that are no longer with us. Lehman Brothers, for instance, 

suffered a lot of uncertainty about valuation, so you have a financial firm, they are typically opaque. You do not know exactly what 

is going on with them. That is the nature of a financial firm. Valuations become questions because you are holding, for example, commercial whole loans in the case of Lehman, where people doubted 

valuations. 

In a situation like that, people will be wary about funding because even if you can potentially get your money back, you are not 

in the business of getting tied up in an uncertainty. And that 

causes a situation that can cause a run. 

Senator REED. Thank you very much. 

Let me ask a general question, which I do not think requires a 

specific answer unless you—my assumption is that the umbrella 

regulator—and each one of these large institutions had an umbrella regulator—had the responsibility for the risk assessment 

22 

throughout the organization, that it was not a case where the overall enterprise risk assessment or enterprise activities were not at 

all under the authority of a regulator. Is that your understanding, 

Dr. Sirri, in terms of the law? 

Mr. SIRRI. Well, I think the authority stems from different 

places. Again, we had no statutory authority. 

Senator REED. Right, right. 

Mr. SIRRI. We crafted rules. I think in other places it is statutory. And, again, our ability—our question of where we would look 

was governed by a certain set of precepts and risks. Our concern 

was always the broker-dealer. Risks that pertained to things other 

than the broker-dealer that might imperil other entities were not 

our charge, and our program was not crafted to cover those. 

Senator REED. Mr. Polakoff, your responsibility derived from 

statute. Did you feel at OTS that those entities you were the umbrella supervisor, that you had responsibility for enterprise risk 

analysis, assessment by the enterprise? 

Mr. POLAKOFF. Yes, sir. The only thing I would offer is per 

Gramm-Leach-Bliley we did rely to a great extent on functional 

regulators within the system. But as the holding company regulator for our institutions, absolutely we had the overall umbrella 

responsibility. 

Senator REED. Mr. Long, is that your understanding? I know 

OCC is—do you have an umbrella responsibility? Let me ask the 

basic—— 

Mr. LONG. We are the primary regulator for the bank, absolutely. 

Our authority and how we conduct our risk assessments I think 

works very well, and we feel like we have the proper authority. 

Senator REED. So you understand that you have to collaborate 

with others, but that ultimately there is one Federal regulator 

under the statute—Mr. Sirri has an exception—that had responsibility to look across the organization for risk assessment, risk evaluation, and risk compliance? 

Mr. LONG. Well, I am sorry. Maybe I did not understand your 

question. The way it works now is it is dependent on how well we 

communicate with each other and—if that is what you are asking, 

Senator. I want to make sure I am answering your question right. 

Is there a systemic umbrella regulator right now that—— 

Senator REED. I am not talking systemic. I am talking about you 

have a large, integrated financial organization that is regulated 

under statute. There is one regulator who is responsible for the 

overall operation, and let me ask the question. Is there one regulator responsible for the overall operation of the entire enterprise? 

Mr. LONG. Well, the OCC is responsible for the bank, and the 

Fed is responsible for the holding company. 

Senator REED. Let me talk to Mr. Cole. As the umbrella regulator of several large financial institutions, do you feel that you are 

responsible, the Federal Reserve is responsible for the overall capacity of that institution as an enterprise to evaluate risk? 

Mr. COLE. Yes, sir, we do, and we have gone, I think, an extra 

mile to make sure that that is very clear with the firms and our 

examiners by rolling out a Consolidated Supervision Program in 

October of last year and communicating that very clearly with the 

other agencies. 

23 

Senator REED. Let me go back to the point that was raised between Ms. Williams and Senator Bunning about the large financial 

institutions’ perspective on risk, the 2005 reports, the 2006, 2007 

reports. These were internal documents, Ms. Williams, of the Fed? 

These were not released to the public? 

Ms. WILLIAMS. Yes, these were internal. 

Senator REED. And then there was an interruption in the reports, but then in April of 2007, there was a report, ‘‘Perspective 

of Risk.’’ Was that an internal document, too? 

Ms. WILLIAMS. Yes, all of them were internal. 

Senator REED. And it raises the question with respect to the Federal Reserve that if these documents are solely within the purview 

of the Federal Reserve, how is the broader financial community 

and the broader community and how is Congress to inform itself 

of critical issues that you feel could have profound consequences, 

which have profound consequences? 

Mr. COLE. One issue is just getting our own shop in order in 

terms of pulling all the information that is available to gather and 

creating a perspective on risk from a financial stability point of 

view. There is that process. We do have that process. We have a 

formal umbrella group that is in charge of making periodic reports 

to the board on information that is drawn from research and from 

our shop and other payments areas and so on. So we are very focused in terms of creating a holistic picture of what is happening 

in the financial system now. That is very important. 

Now, you know, the question in terms of how do we go kind of 

the step of somehow making that public, and it could well be—you 

know, it obviously would be worthwhile in some form to be public. 

I cannot answer that at this point. 

Senator REED. Well, you know, I guess one presumption would 

be to have this information. I understand there is proprietary information that you have, and also there is a concern about causing 

market movements based not upon, you know, financial information but other information. But I think if such information was in 

the public domain in some capacity in 2005 and 2006 and 2007, it 

was available to Congress, and there was no opportunity for testimony to communicate that, that there might have been earlier 

prompter and more effective action to deal with some of these 

issues which are bedeviling us at the moment. 

In that regard, too, I know, because we have had the chance to 

meet, that the Federal Reserve and all those agencies are taking 

a serious look backwards. You know, you have described some of 

your conclusions. Ms. Williams and her colleagues have provided 

some perspective. But these reports—I will use the term I learned 

as a youth. These After Action Reports have to become public, particularly in the context of organizing a systemic regulator. Because 

if we are unaware, if you remain, you know, opaque, it is hard for 

us, I think, to make a reasoned judgment about who should have 

responsibilities, what could be the lines of communications. 

I know Governor Kohn and his colleagues are working on this report. 

Mr. COLE. Yes. 

Senator REED. I would hope it would be public. 

24 

Let me ask another question, and it comes from the GAO report, 

which is the comment and the conclusion that in many respects 

you are captives of the information of the organization you are regulating, that you have to rely to a certain degree on their models, 

their information. And in some cases, I think talking with respect 

to counterparty risk, there are intuitions about the creditworthiness of counterparties. Is that a fair summary of your conclusions, 

Ms. Williams? 

Ms. WILLIAMS. Basically. 

Senator REED. Let me begin with Dr. Sirri and work the other 

way, which is, you know, being a captive to information to systems 

to model sometimes does not give you the leverage you need to take 

action. Is that, one, accurate? And, two, how do you change that? 

Mr. SIRRI. I think there is an element of accuracy to that, but 

I think there are tools available to us as regulators. Let me give 

you a specific instance. 

You are right, a particular complex financial firm will develop a 

model for risk, but they will have a process around that model for 

risk. And we care about the processes and the robustness of the 

processes and controls. So, for example, a model for risk is developed. Who validates it? Who verifies it? Who runs that model? 

If they report to the trading desk whose assets they are pricing, 

that is not helpful and that is problematic. 

If they report to an independent third-party that perhaps reports 

directly to the CFO or a risk officer, much stronger structure, gives 

you some comfort. 

Again, let me take a second one, a price verification group. You 

may have a firm that trades assets, but they have problems valuing assets, as you do when liquidity dries up. When valuations are 

struck, how are those valuations struck? There may be a model. 

Who validates the model? And how do you resolve disputes? If the 

trader says it is worth more than the risk person says it is worth, 

how do you resolve that? Is there a process where it could go up 

to the audit committee? And if it goes to the audit committee, does 

the After Action Report—the phrase you used—for that instance, 

does that go to the board of directors? Such processes, if they are 

in place, tell you that that firm is taking their job seriously. 

Senator REED. I would presume, and correct me, that those procedures, those appropriate procedures you described, were not 

being deployed very successfully at Bear Stearns or Lehman Brothers. Were you aware of kind of those deficiencies contemporaneously with their—— 

Mr. SIRRI. I do not want to comment on any one firm, but what 

I will say is that there was considerable variation across the firms, 

especially with—let us take that same point, pricing. And one thing 

we saw—and this is mentioned—issues like this are dealt with in 

the Senior Supervisors report that the New York Fed led. The 

stronger your governance, the stronger your controls, it turns out 

the better you probably weathered the storm. The best-run firms 

had good processes, and some of the firms that got into the most 

trouble had distinct weaknesses. It varied from firm to firm. 

Senator REED. Just to follow up, the firms that you saw, and 

some of which have failed, did you note those weaknesses? Did you 

communicate those weaknesses to the board? It goes to the essence 

25 

of many of the questions we have raised. You know, making the diagnosis that you are ill and then not treating the patient is, you 

know, malpractice. What do you think? 

Mr. SIRRI. We had escalation procedures, and we used them. I do 

not want to come here and tell you that every time we did it perfectly. But I personally met with audit committee members when 

I felt that there was an issue that was not being resolved properly. 

But I do not want to overstate and say in each way we escalated 

as far as we should have looking back. We probably should have 

done more at times. 

Senator REED. Mr. Polakoff, same general line of questions about 

the reliance upon internal models, the data of the company, sort of 

captive of what they are doing versus being—having the resources 

to leverage appropriately behavior. 

Mr. POLAKOFF. Senator, I would say that there is an element of 

truth to that statement in the report, but it probably does not capture the entire universe. What we do and we do very well is put 

boots on the ground. We have examiners that go onsite from one 

large institution to another large institution. And while there may 

be a stable—and there is a stable examiner in charge, we send specialists from institution to institution, which allows a horizontal review, which allows an assessment of best practices. So whether it 

is modeling, whether it is pricing, whether it is risk factors, we do 

not silo the examination approach. And that is very helpful in addressing these kind of issues. That is number one. 

Number two, we look to the outside parties, so whether it is the 

external auditors, whether it is the external accountants, we work 

with them on models, because they also bring a similar expertise 

of looking horizontally across a number of institutions for best 

practices in a number of areas. 

And then, number three, like Erik said, we look at the corporate 

governance of the institution itself; how is it structured, how robust 

is the risk management committee, how robust is the audit committee as part of the board, how are the reporting lines handled. 

Each of those three areas, I think, allows us to very independently assess and judge whether it is the risk models or other factors. 

Senator REED. Having listened to that, it is, I think, very insightful, and it seems to be a great approach. It just does not seem to 

have worked in the case of some of the institutions that you regulated. What would you point—that was not the approach that was 

being used in 2004, 2005, and 2006? Or it was an approach, but 

something else undermined it? 

Mr. POLAKOFF. It was the approach. Senator, the one common 

theme that all of us see is an economic cycle that was unprecedented in its deterioration. All of our institutions, all of our risk 

management practices, all of our examination approaches work 

well, but it is difficult to look at all the risk models and stress 

them to unprecedented degrees and then require institutions to operate within those stress models. 

You know, in hindsight, we should have predicted a little better 

in 2004 and 2005 what the economy was going to look like now, 

but the economy we are operating in now has an absolute direct 

effect on the performance. 

26 

Senator REED. Well, let me raise—because this has been publicly 

discussed. I think we actually discussed it last week. In 2005, the 

Financial Products Division of AIG concludes that mortgage-backed 

securities are too risky a bet. At the same time, the securities lending operation decides that they want to take the cash that they are 

getting and invest it decisively in these types of securities. 

You know, where was the risk assessment at the enterprise, as 

you described it? And where was the OTS to say, wait a second, 

you cannot have two contradictory approaches based upon, one, 

this is the best investment, and, two, this is the worst investment? 

Mr. POLAKOFF. So, Senator, you are right, and you identified 

what is either a hole or an overlap, depending on one’s view. Those 

activities, as you remember, were regulated by the State insurance 

commissioners. So under Gramm-Leach-Bliley, the umbrella regulator typically will defer to the functional regulator to assess the 

risks and then report up to the umbrella regulator. 

Senator REED. But, you know, it goes back to the question I 

raised before, to which I think you affirmatively responded, that in 

terms of overall risk mechanisms or risk compliance, that it was 

clear that the umbrella regulator had that responsibility. And here, 

if you had communicated with the supervisor and they had indicated that this was the investment pattern of the securities lending—their regulated insurance part, it would have seemed to have 

raised a huge red flag. You both cannot be right. 

Mr. POLAKOFF. Senator, I can assure you that there was ample 

communication between OTS in its umbrella responsibility and the 

functional regulators. But you are identifying an absolute inconsistency, which is, Why did we stop one function from performing that 

kind of activity? And why did another functional regulator allow its 

entities to move forward with it? There has to be a postmortem on 

what broke down in that process. 

Senator REED. Yes. Mr. Long, the same sort of set of issues about 

reliance upon information and being a captive of the regulated entity. 

Mr. LONG. Well, I agree with what Scott said. I am not going to 

repeat it. I think we have ample authority to take whatever action 

we need. I think it is an oversimplification to say that this was a 

modeling problem. If you go back to the last time we went through 

this and you talk to the CEOs that went through this back in the 

late 1980s and early 1990s, they are going to tell you there are two 

things that got them: one was the concentrations, and number two, 

mitigating the policy overrides on the underwriting. 

Quite frankly, I think that is really the center of this thing. This 

was not that we missed a bunch of models. Clearly, the banks were 

not modeling in their tail risk that there would be a complete shutdown of the liquidity across the system. And that was a problem 

with their models. 

But this goes to basic underwriting, and it goes to basic concentration risk. They had too much of a bad deal, and that has 

compounding effects on liquidity, and on capital. And when the 

global liquidity market shut down, they had a real problem. 

So, yes, we look at all of it. We look at corporate governance. We 

look at underwriting. We look at all of the risk areas. And, clearly, 

we look at modeling, too. We have rigorous stress testing around 

27 

those models. And, quite frankly, a lot of people missed it—they 

would stress tail risk in the company. They did not stress tail risk 

across the world. 

Senator REED. Mr. Cole, briefly, if you could, please. I have additional questions. 

Mr. COLE. Indeed, Senator, we clearly, as umbrella oversight supervisors, rely significantly on the functional regulators. I will say, 

though, that in terms of really doing our job, if we sense that there 

are deficiencies and need to do more than the functional regulator 

is doing, we do reserve the ability, I think—under Gramm-LeachBliley, in fact, by authority to go in and do more. 

Senator REED. Ms. Williams, you talked about and we have had 

a discussion about communicating concerns, looking at regulatory 

structures, looking at the governance, et cetera. But there is another way sort of to get the message across to the marketplace, and 

that is enforcement action. That is public enforcement action that 

is clear to everyone that there is not only a particular situation, 

but a category of situations that regulators are concerned about. 

Did you touch upon that in your report about the—or your review about the follow-up enforcement, any follow-up enforcement, 

official enforcement actions, rather than informal discussions? 

Ms. WILLIAMS. I think we did touch on the process and the range 

of options, and the fact that with the banking regulators, in particular, there was a tendency not to pursue formal public actions, 

formal public enforcement actions. It has to do with the fact that 

it does become public and that can have an adverse impact on an 

open bank. 

Senator REED. Can I—can you cite a situation, Dr. Sirri, where 

the SEC took a formal enforcement action with respect to the risk 

practices of any of the regulated entities? 

Mr. SIRRI. I am not sure I can cite a public action, something 

that has happened and been closed. 

I will cite something that is public. I do not know the current 

list, but a number of months ago we stated how many cases we had 

in progress on matters related to subprime mortgages. Now 

subprime mortgages run the gamut, the cases from issues about 

origination through issues related to other things within large 

firms. It would not surprise me, and it may be possible, I honestly 

do not know, that there might be something related in there. But 

I truly do not know. And even if I did, I should not comment. 

Senator REED. Mr. Polakoff? 

Mr. POLAKOFF. Absolutely, Senator. We took public enforcement 

action against AIG regarding some of its inappropriate lending. 

Senator REED. No, I am talking about the issue of risk assessment, risk management, the issues that have been the subject of 

this GAO report? 

Mr. POLAKOFF. I cannot—I am not sure about all of the specifics 

from the GAO report, but I think Ms. Williams said that for some 

of the larger institutions the regulators were shy in pursuing formal enforcement action because it was public. And I would like to 

suggest that that would not be an accurate statement, at least from 

an OTS perspective. 

Senator REED. And what actions did you take with respect to 

AIG? 

28 

Mr. POLAKOFF. It was a cease and desist order. We took a cease 

and desist order against a large institution on the West Coast for 

BSA-related problems. And these are all formal and public. I do not 

think any of the banking regulators would shy away from taking 

formal enforcement action because it is public. We do not shy away 

because it is public. We do not shy away even when an institution 

is trying to raise capital. We have to do the right thing from an 

enforcement action perspective. 

Senator REED. Mr. Long, your view? 

Mr. LONG. Congressman, we have taken both formal and informal enforcement actions, and we use them regularly. 

But let me clarify something because I think it is important to 

this point. Congress specifically gave the banking regulators specific authority to either do a series of informal actions or a series 

of formal actions. And you know, in some cases, we choose to go 

informal and we go non-public. 

I want to assure you that that is no less rigorous than formal action. I have been in the boardroom for the signings of many informal documents throughout my career and recently. And I can assure you that the environment in that room in the signing of the 

informal documents can be a career-altering experience for the 

management of that firm. 

The fact that it is informal does not mean that it is not serious 

and not taken seriously. 

Senator REED. I am not suggesting that these are not serious actions and you are not serious about your actions. It is just that 

many times an action which is publicized gets the attention of more 

people than just the people in the boardroom. And behaviors 

change not just within that boardroom of that organization but 

throughout the system. 

Mr. LONG. Senator, that is a good point and we look at every action that we take and we weigh the pros and cons. We feel like we 

use both effectively. But we do utilize both and we do it regularly. 

Senator REED. Mr. Cole? 

Mr. COLE. Yes, with regard to the BSA situation that I mentioned earlier, that was a formal public action. I would tend to 

agree very much with Mr. Long in terms of figuring out what the 

most effective approach is given the management situation. And if 

we can effect change by going directly to the management and accomplishing that, that is what we would tend to do rather than 

taking the next step of going to a formal action. 

Senator REED. Well, I do not think there is a—this is so specific 

of a situation that you have to have some deference to regulators. 

But going to the core issue we have had of just the perception, I 

think, that was growing throughout the community of regulators 

that risk systems, risk compliance, attention to risk was not being 

emphasized enough, and then trying to deal with it on a case-bycase quietly, did not seem to work. I think that might be one of the 

conclusions we draw. Not to say you did not have the authority to 

do it or your judgment was—but it just did not seem to work. 

I want to thank you. I want to thank, again, Ms. Williams and 

her colleagues for, I think, a very good report. I want to thank you 

for questions and we will continue to probe all of these issues as 

we go forward. 

29 

Thank you very much. The hearing is adjourned. 

[Whereupon, at 5:09 p.m., the hearing was adjourned.] 

[Prepared statements and responses to written questions follow:] 

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63 

PREPARED STATEMENT OF ROGER T. COLE 

DIRECTOR, DIVISION OF BANKING SUPERVISION AND REGULATION

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

MARCH 18, 2009 

Chairman Reed, Ranking Member Bunning and members of the Subcommittee, it 

is my pleasure to appear today to discuss the state of risk management in the banking industry and steps taken by Federal Reserve supervisors to address risk management shortcomings at banking organizations. 

In my testimony, I will describe the vigorous and concerted steps the Federal Reserve has taken and is taking to rectify the risk management weaknesses revealed 

by the current financial crisis. I will also describe actions we are taking internally 

to improve supervisory practices and apply supervisory lessons learned. This includes a process spearheaded by Federal Reserve Vice Chairman Donald Kohn to 

systematically identify key lessons revealed by recent events and to implement corresponding recommendations. Because this crisis is ongoing, our review is ongoing. 

Background 

The Federal Reserve has supervisory and regulatory authority over a range of financial institutions and activities. It works with other Federal and State supervisory authorities to ensure the safety and soundness of the banking industry, foster 

the stability of the financial system, and provide for fair and equitable treatment 

of consumers in their financial transactions. The Federal Reserve is not the primary 

Federal supervisor for the majority of commercial bank assets. Rather, it is the consolidated supervisor of bank holding companies, including financial holding companies, and conducts inspections of all of those institutions. As I describe below, we 

have recently enhanced our supervisory processes on consolidated supervision to 

make them more effective and efficient. 

The primary purpose of inspections is to ensure that the holding company and its 

nonbank subsidiaries do not pose a threat to the soundness of the company’s depository institutions. In fulfilling this role, the Federal Reserve is required to rely to 

the fullest extent possible on information and analysis provided by the appropriate 

supervisory authority of the company’s bank, securities, or insurance subsidiaries. 

The Federal Reserve is also the primary Federal supervisor of State-member banks, 

sharing supervisory responsibilities with State supervisory agencies. In this role, 

Federal Reserve supervisory staff regularly conduct onsite examinations and offsite 

monitoring to ensure the soundness of supervised State member banks. 

The Federal Reserve is involved in both regulation—establishing the rules within 

which banking organizations must operate—and supervision—ensuring that banking organizations abide by those rules and remain, overall, in safe and sound condition. A key aspect of the supervisory process is evaluating risk management practices, in addition to assessing the financial condition of supervised institutions. 

Since rules and regulations in many cases cannot reasonably prescribe the exact 

practices each individual bank should use for risk management, supervisors design 

policies and guidance that expand upon requirements set in rules and regulations 

and establish expectations for the range of acceptable practices. Supervisors rely extensively on these policies and guidance as they conduct examinations and to assign 

supervisory ratings. 

We are all aware that the U.S. financial system is experiencing unprecedented 

disruptions that have emerged with unusual speed. The principal cause of the current financial crisis and economic slowdown was the collapse of the global credit 

boom and the ensuing problems at financial institutions, triggered by the end of the 

housing expansion in the United States and other countries. Financial institutions 

have been adversely affected by the financial crisis itself, as well as by the ensuing 

economic downturn. 

In the period leading up to the crisis, the Federal Reserve and other U.S. banking 

supervisors took several important steps to improve the safety and soundness of 

banking organizations and the resilience of the financial system. For example, following the September 11, 2001, terrorist attacks, we took steps to improve clearing 

and settlement processes, business continuity for critical financial market activities, 

and compliance with Bank Secrecy Act, anti-money laundering, and sanctions requirements. Other areas of focus pertained to credit card subprime lending, the 

growth in leveraged lending, credit risk management practices for home equity lending, counterparty credit risk related to hedge funds, and effective accounting controls after the fall of Enron. These are examples in which the Federal Reserve took 

aggressive action with a number of financial institutions, demonstrating that effecVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00067 Fmt 6633 Sfmt 6621 S:\DOCS\52966.TXT SHERYL
64 

1Senior Supervisors Group (2008). ‘‘Observations on Risk Management Practices during the 

Recent Market Turbulence’’ March 6, www.newyorkfed.org/newsevents/news/banking/2008/ 

SSGlRisklMgtldoclfinal.pdf. 2President’s Working Group on Financial Markets (2008), ‘‘Policy Statement on Financial 

Market Developments,’’ March 13, www.treas.gov/press/releases/reports/ 

pwgpolicystatemktturmoill03122008.pdf. Financial Stability Forum (2008), ‘‘Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,’’ April 7, 

www.fsforum.org/publications/FSFlReportltolG7l11lApril.pdf. 

tive supervision can bring about material improvements in risk management and 

compliance practices at supervised institutions. 

In addition, the Federal Reserve, working with the other U.S. banking agencies, 

issued several pieces of supervisory guidance before the onset of the recent crisis— 

taking action on nontraditional mortgages, commercial real estate, home equity 

lending, complex structured financial transactions, and subprime lending—to highlight emerging risks and point bankers to prudential risk management practices 

they should follow. Moreover, we identified a number of potential issues and concerns and communicated those concerns to the industry through the guidance and 

through our supervisory activities. 

Supervisory Actions to Improve Risk Management Practices 

In testimony last June, Vice Chairman Kohn outlined the immediate supervisory 

actions taken by the Federal Reserve to identify risk management deficiencies at 

supervised firms related to the current crisis and bring about the necessary corrective steps. We are continuing and expanding those actions. While additional work 

is necessary, we are seeing progress at supervised institutions toward rectifying 

issues identified amid the ongoing turmoil in the financial markets. We are also devoting considerable effort to requiring bankers to look not just at risks from the past 

but also to have a good understanding of their risks going forward. 

The Federal Reserve has been actively engaged in a number of efforts to understand and document the risk management lapses and shortcomings at major financial institutions revealed during the current crisis. In fact, the Federal Reserve 

Bank of New York organized and leads the Senior Supervisors Group (SSG), which 

published a report last March on risk management practices at major international 

firms.1 I do not plan to summarize the findings of the SSG report and similar public 

reports, since others from the Federal Reserve have already done so.2 But I would 

like to describe some of the next steps being taken by the SSG. 

A key initiative of the Federal Reserve and other supervisors since the issuance 

of the March 2008 SSG report has been to assess the response of the industry to 

the observations and recommendations on the need to enhance key risk management practices. The work of the SSG has been helpful, both in complementing our 

evaluation of risk management practices at individual firms and in our discussions 

with bankers and their directors. It is also providing perspective on how each individual firm’s risk management performance compares with that of a broad cross-section of global financial services firms. 

The continuation of the SSG process requires key firms to conduct self-assessments that are to be shared with the organization’s board of directors and serve to 

highlight progress in addressing gaps in risk management practices and identify 

areas where additional efforts are still needed. Our supervisory staff is currently in 

the process of reviewing the firms’ self assessments, but we note thus far that in 

many areas progress has been made to improve risk management practices. We plan 

to incorporate the results of these reviews into our future examination work to validate management assertions. 

The next portion of my remarks describes the supervisory actions we have been 

taking in the areas of liquidity risk management, capital planning and capital adequacy, firm-wide risk identification, residential lending, counterparty credit risk, 

and commercial real estate. In all of these areas we are moving vigorously to address the weaknesses at financial institutions that have been revealed by the crisis. 

Liquidity risk management 

Since the beginning of the crisis, we have been working diligently to bring about 

needed improvements in institutions’ liquidity risk management practices. One lesson learned in this crisis is that several key sources of liquidity may not be available in a crisis. For example, Bear Stearns collapsed in part because it could not 

obtain liquidity even on a basis fully secured by high-quality collateral, such as U.S. 

Government securities. Others have found that back-up lines of credit are not made 

available for use when most needed by the borrower. 

These lessons have heightened our concern about liquidity and improved our approach to evaluating liquidity plans of banking organizations. Along with our U.S. 

65 

supervisory colleagues, we are monitoring the major firms’ liquidity positions on a 

daily basis, and are discussing key market developments and our supervisory views 

with the firms’ senior management. We also are conducting additional analysis of 

firms’ liquidity positions to examine the impact various scenarios may have on their 

liquidity and funding profiles. We use this ongoing analysis along with findings from 

examinations to ensure that liquidity and funding risk management and contingency funding plans are sufficiently robust and that the institutions are prepared 

to address various stress scenarios. We are aggressively challenging those assumptions in firms’ contingency funding plans that may be unrealistic. 

Our supervisory efforts require firms to consider the potential impact of both disruptions in the overall funding markets and idiosyncratic funding difficulties. We 

are also requiring more rigor in the assessment of all expected and unexpected funding uses and needs. Firms are also being required to consider the respective risks 

of reliance on wholesale funding and retail funding, as well as the risks associated 

with off-balance sheet contingencies. These efforts include steps to require banks to 

consider the potential impact on liquidity that arises from firms’ actions to protect 

their reputation, such as an unplanned increase in assets requiring funding that 

would arise with support given to money market funds and other financial vehicles 

where no contractual obligation exists. These efforts also pertain to steps banks 

must take to prepare for situations in which even collateralized funding may not 

be readily available because of market disruptions or concern about the health of 

a borrowing institution. As a result of these efforts, supervised institutions have significantly improved their liquidity risk management practices, and have taken steps 

to stabilize and improve their funding sources as market conditions permit. 

In conducting work on liquidity risk management, we have used established supervisory guidance on liquidity risk management as well as updated guidelines on 

liquidity risk management issued by the Basel Committee on Banking Supervision 

last September—a process in which the Federal Reserve played a lead role. So that 

supervisory expectations for U.S. depository institutions are aligned with these 

international principles, the U.S. banking agencies plan to update their own interagency guidance on liquidity risk management practices in the near future. The new 

guidance will emphasize the need for institutions of all sizes to conduct meaningful 

cash-flow forecasts of their funding needs in both normal and stressed conditions 

and to ensure that they have an adequately diversified funding base and a cushion 

of liquid assets to mitigate stressful market conditions. Our supervisory efforts at 

individual institutions and the issuance of new liquidity risk management guidance 

come on top of broader Federal Reserve efforts outside of the supervision function 

to improve liquidity in financial markets, such as introduction of the Term Auction 

Facility and the Term Asset-Backed Securities Loan Facility. 

Capital planning and capital adequacy 

Our supervisory activities for capital planning and capital adequacy are similar 

to those for liquidity. We have been closely monitoring firms’ capital levels relative 

to their risk exposures, in conjunction with reviewing projections for earnings and 

asset quality and discussing our evaluations with senior management. We have 

been engaged in our own analysis of loss scenarios to anticipate institutions’ future 

capital needs, analysis that includes the potential for losses from a range of sources 

as well as assumption of assets currently held off balance sheet. We have been discussing our analysis with bankers and requiring their own internal analyses to reflect a broad range of scenarios and to capture stress environments that could impair solvency. As a result, banking organizations have taken a number of steps to 

strengthen their capital positions, including raising substantial amounts of capital 

from private sources in 2007 and 2008. 

We have stepped up our efforts to evaluate firms’ capital planning and to bring 

about improvements where they are needed. For instance, we recently issued guidance to our examination staff—which was also distributed to supervised institutions—on the declaration and payment of dividends, capital repurchases, and capital 

redemptions in the context of capital planning processes. We are forcefully requiring 

institutions to retain strong capital buffers-above the levels prescribed by minimum 

regulatory requirements—not only to weather the immediate environment but also 

to remain viable over the medium and long term. 

Our efforts related to capital planning and capital adequacy are embodied in the 

interagency supervisory capital assessment process, which began in February. We 

are conducting assessments of selected banking institutions’ capital adequacy, based 

on certain macroeconomic scenarios. For this assessment, we are carefully evaluating the forecasts submitted by each financial institution to ensure they are appropriate, consistent with the firm’s underlying portfolio performance, and reflective of 

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66 

ital under the two macroeconomic scenarios being used in the capital assessment 

program will permit supervisors to ascertain whether institutions’ capital buffers 

over the regulatory capital minimum are appropriate under more severe but plausible scenarios. 

Federal Reserve supervisors have been engaged over the past few years in evaluating firms’ internal processes to assess overall capital adequacy as set forth in existing Federal Reserve supervisory guidance. A portion of that work has focused on 

how firms use economic capital practices to assess overall capital needs. We have 

communicated our findings to firms individually, which included their need to improve some key practices, and demanded corrective actions. We also presented our 

overall findings to a broad portion of the financial industry at a System-sponsored 

outreach meeting last fall that served to underscore the importance of our message. 

Firm-wide risk identification and compliance risk management 

One of the most important aspects of good risk management is risk identification. 

This is a particularly challenging exercise because some practices, each of which appears to present low risk on its own, may combine to create unexpectedly high risk. 

For example, in the current crisis, practices in mortgage lending—which historically 

has been seen as a very low-risk activity—have become distorted and, consequently 

riskier, as they have been fueled by another activity that was designed to reduce 

risk to lenders—the sale of mortgage assets to investors outside the financial industry. 

Since the onset of the crisis, we have been working with supervised institutions 

to improve their risk identification practices where needed, such as by helping identify interconnected risks. These improvements include a better understanding of 

risks facing the entire organization, such as interdependencies among risks and concentrations of exposures. One of the key lessons learned has been the need for timely and effective communication about risks, and many of our previously mentioned 

efforts pertaining to capital and liquidity are designed to ensure that management 

and boards of directors understand the linkages within the firm and how various 

events might impact the balance sheet and funding of an organization. We have demanded that institutions address more serious risk management deficiencies so that 

risk management is appropriately independent, that incentives are properly aligned, 

and that management information systems (MIS) produce comprehensive, accurate, 

and timely information. 

In our 2006 guidance on nontraditional mortgage products, we recognized that 

poor risk management practices related to retail products and services could have 

serious effects on the profitability of financial institutions and the economy; in other 

words, there could be a relationship between consumer protection and financial 

soundness. For example, consumer abuses in the subprime mortgage lending market 

were a contributing cause to the current mortgage market problems. Here, too, we 

are requiring improvements. The Federal Reserve issued guidance on compliance 

risk management programs to emphasize the need for effective firm-wide compliance risk management and oversight at large, complex banking organizations. This 

guidance is particularly applicable to compliance risks, including its application to 

consumer protection, that transcend business lines, legal entities, and jurisdictions 

of operation. 

Residential lending 

Financial institutions are still facing significant challenges in the residential 

mortgage market, particularly given the rising level of defaults and foreclosures and 

the lack of liquidity for private label mortgage-backed securities. Therefore, we will 

continue to focus on the adequacy of institutions’ risk management practices, including their underwriting standards, and re-emphasize the importance of a lender’s assessment of a borrower’s ability to repay the loan. Toward that end, we are requiring institutions to maintain risk management practices that more effectively identify, monitor, and control the risks associated with their mortgage lending activity 

and that more adequately address lessons learned from recent events. 

In addition to efforts on the safety and soundness front, last year we finalized 

amendments to the rules under the Home Ownership and Equity Protection Act 

(HOEPA). These amendments establish sweeping new regulatory protections for 

consumers in the residential mortgage market. Our goal throughout this process has 

been to protect borrowers from practices that are unfair or deceptive and to preserve 

the availability of credit from responsible mortgage lenders. The Board believes that 

these regulations, which apply to all mortgage lenders, not just banks, will better 

protect consumers from a range of unfair or deceptive mortgage lending and advertising practices that have been the source of considerable concern and criticism. 

67 

3See http://www.Federalreserve.gov/newsevents/press/bcreg/20090304a.htm. 

Given escalating mortgage foreclosures, we have urged regulated institutions to 

establish systematic, proactive, and streamlined mortgage loan modification protocols and to review troubled loans using these protocols. We expect an institution 

(acting either in the role of lender or servicer) to determine, before proceeding to 

foreclosure, whether a loan modification will enhance the net present value of the 

loan, and whether loans currently in foreclosure have been subject to such analysis. 

Such practices are not only consistent with sound risk management but are also in 

the long-term interests of borrowers, lenders, investors, and servicers. We are encouraging regulated institutions, through government programs, to pursue modifications that result in mortgages that borrowers will be able to sustain over the remaining maturity of their loan. In this regard, just recently the Federal Reserve 

joined with other financial supervisors to encourage all of the institutions we supervise to participate in the Treasury Department’s Home Affordable loan modification 

program, which was established under the Troubled Assets Relief Program.3 Our examiners are closely monitoring loan modification efforts of institutions we supervise. 

Counterparty credit risk 

The Federal Reserve has been concerned about counterparty credit risk for some 

time, and has focused on requiring the industry to have effective risk management 

practices in place to deal with risks associated with transacting with hedge funds, 

for example, and other key counterparties. This focus includes assessing the overall 

quality of MIS for counterparty credit risk and ensuring that limits are complied 

with and exceptions appropriately reviewed. As the crisis has unfolded, we have intensified our monitoring of counterparty credit risk. Supervisors are analyzing management reports and, in some cases, are having daily conversations with management about ongoing issues and important developments. This process has allowed 

us to understand key linkages and exposures across the financial system as specific 

counterparties experience stress during the current market environment. Federal 

Reserve supervisors now collect information on the counterparty credit exposures of 

major institutions on a weekly and monthly basis, and have enhanced their methods 

of assessing this exposure. 

Within counterparty credit risk, issues surrounding the credit default swap (CDS) 

market have been particularly pertinent. As various Federal Reserve officials have 

noted in past testimony to congressional committees and in other public statements, 

regulators have, for several years, been addressing issues surrounding the over-thecounter (OTC) derivatives market in general and the CDS market in particular. 

Since September 2005, an international group of supervisors, under the leadership 

of the Federal Reserve Bank of New York, has been working with dealers and other 

market participants to strengthen arrangements for processing, clearing, and settling OTC derivatives. An early focus of this process was on CDS. This emphasis 

includes promoting such steps as greater use of electronic-confirmation platforms, 

adoption of a protocol that requires participants to request counterparty consent before assigning trades to a third party, and creation of a contract repository that 

maintains an electronic record of CDS trades. 

More recently, and in response to the recommendations of the President’s Working Group on Financial Markets and the Financial Stability Forum, supervisors are 

working to bring about further improvements to the OTC derivatives market infrastructure. With respect to credit derivatives, this agenda includes: (1) further increasing standardization and automation; (2) incorporating an auction-based cash 

settlement mechanism into standard documentation; (3) reducing the volume of outstanding CDS contracts; and (4) developing well-designed central counterparty services to reduce systemic risks. 

The most important potential change in the infrastructure for credit derivatives 

is the creation of one or more central counterparties (CCPs) for CDS. The Federal 

Reserve supports CCP clearing of CDS because, if properly designed and managed, 

CCPs can reduce risks to market participants and to the financial system. In addition to clearing CDS through CCPs, the Federal Reserve believes that exchange 

trading of sufficiently standardized contracts by banks and other market participants can increase market liquidity and transparency, and thus should be encouraged. In a major step toward achieving that goal, the Federal Reserve Board, on 

March 4, 2009, approved the application by ICE US Trust LLC (ICE Trust) to become a member of the Federal Reserve System. ICE Trust intends to provide central 

counterparty services for certain credit default swap contracts. 

68 

Commercial real estate 

For some time, the Federal Reserve has been focused on commercial real estate 

(CRE) exposures. For background, as part of our onsite supervision of banking organizations in the early 2000s, we began to observe rising CRE concentrations. Given 

the central role that CRE lending played in the banking problems of the late 1980s 

and early 1990s, we led an interagency effort to issue supervisory guidance on CRE 

concentrations. In the 2006 guidance on CRE, we emphasized our concern that some 

institutions’ strategic- and capital-planning processes did not adequately acknowledge the risks from their CRE concentrations. We stated that stress testing and 

similar exercises were necessary for institutions to identify the impact of potential 

CRE shocks on earnings and capital, especially the impact from credit concentrations. 

Because weaker housing markets and deteriorating economic conditions have 

clearly impaired the quality of CRE loans at supervised banking organizations, we 

have redoubled our supervisory efforts in regard to this segment. These efforts include monitoring carefully the impact that declining collateral values may have on 

CRE exposures as well as assessing the extent to which banks have been complying 

with the interagency CRE guidance. We found, through horizontal reviews and 

other examinations, that some institutions would benefit from additional and better 

stress testing and could improve their understanding of how concentrations—both 

single-name and sectoral/geographical concentrations—can impact capital levels during shocks. We have also implemented additional examiner training so that our supervisory staff is equipped to deal with more serious CRE problems at banking organizations as they arise, and have enhanced our outreach to key real estate market 

participants and obtained additional market data sources to help support our supervisory activities. As a result of our supervisory work, risk management practices related to CRE are improving, including risk identification and measurement. 

To sum up our efforts to improve banks’ risk management, we are looking at all 

of the areas mentioned above—both on an individual and collective basis—as well 

as other areas to ensure that all institutions have their risk management practices 

at satisfactory levels. More generally, where we have not seen appropriate progress, 

we are aggressively downgrading supervisory ratings and using our enforcement 

tools. 

Supervisory Lessons Learned 

Having just described many of the steps being taken by Federal Reserve supervisors to address risk management deficiencies in the banking industry, I would 

now like to turn briefly to our internal efforts to improve our own supervisory practices. The current crisis has helped us to recognize areas in which we, like the banking industry, can improve. 

Since last year, Vice Chairman Kohn has led a System-wide effort to identify lessons learned and to develop recommendations for potential improvements to supervisory practices. To benefit from multiple perspectives in these efforts, this internal 

process is drawing on staff from around the System. For example, we have formed 

System-wide groups, led by Board members and Reserve Bank Presidents, to address the identified issues in areas such as policies and guidance, the execution of 

supervisory responsibilities, and structure and governance. Each group is reviewing 

identified lessons learned, assessing the effectiveness of recent initiatives to rectify 

issues, and developing additional recommendations. We will leverage these group 

recommendations to arrive at an overall set of enhancements that will be implemented in concert. As you know, we are also meeting with Members of the Congress 

and other government bodies, including the Government Accountability Office, to 

consult on lessons learned and to hear additional suggestions for improving our 

practices. 

One immediate example of enhancements relates to System-wide efforts for forward-looking risk identification efforts. Building on previous System-wide efforts to 

provide perspectives on existing and emerging risks, the Federal Reserve has recently augmented its process to disseminate risk information to all the Reserve 

Banks. That process is one way we are ensuring that risks are identified in a consistent manner across the System by leveraging the collective insights of Federal 

Reserve supervisory staff. We are also using our internal risk reporting to help establish supervisory priorities, contribute to examination planning and scoping, and 

track issues for proper correction. Additionally, we are reviewing staffing levels and 

expertise so that we have the appropriate resources, including for proper risk identification, to address not just the challenges of the current environment but also those 

over the longer term. 

We have concluded that there is opportunity to improve our communication of supervisory and regulatory policies, guidance, and expectations to those we regulate. 

69 

This includes more frequently updating our rules and regulations and more quickly 

issuing guidance as new risks and concerns are identified. For instance, we are reviewing the area of capital adequacy, including treatment of market risk exposures 

as well as exposures related to securitizations and counterparty credit risk. We are 

taking extra steps to ensure that as potential areas of risk are identified or new 

issues emerge, policies and guidance address those areas in an appropriate and 

timely manner. And we will increase our efforts to ensure that, for global banks, 

our policy and guidance responses are coordinated, to the extent possible, with those 

developed in other countries. 

One of the Federal Reserve’s latest enhancements related to guidance, a project 

begun before the onset of the crisis, was the issuance of supervisory guidance on 

consolidated supervision. This guidance is intended to assist our examination staff 

as they carry out supervision of banking institutions, particularly large, complex 

firms with multiple legal entities, and to provide some clarity to bankers about our 

areas of supervisory focus. Importantly, the guidance is designed to calibrate supervisory objectives and activities to the systemic significance of the institutions and 

the complexity of their regulatory structures. The guidance provides more explicit 

expectations for supervisory staff on the importance of understanding and validating 

the effectiveness of the banking organization’s corporate governance, risk management, and internal controls that are in place to oversee and manage risks across 

the organization. Our assessment of nonbank activities is an important part of our 

supervisory process to understand the linkages between depository and nondepository subsidiaries, and their effects on the overall risks of the organization. 

In addition to issues related to general risk management at nonbank subsidiaries, 

the consolidated supervision guidance addresses potential issues related to consumer compliance. In this regard, in 2007 and 2008 the Board collaborated with 

other U.S. and State government agencies to launch a cooperative pilot project 

aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. This interagency initiative has clarified jurisdictional issues and improved information-sharing among the 

participating agencies, along with furthering its overarching goal of preventing abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. 

As stated earlier, there were numerous cases in which the U.S. banking agencies 

developed policies and guidance for emerging risks and issues that warranted the 

industry’s attention, such as in the areas of nontraditional mortgages, home equity 

lending, and complex structured financial transactions. It is important that regulatory policies and guidance continue to be applied to firms in ways that allow for 

different business models and that do not squelch innovation. However, when bankers are particularly confident, when the industry and others are especially vocal 

about the costs of regulatory burden and international competitiveness, and when 

supervisors cannot yet cite recognized losses or writedowns, we must have even 

firmer resolve to hold firms accountable for prudent risk management practices. It 

is particularly important, in such cases, that our supervisory communications are 

very forceful and clear, directed at senior management and boards of directors so 

that matters are given proper attention and resolved to our satisfaction. 

With respect to consumer protection matters, we have an even greater understanding that reviews of consumer compliance records of nonbank subsidiaries of 

bank holding companies can aid in confirming the level of risk that these entities 

assume, and that they assist in identifying appropriate supervisory action. Our consumer compliance division is currently developing a program to further the work 

that was begun in the interagency pilot discussed earlier. In addition to these 

points, it is important to note that we have learned lessons and taken action on important aspects of our consumer protection program, which I believe others from the 

Federal Reserve have discussed with the Congress. 

In addition, we must further enhance our ability to develop clear and timely analysis of the interconnections among both regulated and unregulated institutions, and 

among institutions and markets, and the potential for these linkages and interrelationships to adversely affect banking organizations and the financial system. In 

many ways, the Federal Reserve is well positioned to meet this challenge. In this 

regard, the current crisis has, in our view, demonstrated the ways in which the Federal Reserve’s consolidated supervision role closely complements our other central 

bank responsibilities, including the objectives of fostering financial stability and deterring or managing financial crises. 

The information, expertise, and powers derived from our supervisory authority enhance the Federal Reserve’s ability to help reduce the likelihood of financial crises, 

and to work with the Treasury Department and other U.S. and foreign authorities 

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70 

vision guidance that the Federal Reserve issued in 2008 explicitly outlines the process by which we will use information obtained in the course of supervising financial 

institutions—as well as information and analysis obtained through relationships 

with other supervisors and other sources—to identify potential vulnerabilities across 

financial institutions. It will also help us identify areas of supervisory focus that 

might further the Federal Reserve’s knowledge of markets and counterparties and 

their linkages to banking organizations and the potential implications for financial 

stability. 

A final supervisory lesson applies to the structure of the U.S. regulatory system, 

an issue that the Congress, the Federal Reserve, and others have already raised. 

While we have strong, cooperative relationships with other relevant bank supervisors and functional regulators, there are obvious gaps and operational challenges 

in the regulation and supervision of the overall U.S. financial system. This is an 

issue that the Federal Reserve has been studying for some time, and we look forward to providing support to the Congress and the Administration as they consider 

regulatory reform. In a recent speech, Chairman Bernanke introduced some ideas 

to improve the oversight of the U.S. financial system, including the oversight of 

nonbank entities. He stated that no matter what the future regulatory structure in 

the United States, there should be strong consolidated supervision of all systemically important banking and nonbanking financial institutions. 

Finally, Mr. Chairman, I would like to thank you and the Subcommittee for holding this second hearing on risk management—a crucially important issue in understanding the failures that have contributed to the current crisis. Our actions, with 

the support of the Congress, will help strengthen institutions’ risk management 

practices and the supervisory and regulatory process itself—which should, in turn, 

greatly strengthen the banking system and the broader economy as we recover from 

the current difficulties. 

I look forward to answering your questions. 

PREPARED STATEMENT OF TIMOTHY W. LONG 

SENIOR DEPUTY COMPTROLLER, BANK SUPERVISION POLICY AND

CHIEF NATIONAL BANK EXAMINER

MARCH 18, 2009 

Introduction 

Chairman Reed, Ranking Member Bunning, and members of the Subcommittee, 

my name is Timothy Long and I am the Senior Deputy Comptroller for Bank Supervision Policy and Chief National Bank Examiner at the Office of the Comptroller 

of the Currency (OCC). I welcome this opportunity to discuss the OCC’s perspective 

on the recent lessons learned regarding risk management, as well as the steps we 

have taken to strengthen our supervision and examination processes in this critical 

area, and how we supervise the risk management activities at the largest national 

banking companies. 

Your letter of invitation also requested our response to the findings of the GAO 

regarding the OCC’s oversight of bank risk management. Because we only received 

the GAO’s summary statement of facts on Friday night, we have not had an opportunity to thoroughly review and assess their full report and findings. Therefore, I 

will only provide some brief observations on their initial findings. We take findings 

and recommendations from the GAO very seriously and will be happy to provide 

Subcommittee members a written response to the GAO’s findings once we have had 

the opportunity to carefully review their report. 

Role of Risk Management 

The unprecedented disruption that we have seen in the global financial markets 

over the last eighteen months, and the events and conditions leading up to this disruption, have underscored the critical need for effective and comprehensive risk 

management processes and systems. As I will discuss in my testimony, these events 

have revealed a number of weaknesses in banks’ risk management processes that 

we and the industry must address. Because these problems are global in nature, 

many of the actions we are taking are in coordination with other supervisors around 

the world. 

More fundamentally, recent events have served as a dramatic reminder that risk 

management is, and must be, more than simply a collection of policies, procedures, 

limits and models. Effective risk management requires a strong corporate culture 

and corporate risk governance. As noted in the March 2008 Senior Supervisors 

Group report on ‘‘Observations on Risk Management Practices During the Recent 

71 

1See Senior Supervisors Group Report, ‘‘Observations on Risk Management Practices,’’ at 

http://www.newyorkfed.org/newsevents/news/banking/2008/SSGlRisklMgtldoclfinal.pdf. 

Market Turmoil,’’ companies that fostered a strong risk management culture and 

encouraged firm-wide identification and control of risk, were less vulnerable to significant losses, even when engaged in higher risk activities.1

While current economic conditions have brought renewed attention to risk management, it is during periods of expansionary economic growth when risk management can be most critical and challenging both for bankers and supervisors. Financial innovation and expansion of credit are important drivers of our economy. Banks 

must be able to respond to customer and investor demand for new and innovative 

products and services. They must also be able to compete with firms that may be 

less regulated and with financial service companies across the globe. Failure to 

allow this competition risks ceding the prominent role that U.S. financial firms have 

in the global marketplace. 

Banks are in the business of managing financial risk. Competing in the marketplace and allowing market innovation means that there will be times when banks 

lose money. There will also be times when, despite a less favorable risk/reward return, a bank will need to maintain a market presence to serve its customers and 

to retain its role as a key financial intermediary. These are not and should not be 

viewed as risk management failures. The job of risk management is not to eliminate 

losses or risk, but rather to ensure that risk exposures are fully identified and understood so that bank management and directors can make informed business decisions about the firm’s level of risk. 

In this regard, a key issue for bankers and supervisors is determining when the 

accumulation of risks either within an individual firm or across the system has become too high, such that corrective or mitigation actions are needed. Knowing when 

and how to strike this balance is one of the most difficult jobs that supervisors and 

examiners face. Taking action too quickly can constrain economic growth and impede credit to credit worthy borrowers; waiting too long can result in an overhang 

of risk becoming embedded into banks and the marketplace. Effective risk management systems play a critical role in this process. 

Risk Management Lessons Learned 

It is fair to ask what the banking industry and supervisors have learned from the 

major losses that have occurred over the past 18 months. The losses have been so 

significant, and the damage to the economy and confidence so great, that we all 

must take stock of what we missed, and what we should have done differently to 

make sure that we minimize the possibility that something like this happens again. 

Below are some of our assessments: 

• Underwriting Standards Matter, Regardless of Whether Loans are Held 

or Sold—The benign economic environment of the past decade, characterized 

by low interest rates, strong economic growth and very low rates of borrower 

defaults led to complacency on the part of many lenders. Competitive pressures 

drove business line managers to ease underwriting standards for the origination 

of credit and to assume increasingly complex and concentrated levels of risk. Increased investor appetite for yield and products, fueled by a global abundance 

of liquidity, led many larger banks to adopt the so-called ‘‘originate-to-distribute’’ model for certain commercial and leveraged loan products, whereby 

they originated a significant volume of loans with the express purpose of packaging and selling them to investors. Many of these institutional investors were 

willing to accept increasingly liberal repayment terms, reduced financial covenants, and higher borrower leverage on these transactions in return for marginally higher yields. Similar dynamics were occurring in the residential mortgage markets, where lenders, primarily non-bank lenders, were aggressively relaxing their underwriting standards. 

Given the abundance of liquidity and willing investors for these loans, lenders became complacent about the risks underlying the loans. However, in the fall of 2007 

the risk appetite of investors changed dramatically and, at times, for reasons not 

directly related to the exposures that they held. This abrupt change in risk tolerance left banks with significant pipelines of loans that they needed to fund as the 

syndicated loan and securitization markets shut down. Bankers and supervisors underestimated the rapidity and depth of the global liquidity freeze. A critical lesson, 

which the OCC and other Federal banking agencies noted in their 2007 Shared National Credit results, is that banking organizations should ensure that underwriting 

standards are not compromised by competitive pressures. The agencies warned that 

‘‘consistent with safe and sound banking practice, agent banks should underwrite 

72 

2See Joint Release, NR 2007–102 at: http://www.occ.treas.gov/ftp/release/2007-102.htm. 

funding commitments in a manner reasonably consistent with internal underwriting 

standards.’’2

• Risk Concentrations Can Accumulate Across Products and Business 

Lines and Must be Controlled—Risk concentrations can arise as banks seek 

to maximize their expertise or operational efficiencies in a highly competitive 

business. Community banks can often develop significant concentrations as 

their lending portfolios tend to be highly concentrated in their local markets. 

For larger institutions, a key issue has been the ability to aggregate risk exposures across business and product lines and to identify risks that may be highly 

correlated. For example, many national banks underestimated their exposure to 

subprime mortgages because they did not originate them. Indeed, some senior 

bank management thought they had avoided subprime risk exposures by deliberately choosing to not originate such loans in the bank—only to find out after 

the fact that their investment bank affiliates had purchased subprime loans 

elsewhere to structure them into collateralized debt obligations. Because of inadequate communication within these firms, those structuring businesses were 

aggressively expanding activity at the same time that retail lending professionals in the bank were avoiding or exiting the business because of their refusal to meet weak underwriting conditions prevalent in the market. These failures were compounded when products, markets, and geographic regions that 

previously were looked to as a source of risk diversification became more highly 

correlated as contagion effects spread across the globe. Additionally, significant 

corporate acquisitions, especially if they were not consistent with the bank’s 

business strategy and corporate culture, affected the institutions’ financial well 

being, their risk positions and reputations, and placed significant strains on 

their risk management processes. 

• Asset-Based Liquidity Provides a Critical Cushion—There is always a tension of how much of a bank’s balance sheet capacity should be used to provide 

a cushion of liquid assets—assets that can be readily converted to liquid funds 

should there be a disruption in the bank’s normal funding markets or in its 

ability to access those markets. Because such assets tend to be low risk and, 

thus, low yielding, many banks have operated with very minimal cushions in 

recent years. These decisions reflected the abundance of liquidity in the market 

and the ease with which banks could tap alternative funding sources through 

various capital and securitization markets. Here again, when these markets became severely constrained, many banks faced significant short-term funding 

pressures. For some firms, these funding pressures, when combined with high 

credit exposures and increased leverage, resulted in significant strains and, in 

some cases, liquidity insolvency. 

• Systemically Important Firms Require State-of-the-Art Infrastructure— 

As noted in a number of visible cases during this period of market turmoil, a 

large firm’s ability to change its risk profile or react to the changing risk tolerance of others is dependent on an extremely robust supporting infrastructure. 

The velocity with which information is transmitted across financial markets and 

the size, volume and complexity of transactions between market participants 

has been greatly expanded through technology advancements and globalization 

of markets. Failure to have sufficient infrastructure and backroom operations 

resulted in failed trades and increased counterparty exposures, increasing both 

reputation and credit risks. 

• Need for Robust Capital Levels and Capital Planning Processes—Although we are clearly seeing strains, the national banking system, as a whole, 

has been able to withstand the events of the past 18 months due, in part, to 

their strong levels of regulatory capital. The strong levels of capital in national 

banks helped to stabilize the financial system. National banking organizations 

absorbed many weaker competitors (e.g., Bear Stearns, Countrywide, and 

WAMU). This relative strength is more apparent when compared to the highly 

leveraged position of many broker-dealers. Nonetheless, it is clear that both 

banks’ internal capital processes and our own supervisory capital standards 

need to be strengthened to more fully incorporate potential exposures from both 

on- and off-balance sheet transactions across the entire firm. In addition, capital 

planning and estimates of potential credit losses need to be more forward looking and take account of uncertainties associated with models, valuations, concentrations, and correlation risks throughout an economic cycle. 

73 

3Senior Supervisors Group Report, ‘‘Observations on Risk Management Practices,’’ at http:// 

www.newyorkfed.org/newsevents/news/banking/2008/SSGlRisklMgtldoclfinal.pdf; Financial Stability Forum, ‘‘Enhancing Market and Institutional Resilience,’’ at http:// 

www.fsforum.org/publications/FSFl ReportltolG7l11lApril.pdf; Joint Forum, ‘‘Cross-sectoral review of group-wide identification and management of risk concentrations’’ at http:// 

www.bis.org/publ/joint19.htm; and Basel Committee on Banking Supervision Report, ‘‘Sound 

principles for stress testing practices and supervision,’’ at http://www.bis.org/publ/ 

bcbs147.htm. 4See Basel Committee on Banking Supervision, ‘‘Principles for Sound Liquidity Management 

and Supervision,’’ at http://www.bis.org/publ/bcbs144.htm. 

These findings are consistent with reports issued by the SSG’s report on ‘‘Risk 

Management Practices,’’ the Financial Stability Forum’s (FSF) report on ‘‘Enhancing 

Market and Institutional Resilience,’’ the Joint Forum’s report on ‘‘Cross- Sectoral 

Review of Group-wide Identification and Management of Risk Concentrations,’’ and 

the Basel Committee on Banking Supervision’s consultative paper on ‘‘Principles for 

Sound Stress Testing Practices and Supervision.’’3 Two common themes from these 

reports and other studies in which the OCC has actively participated are the need 

to strengthen risk management practices and improve stress testing and firm-wide 

capital planning processes. The reports also note several areas where banking supervisors need to enhance their oversight regimes. The recommendations generally 

fall into three broad categories: 1) providing additional guidance to institutions with 

regard to the risk management practices and monitoring institutions’ actions to implement those recommendations; 2) enhancing the various aspects of the Basel II 

risk-based capital framework; and 3) improving the exchange of supervisory information and sharing of best practices. 

OCC Supervisory Responses 

The OCC has been actively involved in the various work groups that issued these 

reports, and we are taking a number of steps, primarily in our large bank supervision program, to ensure that our supervisory process and the risk management 

practices of our institutions incorporate these recommendations. I will focus on the 

three key areas identified by the Subcommittee: liquidity risk management, capital 

requirements, and enterprise-wide risk management. 

Liquidity Risk Management 

The sudden and complete shutdown in many traditional funding markets was not 

contemplated by most contingency funding plans. This period of market disruption 

has magnified the risks associated with underestimating liquidity risk exposures 

and improperly planning for periods of significant duress. The SSG report specifically noted that better performing firms carefully monitored their and on- and offbalance sheet risk exposures and actively managed their contingent liquidity needs. 

In April 2008, the OCC developed a liquidity risk monitoring program to standardize liquidity monitoring information across our large bank population and provide more forward looking assessments. We developed a template for the monthly 

collection of information about balance sheet exposures, cash-flow sources and uses, 

and financial market risk indicators. Our resident examiners complete this template 

each month and then work with our subject matter specialists in the Credit and 

Market Risk (CMR) division in Washington to produce a monthly report that summarizes the liquidity risk profile, based on levels of risk and quality of risk management, for 15 banking companies in our Large and Mid-size bank programs. These 

risk profiles provide a forward looking assessment of liquidity maturity mismatches 

and capacity constraints, both of which are considered early warning signals of potential future problems. 

In September 2008, the Basel Committee on Banking Supervision (Basel Committee) issued a report on, ‘‘Principles for Sound Liquidity Risk Management and 

Supervision.’’4 This report represents critical thinking that was done by supervisors 

in over 15 jurisdictions on the fundamental principles financial institutions and supervisors must adopt to provide appropriate governance of liquidity risk. OCC subject matter specialists in our CMR division were actively involved in the development of this important paper on risk management expectations, and are now contributing to the second phase of this work which is focused on identifying key liquidity metrics and benchmarks that may be valuable for enhancing transparency about 

liquidity risk at financial institutions. We are also working with the other U.S. Federal banking agencies to adapt and apply these key principles more broadly to all 

U.S. banking institutions through an interagency policy statement. 

The OCC reviews bank liquidity on an ongoing basis and we have incorporated 

these valuable lessons into our evaluations. Our strategic bank supervision operating plan for 2009 directs examiners at our largest national banks to focus on 

74 

5See: ‘‘Proposed enhancements to the Basel II framework,’’ ‘‘Revisions to the Basel II Market 

Risk Framework,’’ and ‘‘Guidelines for computing capital for incremental risk in the trading 

book,’’ January 2009 at http://www.bis.org/press/p090116.htm. 6See ‘‘Initiatives on capital announced by the Basel Committee,’’ March 12, 2009 at: http:// 

www.bis.org/press/p090312.htm. 7See ‘‘Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,’’ April 2008 at: http://www.fsforum.org/publications/rl0804.pdf. 8See: OCC Bulletin 2007–1, ‘‘Complex Structured Finance Transactions’’ at http:// 

www.occ.gov/ftp/bulletin/2007-1.html. 

banks’ firm-wide assessments of their liquidity risk and the adequacy of their liquidity cushions (short-term liquid assets and collateralized borrowing capacity) to meet 

short and medium term funding needs, as well as on the effectiveness of their liquidity risk management, including management information systems and contingency funding plans. 

Capital Requirements 

The market turmoil has highlighted areas where the current Basel II capital 

framework needs to be strengthened. The OCC, through its membership on the 

Basel Committee and work with the FSF, has been actively involved in formulating 

improvements to the capital framework. Among the refinements recommended by 

the Basel Committee in its January 2009 consultative papers are higher capital requirements for re-securitizations, such as collateralized debt obligations, which are 

themselves comprised of asset-backed securities.5 These structured securities suffered significant losses during the recent market turmoil. Other proposed changes 

to the Basel II framework would increase the capital requirements for certain liquidity facilities that support asset-backed commercial paper conduits. 

In addition, the Basel Committee has proposed requirements for certain banks to 

incorporate default risk and credit migration risk in their value-at-risk models. 

These proposals are designed to better reflect the risks arising from the more complex, and less liquid, credit products that institutions now hold in their trading portfolios. The intention is also to reduce the extent of regulatory capital arbitrage that 

currently exists between the banking and trading books. 

The January consultative paper that proposed enhancements to the Basel II 

framework would also strengthen supervisory guidance regarding Pillar 2, or the supervisory review process of Basel II. Specifically, the proposed supervisory guidance 

would address firm-wide governance and risk management; capturing the risk of offbalance sheet exposures and securitization activities; and incentives to manage risk 

and returns over the long-term. 

More recently, following its meeting last week, the Basel Committee announced 

additional initiatives to strengthen capital in the banking system. These include introducing standards to promote the buildup of capital buffers that can be drawn 

down in periods of stress, as well as a non-risk-based capital measure like our leverage ratio.6 Once the Basel Committee finalizes these and other changes to the Basel 

II framework, the OCC and other Federal banking agencies will jointly consider 

their adoption in the U.S. through the agencies’ notice and comment process. 

Enterprise Risk Management 

As previously noted, the recent market turmoil has highlighted the importance of 

a comprehensive firm-wide risk management program. The SSG report advised that 

striking the right balance between risk appetite and risk controls was a distinguishing factor among firms surveyed in its study. Additionally, the FSF report 

noted that, ‘‘Supervisors and regulators need to make sure that the risk management and control framework within financial institutions keeps pace with the 

changes in instruments, markets and business models, and that firms do not engage 

in activities without having adequate controls.’’7

Proper risk governance was a key focus of guidance that the OCC, the SEC, and 

other Federal banking regulators issued in January 2007 on complex finance activities.8 That guidance stressed the need for firms to have robust internal controls and 

risk management processes for complex structured finance transactions. The guidance emphasized the importance of a strong corporate culture that includes and encourages mechanisms that allow business line and risk managers to elevate concerns to appropriate levels of management and to ensure the timely resolution of 

those concerns. It also stressed the need to ensure appropriate due diligence at the 

front-end, before products are offered, to ensure that all risks have been appropriately considered and can be effectively identified, managed and controlled. At the 

OCC, approval of new or novel banking activities is predicated on the bank having 

sufficient risk management controls in place. 

75 

Assessing management’s ability to effectively identify, measure, monitor, and control risk across the firm and to conduct effective stress testing is a key focus of our 

examination strategies for large national banks this year. Stress tests are a critical 

tool for effective enterprise-wide risk assessments. Such tests can help identify concentrations and interconnected risks and determine the adequacy of capital and liquidity. As with most other issues, the success of a stress testing program depends 

importantly on the support and sponsorship provided by senior management. In 

banks where risk management functions did not perform well, stress testing typically was a mechanical exercise. Management viewed stress tests as more of a ‘‘requirement’’ than an important risk management tool that could lead to internal discussions and debate about whether existing exposures constituted unacceptable 

risks. 

In addition, many stress tests failed to fully estimate the potential severity and 

duration of stress events and to identify and capture risks across the firm. Often, 

stress tests would focus on a single line of business and/or use only historical statistical relationships. When designing a stress test, particularly after a prolonged period of abundant liquidity, low credit spreads and low interest rates, it is important 

to probe for weaknesses in the portfolio that may not be evident from historically 

based stress exercises. Expert judgment can help define scenarios to address the 

likely breakdown in normal statistical relationships, as well as feedback loops, in 

a crisis. Such scenario-based stress tests, often dismissed as implausible by business 

unit personnel, allow firms to shock multiple market factors (e.g., interest rates 

credit spreads and commodity prices) simultaneously. Such stress tests are an important way to capture risks missed in traditional stress testing exercises, such as 

market liquidity risk and basis risk. 

OCC’s Supervision of Risk Management at Large National Banks 

Let me now turn to how we apply and incorporate our perspective on risk management into the supervision of large national banks. The OCC is responsible for 

supervising over 1,600 banks, including some of the largest in the world that offer 

a wide array of financial services and are engaged in millions of transactions every 

day. 

Pursuant to the provision of the Gramm Leach Bliley Act (GLBA), the OCC serves 

as the primary Federal banking regulator for activities conducted within the national bank charter and its subsidiaries, except for those activities where jurisdiction has been expressly provided to another functional supervisor, such as the Securities and Exchange Commission (SEC), for certain broker-dealer activities. Nonetheless, we work closely with the Federal Reserve Board, the SEC, and other appropriate regulators to help promote consistent and comprehensive supervision across 

the company. 

The foundation of the OCC’s supervisory efforts is our continuous, onsite presence 

of examiners at each of our 14 largest banking companies. These 14 banking companies account for approximately 89 percent of the assets held in all of the national 

banks under our supervision. The resident examiner teams are supplemented by 

subject matter specialists in our Policy Division and PhD economists from our Risk 

Analysis Division trained in quantitative finance. 

Our Large Bank program is organized with a national perspective. It is highly 

centralized and headquartered in Washington, and structured to promote consistent 

uniform coordination across institutions. The onsite teams at each or our 14 largest 

banks are led by an Examiner-In-Charge (EIC), who reports directly to the Deputy 

Comptrollers in our Large Bank Supervision Office in Washington, DC. The Large 

Bank Deputies are in ongoing communication with the EICs, in addition to holding 

monthly calls and quarterly face-to-face meetings with all EICs. To enhance our 

ability to identify risks and share best practices across the large bank population, 

we have established a program of examiner network groups in Large Banks. There 

are eight main network groups (Commercial Credit, Retail Credit, Mortgage Banking, Capital Markets, Asset Management, Information Technology, Operational Risk 

and Compliance) and numerous subgroups. These groups facilitate sharing of information, concerns and policy application among examiners with specialized skills in 

these areas. The EICs and leadership teams of each of the network groups work 

closely with specialists in our Policy and Risk Analysis Divisions to promote consistent application of supervisory standards and coordinated responses to emerging 

issues. 

All of this enables the OCC to maintain an on-going program of risk assessment, 

monitoring, and communication with bank management and directors. Nonetheless, 

given the volume and complexity of bank transactions, it is not feasible to review 

every transaction in each bank, or for that matter, every single product line or bank 

76 

activity. Accordingly, we focus on those products and services posing the greatest 

risk to the bank through risk-based supervision. 

Resident examiners apply risk-based supervision to a broad array of risks, including credit, liquidity, market, compliance and operational risks. Supervisory activities 

are based upon supervisory strategies that are developed for each institution that 

are risk-based and focused on the more complex banking activities. Although each 

strategy is tailored to the risk profile of the individual institution, our strategy development process is governed by supervisory objectives set forth annually in the 

OCC’s bank supervision operating plan. Through this operating plan, the OCC identifies key risks and issues that cut across the industry and promotes consistency in 

areas of concerns. With the operating plan as a guide, EICs develop detailed strategies that will direct supervisory activities and resources for the coming year. Each 

strategy is reviewed by the appropriate Large Bank Deputy Comptroller. Our riskbased supervision is flexible, allowing strategies to be revised, as needed, to reflect 

the changing risk profile of the supervised institutions. We have a Quality Assurance group within our Large Bank program that selects strategies to review as part 

of a supervisory program review to ensure reasonableness and quality supervision. 

Our supervisory goal is to ensure banks have sound risk governance processes 

commensurate with the nature of their risk-taking activities. Risk management systems must be sufficiently comprehensive to enable senior management to identify 

and effectively manage risk throughout the firm. Therefore, examinations of our 

largest banks focus on the overall integrity and effectiveness of risk management 

systems. 

The first step in risk-based supervision is to identify the most significant risks 

and then to determine whether a bank has systems and controls to identify and 

manage those risks. Next, we assess the integrity and effectiveness of risk management systems, with appropriate validation through transaction testing. This is accomplished through our supervisory process which involves a combination of ongoing 

monitoring and targeted examinations. The purpose of our targeted examinations is 

to validate that risk management systems and processes are functioning as expected 

and do not present any significant supervisory concerns. Our supervisory conclusions, including any risk management deficiencies, are communicated directly to 

bank senior management. Thus, not only is there ongoing evaluation, but there is 

also a process for timely and effective corrective action when needed. To the extent 

we identify concerns, we ‘‘drill down’’ to test additional transactions. 

These concerns are then highlighted for management and the Board as ‘‘Matters 

Requiring Attention’’ (‘‘MRAs’’) in supervisory communications. Often these MRAs 

are line of business specific, and can be corrected relatively easily in the normal 

course of business. However, a few MRAs address more global concerns such as enterprise risk management or company-wide information security. We also have a 

consolidated electronic system to monitor and report outstanding MRAs. Each MRA 

is assigned a due date and is followed-up by onsite staff at each bank. If these concerns are not appropriately addressed within a reasonable period, we have a variety 

of tools with which to respond, ranging from informal supervisory actions directing 

corrective measures, to formal enforcement actions, to referrals to other regulators 

or law enforcement. 

Our supervision program includes targeted and on-going analysis of corporate governance at our large national banks. This area encompasses a wide variety of supervisory activities including: 

• Analysis and critique of materials presented to directors; 

• Review of board activities and organization; 

• Risk management and audit structures within the organization, including the 

independence of these structures; 

• Reviews of the charters, structure and minutes of significant decisionmaking 

committees in the bank; 

• Review of the vetting process for new and complex products and the robustness 

of new product controls; and 

• Analysis of the appropriateness and adequacy of management information packages used to measure and control risk. 

It is not uncommon to find weaknesses in structure, organization, or management 

information, which we address through MRAs and other supervisory processes described above. But more significantly, at some of our institutions what appeared to 

be an appropriate governance structure was made less effective by a weak corporate 

culture, which discouraged credible challenge from risk managers and did not hold 

lines of business accountable for inappropriate actions. When the market disruption 

occurred in mid 2007, it became apparent that in some banks, risk management 

77 

9See OCC Bulletin 2003–1, ‘‘Credit Card Lending: Account Management and Loss Allowance 

Guidance,’’ at http://www.occ.gov/ftp/bulletin/2003-1.doc. 

lacked support from executive management and the board to achieve the necessary 

stature within the organization, or otherwise did not exercise its authority to constrain business activities. At institutions where these issues occurred, we took 

strong supervisory actions, and we effected changes in personnel, organization and/ 

or processes. 

Just as we adjust our strategies for individual banks, we also make adjustments 

to our overall supervisory processes, as needed. And of course we are adjusting our 

supervisory processes to incorporate the lessons we have learned during this period 

of extreme financial distress. For example, recent strategy guidance prepared by our 

Large Bank network groups and issued by Large Bank senior management increases our focus on: 

• Risk concentrations across the enterprise; 

• Refinancing risk arising from illiquidity in credit markets and changes in underwriting standards that limit the ability of many borrowers to refinance debt 

as originally intended; 

• Collections, recovery and loss mitigation programs; 

• Decision modeling; 

• Liquidity contingency planning; 

• Allowance for loan and lease loss adequacy; 

• Capital buffers and stress assessments; and 

• Syndication and other distribution processes and warehouse/pipeline controls. 

Our supervisory activities at individual banks are often supplemented with horizontal reviews of targeted areas across a group of banks. These horizontal reviews 

can help us to identify emerging risks that, while not posing a significant threat 

to any one institution could, if not corrected, pose more system-wide implications for 

the industry. For example, reviews of certain credit card account management practices several years ago revealed that as a result of competitive pressures, banks 

were reducing minimum payments required from credit card customers to the point 

where many consumers could simply continue to increase their outstanding balances 

over time with no meaningful reduction in principal. We were concerned that these 

competitive pressures could mask underlying deterioration in a borrower’s condition 

and could also result in consumers becoming over-extended. Because of the highly 

competitive nature of this business, we recognized that we needed to address this 

problem on a system-wide basis and as a result, worked with the other Federal 

banking agencies to issue the 2003 guidance on Credit Card Account Management 

Practices.9

In addition to the aforementioned liquidity monitoring data we have begun collecting, we have also initiated loan level data collection from our major banks for 

residential mortgages, home equity loans, large corporate credits, and credit card 

loans. This data is being used to enhance our horizontal risk assessments in these 

key segments and offers a tool for examiners to benchmark their individual institution against the industry. 

More recently, in early 2008 we began developing a work plan to benchmark our 

largest national banks against the risk management ‘‘best practices’’ raised in various reports issued by the President’s Working Group (PWG), SSG, FSF, and Basel 

Committee. OCC staff developed a template for our examining staff to collect information to conduct this benchmarking exercise and we shared this with our colleagues at the PWG and SSG. In the interest of expanding the pool of firms and 

expediting the collection of risk management information, agency principals elected 

to use the SSG as the forum for undertaking the risk management assessment. In 

December 2008, a self-assessment template was sent to 23 globally active financial 

firms and the completed self-assessments are now in the process of being collected 

and shared among the participating agencies. These self-assessments will be supplemented with interviews at selected firms to discuss the status of addressing risk 

management deficiencies already identified and also probe for further information 

on emerging issues that may not yet be evident. 

To summarize, the goal of our supervision is to ensure that banks are managed 

in a safe and sound manner, to identify problems or weaknesses as early as possible 

and to obtain corrective action. Through our examinations and reviews, we have directed banks to be more realistic in assessing their credit risks; to improve their 

valuation techniques for certain complex transactions; to raise capital as market opVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00081 Fmt 6633 Sfmt 6621 S:\DOCS\52966.TXT SHERYL
78 

portunities permit; to aggressively build loan loss reserves; and to correct various 

risk management weaknesses. 

As previously noted, we have a staff of specialists who provide on-going technical 

assistance to our onsite examination teams. Our Risk Analysis Division includes 40 

PhD economists and mathematicians who have strong backgrounds in statistical 

analysis and risk modeling. These individuals frequently participate in our risk 

management examinations to help evaluate the integrity and empirical soundness 

of banks’ risk models and the assumptions underlying those models. Our policy specialists assist by keeping abreast of emerging trends and issues within the industry 

and the supervisory community. Staffs from our CMR, Operational Risk, and Capital Policy units have been key participants and contributors to the ongoing work 

of the SSG, FSF, PWG and Basel Committee. 

In 2008, we established a Financial Markets Group within the agency and tasked 

them with the build-out of a market intelligence program. Their mission is to look 

around corners, to seek out early warning signs of emerging and/or systemic risk 

issues. This team is comprised of highly experienced bank examiners and subject 

matter specialists hired from the industry, and they spend considerable time meeting with bank investors, bank counterparties, bank competitors, bank analysts, and 

other relevant stakeholders. Their work is discussed with members of the OCC’s 

senior management team on a bi-weekly basis, or more frequently when needed, and 

discussed in detail with the OCC’s National Risk Committee members, who represent all lines of bank supervision within the OCC, as well as our legal and economics teams. 

Coordination with Other Supervisors 

Successful execution of our supervisory priorities requires an effective working relationship with other supervisors, both domestically and internationally. The events 

of the past 18 months highlight the global nature of the problems we are facing and 

the need for global responses. 

The OCC has taken a significant leadership role in the interagency work underway to address risk management issues raised during this period of market turmoil. 

Comptroller Dugan is an active member of the PWG and also serves as the Chair 

of the Joint Forum. In that capacity, he has sponsored critical work streams to address credit risk transfer, off-balance sheet activities and reliance on credit rating 

agencies. The Joint Forum work not only builds transparency about how large, financial conglomerates manage critical aspects of risk management, but it also 

serves as a vehicle for identifying risk management ‘‘best practices.’’ 

Close coordination with our supervisory colleagues at the other banking agencies, 

as well as the securities agencies, has proven beneficial for all parties—firms, supervisors and policymakers. One example where this is evident has been the cooperative work among major market players and key regulators (the New York Federal 

Reserve Bank, the Federal Reserve Board, the OCC, the SEC, and other key global 

regulators) to strengthen the operational infrastructure and backroom processes 

used for various over-the-counter (OTC) derivative transactions. This is another example where a collective effort was needed to address problems where there was not 

a clear incentive for any individual firm to take corrective action. As a result of 

these efforts, we have seen material improvements in the reduction of unconfirmed 

trades across all categories of OTC derivatives, with the most notable reduction in 

the area of credit derivatives, where the large dealers have reduced by over 90 percent the backlog of credit derivatives confirmations that are outstanding by more 

than 30 days. 

GAO Report 

As I noted in my introduction, we received the GAO’s draft statement of findings 

on Friday night and, as requested, provided them with summary comments on those 

draft findings on Monday morning. Once we receive the GAO’s final report, we will 

give careful consideration to its findings and any recommendations therein for improvement in our supervisory processes. We will be happy to share our conclusions 

and responses with the Subcommittee. 

As I have described in my testimony, the OCC has a strong, centralized program 

for supervising the largest national banks. But clearly, the unprecedented global 

disruptions that we have witnessed across the credit and capital markets have revealed risk management weaknesses across banking organizations that need to be 

fixed and we are taking steps to ensure this happens. In this regard, it is important 

to recognize that risk management systems are not static. These systems do and 

must evolve with changes in markets, business lines, and products. For example, 

improving and validating risk models is an ongoing exercise at our largest institutions. Therefore it should not be surprising that we routinely have outstanding 

79 

MRAs that direct bank management to make improvements or changes to their risk 

models and risk management practices. This is an area where we continuously 

probe to look for areas of improvement and best practices. As I described earlier, 

we have systems in place to monitor and track these MRAs and, when we determine 

that the bank is not making sufficient progress to address our concerns, we can and 

do take more forceful action. However, unless we believe the model deficiency is so 

severe as to undermine the bank’s safety and soundness, we will allow the bank to 

continue to use the model as it makes necessary refinements or adjustments. Given 

the iterative process of testing and validating risk models, it simply is not realistic 

to suggest that a bank suspend its operations or business whenever it needs to 

make enhancements to those processes. 

One of the GAO’s major findings is that institutions failed to adequately test for 

the effects of a severe economic downturn scenario. As I have discussed, we agree 

that the events of the past 18 months have underscored the need for improved and 

more robust stress testing. Banks’ stress tests need to more fully incorporate potential interconnection risks across products, business lines and markets, and evaluate 

such exposures under extreme tail-events. The OCC was actively involved in developing the January 2009 report issued by the Basel Committee cited by the GAO. 

Indeed, many of the findings and recommendations in that report were drawn from 

our findings and work in our large banking institutions. We will be working with 

these institutions to ensure that they incorporate those recommendations into their 

stress testing processes. 

Conclusion 

The events of the past 18 months have highlighted and reinforced the need for 

effective risk management programs and revealed areas where improvements are 

needed. I believe the OCC and the banking industry are taking appropriate steps 

to implement needed changes. I also believe that these events have demonstrated 

the strength of the OCC’s large bank supervision program. Throughout the recent 

market turmoil, our resident examination staffs at the largest institutions have had 

daily contact with the business and risk managers of those institutions’ funding, 

trading, and lending areas to enable close monitoring of market conditions, deal flow 

and funding availability. Their insights and on-the-ground market intelligence have 

been critical in helping to assess appropriate policy and supervisory responses as 

market events have continued to unfold. Indeed, I believe that the OCC’s large bank 

supervision program, with its centralized oversight from Washington D.C., and highly experienced resident teams of bank examiners and risk specialists, is the most 

effective means of supervising large, globally active financial firms. 

Statement Required by 12 U.S.C. § 250: The views expressed herein are those of 

the Office of the Comptroller of the Currency and do not necessarily represent the 

views of the President. 

PREPARED STATEMENT OF SCOTT M. POLAKOFF 

ACTING DIRECTOR, OFFICE OF THRIFT SUPERVISION

MARCH 18, 2009 

I. Introduction 

Good afternoon Chairman Reed, Ranking Member Bunning and members of the 

Subcommittee. Thank you for inviting me to testify on behalf of the Office of Thrift 

Supervision (OTS) on how the Federal financial regulators conduct oversight of risk 

management. I appreciate the opportunity to familiarize the Subcommittee with 

several critical risk management areas and how OTS has revised its supervisory 

oversight based on lessons learned. I also appreciate the opportunity to comment on 

the state of risk management in the financial services industry and OTS’s recommendations for improving regulatory oversight and cooperation. 

In my testimony, I will discuss critical risk management areas that led to the failure or near-failure of an array of financial institutions. I will provide examples of 

the lessons learned and the actions that OTS has taken to revise industry and examiner guidance to ensure effective and efficient regulation. I will also describe risk 

management areas that warrant close supervision and provide OTS’s perspective on 

how to proceed. My discussion will focus on five primary risk areas that played roles 

in the economic crisis: concentration risk, liquidity risk, capital adequacy, loan loss 

provisioning and fair value accounting. 

80 

II. Overview of OTS-regulated Entities 

I would like to begin with an overview of the thrift industry. At the end of 2008, OTS supervised 810 savings associations with total assets of $1.2 trillion and 463 

holding company enterprises with approximately $6.1 trillion in U.S. domiciled consolidated assets. The majority of savings associations (97.2 percent) exceed well capitalized regulatory standards with combined assets that represent 95.3 percent of 

industry aggregate assets. 

Recent increases in problem assets have resulted primarily from the housing market downturn and rising unemployment. In December 2008, troubled assets (noncurrent loans and repossessed assets) rose to 2.52 percent of assets, up from 1.66 percent a year ago. The current level of troubled assets is the highest since the early 

1990s, when it reached 3.74 percent; however, the composition is quite different. 

While one- to four-family mortgage loans are traditionally lower-risk, they currently 

account for about 72 percent of the thrift industry’s troubled assets. Economic problems are spreading to commercial real estate (nonresidential mortgage, multifamily 

and construction loans), which now account for 20 percent of the troubled assets. 

In contrast, 68 percent of troubled assets in 1990 were commercial real estate loans. 

One- to four-family mortgages accounted for 23 percent of troubled assets. 

The prominence of residential mortgage loans among troubled assets requires a 

strong commitment to effective loan modification programs. OTS is collaborating 

with the Office of the Comptroller of the Currency to produce a quarterly Mortgage 

Metrics Report that analyzes performance data of first-lien residential mortgage 

loans serviced by federally regulated savings associations and national banks. The 

agencies are finalizing the report for the fourth quarter of 2008. The goal is to provide a comprehensive picture of mortgage servicing activities of the industry’s largest mortgage servicers. This report includes data on mortgage delinquency rates, 

home retention actions and foreclosures. The fourth quarter report will include 

granular information to measure the effectiveness of loan modifications and new 

data on the affordability and sustainability of loan modifications. 

Preliminary analysis from the fourth quarter Mortgage Metrics Report indicates 

that credit quality continues to deteriorate, resulting in increased delinquencies and 

early payment defaults. However, home retention efforts, including loan modifications and payment plans, continue to increase. The fourth quarter report analyzes 

modifications based on four categories of payment modification. The two categories 

that lower the borrower’s monthly payment are the most successful in improving affordability and sustainability. Servicers have increased use of these types of loan 

modifications, which is leading to fewer foreclosures. 

The number of problem thrifts has risen over the past year. OTS defines problem 

institutions as those with the two lowest composite safety-and-soundness exam ratings of ‘‘4’’ or ‘‘5.’’ There were 26 problem thrifts representing 3.2 percent of all 

thrifts at the end of the year. This is more than double from year-end 2007, when 

OTS reported 11 problem institutions. One common measurement of capital 

strength in an unstable economic period is the ratio of tangible common equity capital to tangible assets. The ratio is stable for savings associations, measuring 7.61 

percent at the end of 2008. This measurement remains close to the 9-year average 

of 7.70 percent. 

Focusing attention on core earnings is another method to assess the strength of 

insured depository institutions while eliminating volatile items. Core earnings measures exclude one-time events such as branch sale gains or acquisition charges. They 

also exclude charges for provisions for loan losses, which is a major reason for the 

losses by savings associations. The thrift industry’s operating earnings remained 

stable and measured 1.39 percent of average assets in 2008. This is consistent with 

operating earnings of 1.37 percent and 1.34 percent for 2007 and 2006, respectively. 

Although a focus remains on problem banks and the deteriorating mortgage market, 

the vast majority of insured financial institutions maintain solid capital, sufficient 

loan loss reserves, stable operating earnings and effective risk management. 

III. Critical Risk Areas 

OTS has learned multiple lessons during this economic cycle and has used this 

knowledge to refine and improve its regulatory program. The agency conducts independent internal failed bank reviews for savings associations placed in receivership 

and generates a series of recommended actions to supplement and improve its regulatory oversight. Upon finalizing each review, senior managers distribute internal 

guidance identifying lessons learned to improve examiners’ focus on critical risk 

management areas. OTS also committed to implementing the recommendations derived from the Material Loss Review reports from the Office of the Inspector General. The agency has made substantial progress in implementing recommended actions to improve regulatory oversight. 

81 

The OTS closely monitors—in some cases participates in—and responds to risk 

management recommendations by the Senior Supervisors Group report on Risk 

Management Practices, the Financial Stability Forum’s report on enhancing market 

and institutional resilience, the Basel Joint Forum’s report on the identification and 

management of risk concentrations, and the Government Accountability Office report on regulatory oversight of risk management systems. The agency reviews these 

reports and integrates their findings when revising regulatory guidance and examination programs. OTS participated on the Joint Forum working group that produced the report on risk concentrations. Several of the report’s recommendations derive from OTS’s expertise in supervising or regulating financial institutions ranging 

from community banks to international conglomerates. All of the Federal banking 

agencies are members of the international Basel Committee on Banking Supervision, which comprises banking supervisors worldwide. The Basel Committee on 

Banking Supervision provides an international forum to collaborate and improve the 

quality of bank supervision. 

Managing compliance with consumer protection laws is also a critical element of 

effective enterprise risk management and is a focus of OTS’s supervisory oversight 

of risk management. OTS requires sound compliance risk management programs in 

all savings associations. Excessive compliance risk can harm consumers, diminish 

a savings association’s reputation, reduce its franchise value and limit its business 

opportunities. It can also expose a financial institution to supervisory enforcement 

action and litigation. 

OTS expects the sophistication of a savings association’s risk management program to be appropriate for the size and complexity of the financial institution. OTS 

places responsibility on a financial institution’s Board of Directors for understanding, prescribing limits on and monitoring all risk areas. Traditionally, financial 

institutions have managed their operations by organizational unit or legal entity 

rather than from a holistic, enterprise-wide risk management perspective. However, 

financial institutions are shifting their focus toward enterprise-wide risk management structures. This transition from a silo-based risk management function to horizontal risk management across business lines is an appropriate evolution. One of 

the lessons of the current crisis and a key recommendation of each of the risk management reports mentioned above is that financial institutions must be aware of 

how risk concentrations and business activities interrelate throughout the organization. Regulators, in turn, must identify weaknesses in enterprise risk management 

and ensure that boards of directors take prompt action to correct the deficiencies. 

OTS communicates refinements in its supervisory program to examiners, Chief 

Executive Officers, Board members and industry groups through examination handbooks, official correspondence, outreach meetings, and other internal and external 

issuances. Based on the knowledge we have gained through horizontal reviews of 

OTS-regulated financial institutions, cooperation with domestic and international financial regulators, routine examination and supervision of savings associations and 

their holding companies, and failed bank reviews, the agency has identified several 

key risk management areas for discussion. 

Concentration Risk 

Poorly managed concentration risk contributed significantly to the deterioration 

in performance of several OTS-regulated problem banks. Concentrations are groups 

of assets or liabilities that have similar characteristics and expose a financial institution to one or more closely related risks. OTS defines a concentration as an asset, 

liability, or off-balance sheet exposure that exceeds 25 percent of the association’s 

core capital, plus allowances for loan and lease losses. The agency encourages its 

examiners to use discretion in identifying higher-risk assets or liabilities that may 

not meet this threshold, but still pose a concentration risk. OTS also encourages financial institutions’ Boards of Directors to approve limits and monitor concentrations based on their exposure relative to Tier 1 capital and allowances for loan and 

lease losses. 

Concentrations pose risk because the same economic, political, geographic, or 

other factors can negatively affect the entire group of assets or liabilities. The financial industry and the regulatory community have learned a valuable lesson about 

the risk exposure of asset, liability and off-balance sheet concentrations. Institutions 

with concentrations need to manage the risk of individual assets or liabilities, as 

well as the risk of the whole group. For example, an institution may have a portfolio 

of prudently underwritten loans located in a single geographic location. The geographic concentration exposes otherwise prudent loans to the risk of loss because 

a single regional economic event can expose the entire portfolio to losses. If the institution does not appropriately manage its geographic lending activity through size, 

sector and counterparty limits, then it has heightened risk exposure. Management 

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should regularly evaluate the degree of correlation between related assets or liabilities, and establish internal guidelines and concentration limits that control the institution’s risk exposure. 

The Basel Committee on Banking Supervision Joint Forum’s paper on concentration risk surveyed and summarized concentration risk management among financial 

conglomerates. While its focus was on financial conglomerates, the principles of concentration risk it identified are applicable to all financial institutions. It suggests 

that concentration risk has three elements. The first element of concentration risk 

is materiality. Financial institutions must identify whether the risk concentration 

can produce losses that threaten their health or ability to maintain their core operations. They must also determine whether an interruption in the concentrated business activity would lead to a material change in their risk profile. The second element is the identification of single, or closely related, drivers of risk that may affect 

each part of the institution differently. Effective risk management requires that the 

impact of these drivers be integrated into any analysis to assess the overall risk exposure of the institution. The third element is that risk concentrations arise not just 

in assets, but also in liabilities, off-balance sheet items, or through the execution 

or processing of transactions. 

OTS captures each of these elements in its supervisory program and requires examiners to document concentrations of assets, liabilities and off-balance sheet activity in each comprehensive examination report. The agency is acutely aware of the 

risk that a concentration can pose to an institution, whether the concentration 

arises from a business strategy, a product type, or a funding program. OTS guidelines recommend establishing limits based on a ratio of the asset, liability, or offbalance sheet item to core capital and allowances for loan and lease losses. In many 

cases, OTS places limitations on the amount of assets, liabilities, or other activities 

that expose the institution to concentration risk. Firms should also have additional 

capital as a buffer against the larger loss potential that a concentration can present. 

The agency also has expectations that savings associations with high concentration 

risk establish robust risk management practices to identify, measure, monitor and 

control the risk. 

A key concentration risk that OTS identified in the current crisis is the risk exposure of warehouse and pipeline loans in financial institutions that engage in an 

originate-to-sell business model during stressful market events. In response, OTS 

updated its one- to four-family real estate lending examination handbook in September 2008. The agency also distributed a letter to Chief Executive Officers outlining revised recommendations for monitoring and managing the level of pipeline, 

warehouse and credit-enhancing repurchase exposure for mortgage loans originated 

for sale to nongovernment sponsored purchasers. In the letter, OTS states that any 

concentration that exceeds 100 percent of Tier 1 capital will receive closer supervisory review. This revised guidance was in response to the lessons learned from 

recent bank failures and a horizontal review of all OTS institutions to assess the 

examination and supervision of mortgage banking activity. 

Another example of the regulatory expectations for concentration risk management is the 2006 guidance on managing commercial real estate concentration risk. 

The guidance applied to savings associations actively engaged in commercial real estate (CRE) lending, especially those that are entering or rapidly expanding CRE 

lending. The guidance states that institutions should perform a self-assessment of 

exposure to concentration risk. They should continually monitor potential risk exposure and report identified concentration risk to senior management and the board 

of directors. The guidance also recommends implementing risk management policies 

and procedures to monitor and manage concentration risk based on the size of the 

portfolio and the level and nature of concentrations. 

The OTS expects savings associations to continually assess and manage concentration risk. OTS conducts quarterly monitoring of savings associations’ investments to determine compliance with portfolio limitations and to assess each association’s exposure to concentration risk. An institution should hold capital commensurate with the level and nature of its risk exposure. Accordingly, savings associations 

with mortgage banking or commercial real estate concentration exposure should assess the credit risk, operational risk and concentration risk of those business activities. In assessing the adequacy of an institution’s capital, OTS also considers management expertise, historical performance, underwriting standards, risk management practices and market conditions. 

By the nature of the thrift charter, savings associations are required to hold a 

concentration in real estate mortgage or consumer lending-related assets. OTS-regulated savings associations are subject to two distinct statutory restrictions on their 

assets, which contribute to this inherent concentration in mortgage lending. The 

first is a requirement that thrifts hold 65 percent of their assets in qualified thrift 

83 

investments. This ensures that thrifts maintain a focus on mortgage and retail consumer lending activities. The second set of restrictions includes limitations on the 

ability of savings associations to engage in specific lending activities, including consumer, commercial and small business lending. 

Although there is merit for maintaining restrictions to ensure that savings associations focus on mortgage and retail consumer and community lending activities 

consistent with the purpose of the thrift charter, certain asset restrictions contradict 

the purpose of the charter and compromise safety and soundness. For example, savings associations have no limits on credit card lending, an unsecured lending activity, but are limited to 35 percent of their assets in secured consumer lending activities. This has the clearly unintended effect of promoting unsecured consumer lending activities over secured consumer lending. Similarly, the existing 20 percent of 

assets limit on small business lending discourages thrifts from pursuing business 

activities that could diversify their lending operations and credit risk. 

The OTS has offered several legislative proposals to address these shortcomings, 

while maintaining the thrift charter’s focus on consumer and community lending. 

These increases would strengthen OTS-regulated institutions by further diversifying 

their business lines and would increase the availability of credit in local communities. Small business lending is a key to economic growth and recovery, particularly 

in low- and moderate-income areas. 

Liquidity Risk 

Another risk management area that requires additional focus is liquidity risk. 

OTS and the other U.S. banking agencies published interagency guidance that required institutions to develop a comprehensive liquidity risk management program. 

As articulated in this interagency guidance, a sound liquidity risk management program includes clearly written policies, well-defined responsibilities, strong management information systems, sound forecasting and analysis, thoughtful contingency 

planning, scenario analyses, and diversification and management of funding sources. 

Recent events illustrate that liquidity risk management at many insured depository institutions needs improvement to comply with this guidance. Deficiencies include insufficient holdings of liquid assets, funding risky or illiquid asset portfolios 

with potentially volatile short-term liabilities, insufficient cash-flow projections and 

a lack of viable contingency funding plans. The current crisis also identified areas 

where it is necessary to strengthen supervisory guidance and oversight. In mid 

2007, the secondary mortgage markets began showing signs of stress as investor appetite for non-conforming mortgages greatly diminished. Many large institutions 

that relied on the originate-to-distribute model were trapped by the speed and magnitude of market liquidity evaporation. As the size of their mortgage warehouse 

ballooned, lenders and depositors became increasingly concerned about the financial 

health and long-term viability of these organizations. Those institutions that had a 

strong contingency funding strategy were able to find temporary relief until they 

could develop longer-term solutions. 

OTS is working with the other U.S. banking agencies to issue updated interagency guidance on funding liquidity risk management. The revised guidance will 

incorporate the recent lessons learned and the liquidity guidance issued by the 

Basel Committee on Banking Supervision. As part of this guidance, the agencies 

will reiterate the need for diversified funding sources, stress testing and an 

unencumbered cushion of highly liquid assets that are readily available and are not 

pledged to payment systems or clearing houses. This increased emphasis on highquality liquid assets is important because many firms had a misconception about 

the extent to which decreases in market and funding liquidity are mutually reinforcing. As market liquidity erodes, so does the availability of funding. The regulatory agencies plan to release the revised guidance with a notice for public comment the first half of 2009. 

OTS is also strengthening its examination and supervision of savings associations 

with high-risk business models or reliance on volatile funding sources. In some 

cases, OTS is obtaining daily liquidity monitoring reports from financial institutions 

to identify cash in-flows and out-flows and the availability of unpledged collateral. 

We are also stressing the need for institutions to test the actual availability of lines 

of credit and to work actively with their respective Federal Home Loan Banks to 

ensure sufficient borrowing capacity. OTS is also conducting a review of liquidity 

risk management to identify best practices and issue guidance to savings associations. The agency is using the review to develop additional liquidity metrics as a 

tool for examiners to use to identify institutions with developing liquidity problems. 

84 

Capital Adequacy 

OTS and the other Federal banking agencies agree that capital adequacy is a central component of safe and sound banking. Capital absorbs losses, promotes public 

confidence and provides protection to the deposit insurance fund. It provides a financial cushion for a financial institution to continue operating during adverse 

events. OTS has learned important lessons about how the capital adequacy rules 

work in a broad economic downturn and when financial systems are stressed primarily because of systemic events, including the deterioration in values of entire 

asset classes. 

This crisis underscores the critical importance of prudent underwriting for every 

loan. The risk of home loans varies depending upon factors, such as the loan-tovalue, borrower creditworthiness, loan terms and other underwriting factors. Yet the 

risk-based capital requirements do not adequately address the varying levels of risk 

in different types of home loans. The existing risk-based capital rules treat almost 

all home loans as having similar risk and assign most of them a 50 percent risk 

weight, which effectively requires $4 of capital for every $100 dollars of asset value. 

A more sensitive risk-based capital framework with meaningful risk drivers should 

encourage Federal depositories to make fewer higher-risk mortgage loans, or to support higher-risk lending activity with a more realistic capital cushion. 

Among the capital tools available to a supervisor in an environment of financial 

stress is the early intervention authority under Section 38 of the Federal Deposit 

Insurance Act, known as Prompt Corrective Action (PCA). The purpose of PCA statutory authority was to require and enable supervisory intervention before an institution becomes critically undercapitalized. PCA is triggered by an institution’s capital category, as defined in 12 USC § 1831o and 12 CFR Part 565. Depending on 

an institution’s PCA capital category, the statute automatically imposes certain restrictions and actions. The restrictions begin once an institution falls below the wellcapitalized category. In addition to the automatic restrictions, there are other discretionary PCA actions. The expectation is that banking agencies must apply progressively significant restrictions on operations as an institution’s capital category declines. 

To be effective, supervisory intervention must be timely when an institution is experiencing a rapid and severe deterioration in its financial condition. However, because PCA is linked to declining capital categories, we have learned that its utility 

is limited in a liquidity crisis, particularly when the crisis is widespread. We have 

witnessed severe and rapid declines in the financial condition of well or adequately 

capitalized institutions that were precipitated by an inability to meet rapid, sustained deposit outflows or other cash and collateral demands. In the current crisis, 

PCA has not been an effective supervisory tool because its triggers for supervisory 

action are capital-driven. Extraordinary liquidity demands typically do not produce 

the gradual erosion of capital envisioned by PCA. It is possible to modernize the 

PCA framework to link the PCA system to other risk areas. 

Liquidity and funding problems can stem from a lack of investor confidence in an 

institution’s financial condition. In the current environment, this may also stem 

from a lack of confidence in balance sheets of financial institutions and a belief that 

there is insufficient transparency. While institutions report well-capitalized ratios, 

investors are questioning the value of those ratios under extreme financial stress 

when it is difficult to value assets. Some have also questioned the quantity and 

quality of capital and the validity of capital buffers in stressful periods. The economic crisis demonstrates the interrelationship of portfolio risk, liquidity, risk-based 

capital rules and PCA. The Agencies will continue to review our rules in light of 

these lessons learned. 

OTS and the other Federal banking agencies finalized the Basel II advanced capital adequacy rules, which establish a capital requirement that increases proportionally with loan risk. The advanced rules are mandatory only for the largest financial 

institutions in the United States, in part due to the complexity of measuring risk 

and assigning commensurate capital requirements, often requiring a models-based 

approach. Due to this complexity, implementation of the advanced Basel II rules 

will take several years. 

The Agencies have also developed a proposal for a standardized risk-based capital 

adequacy framework that is simpler than the advanced rule, yet more risk sensitive 

than the existing framework for home mortgages. If this voluntary framework is finalized in its current form, no one knows how many institutions would adopt it, but 

most of the banking industry would likely not choose it. The Agencies proposed 

these new standardized rules in 2008, but based on recent lessons learned, the proposal needs further improvement. OTS supports expanding the risk-based capital refinements in the proposed rule and extending capital modernization to all Federal 

depositories. 

85 

In designing the Basel II capital adequacy framework, the Basel Committee intended for Basel II to be a ‘‘living framework.’’ As part of its strategic response to 

address weaknesses revealed by the financial market crisis, the Basel Committee 

has reviewed the Basel II capital adequacy framework and has developed and published for comment a series of proposed enhancements to strengthen the framework. 

The Basel Committee has also just announced it is developing a combination of 

measures to strengthen the level of capital in the banking system to increase resilience to future episodes of economic stress. It plans to introduce standards to increase capital buffers for stress events and to strengthen the quality of bank capital. 

The Committee also announced that it would review the regulatory minimum level 

of capital to arrive at a higher level than the current Basel II framework. OTS and 

the other Agencies continue our work with other Basel Committee members to 

evaluate the financial crisis and refine our rules. 

Loan Loss Provision 

Another area that deserves attention because of the rapid deterioration in credit 

quality is the adequacy of allowances for loan and lease losses (ALLL). Economic 

weakness and uncertainty of the timing of the economic recovery require elevated 

levels of loan loss reserves. Savings associations responded to this environment and 

outlook by significantly bolstering their ALLL. In the fourth quarter, savings associations added $8.7 billion to loan loss provisions, bringing the total additions to a 

record $38.7 billion for the year. These substantial loan loss provisions increased the 

ratio of loss reserves to total loans and leases 63 percent, from 1.10 percent 1 year 

ago to 1.79 percent at the end of 2008. 

Because financial institutions build loan loss reserves through charges to earnings, these substantial loss provision expenses are driving industry net losses. The 

large provision for losses in the fourth quarter resulted in a net loss of $3 billion, 

or an annualized return on average assets (ROA) of negative 1.02 percent. The 

record annual provision drove the industry’s loss to a record for all of 2008 of $13.4 

billion, or an ROA of negative 1.00 percent. Loss provisioning will continue to 

dampen industry earnings until home prices stabilize, job market losses slow and 

the employment outlook improves. 

On September 30, 2008, OTS issued guidance to its examiners and other supervision staff members about the allowance for loan losses. The purpose of the guidance was to highlight best practices for savings associations. This guidance discussed inflection points, or periods of increasing or decreasing losses, the use of lagging data when loss rates change quickly, and validation methods that rely on leading data rather than historical loss experience. 

Institutions rely on the 2006 interagency guidance, ‘‘Interagency Policy Statement 

on the Allowance for Loan and Lease Losses and supplemental Questions and Answers on Accounting for Loan and Lease Losses,’’ to manage loan loss provisions. 

This guidance uses the Generally Accepted Accounting Principles’ incurred loss 

model for assessing losses and establishing reserves. When there is a significant economic downturn following an extended period of positive economic performance, the 

incurred loss model may result in insufficient loan loss allowances and the need for 

substantial increases. OTS supports refining the current accounting model to one 

based on expected credit losses for the life of the loan. An expected loss model will 

result in more robust allowances throughout the credit cycle to absorb all expected 

charge-offs as they occur over the life of the loan, without regard to the economic 

environment. The expected loss model would not eliminate pro-cyclicality, but it 

would allow for earlier recognition of loan losses. 

Fair Value Accounting 

Many have blamed the current economic crisis on the use of ‘‘mark-to-market’’ accounting. Some assert that this accounting model contributes to pro-cyclicality or a 

downward spiral in asset prices. The theory is that as financial institutions write 

down assets to current market values in an illiquid market, those losses reduce regulatory capital. In order to increase regulatory capital ratios, those institutions deleverage by selling assets into stressed, illiquid markets. This triggers a cycle of additional sales at depressed prices and results in further write-downs by institutions 

holding similar assets. 

The term ‘‘mark-to-market’’ can be misleading. Thrifts carry less than 5 percent 

of their assets at market value, with gains and losses recognized in earnings and 

regulatory capital. These include trading assets, derivatives and financial instruments for which the thrift has voluntarily elected the fair-value option. We believe 

it is appropriate to report these assets at fair value because financial institutions 

manage them, or should manage them, on a fair-value basis. 

86 

Fair value accounting requires the recognition in earnings and regulatory capital 

of significant declines in the fair value of investment securities, including mortgage 

backed securities. Fair value determinations are more challenging when the markets are illiquid. Financial institutions find it difficult to determine fair value because there is a lack of trades of identical or similar securities. The result is that 

institutions must rely on models and assumptions to estimate fair value. The OTS 

supports disclosure of the assumptions used to estimate fair value. Increased transparency would improve confidence in the fair value adjustment. 

The Securities and Exchange Commission (SEC), in its Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: 

Study on Mark-To-Market Accounting, stated that fair value accounting did not play 

a meaningful role in bank failures in 2008. The SEC staff concluded that U.S. bank 

failures resulted from growing probable credit losses, concerns about asset quality 

and, in certain cases, eroding lender and investor confidence. The report also concluded that for the failed banks that did recognize sizable fair-value losses, the reporting of these losses was not the reason the bank failed. 

OTS believes that refining fair value accounting is a better approach than suspending it. It is possible to improve the accounting standards to respond to both 

those who insist fair value accounting should continue and those that call for its 

suspension. 

The most significant fair value issue facing savings associations relates to nontrading investment securities. Non-trading investment securities are those the institution designates as available-for-sale or held-to-maturity. The concept of ‘‘otherthan-temporary impairment’’ (or OTTI) is the primary area of concern. Accounting 

standards call for different impairment (loss) recognition models, based on whether 

an asset is a loan or a security. Loan impairment reflects only credit losses. The 

measure of impairment of debt securities is fair value. In the current market, fair 

value can include recognition of significant additional losses because of illiquidity 

and other non-credit losses that may be temporary. This discrepancy, although 

largely overlooked in the past, is at the center of the debate about fair value accounting because the non-credit components of fair value losses in some cases represent the majority of the loss amount. 

OTS supports an alternative to the current mark-to-market accounting model that 

is gaining recognition through recent roundtable discussions on accounting standards. The Center for Audit Quality recommended this alternative approach to the 

SEC in its November 13, 2008 letter responding to the SEC’s study of mark-to-market accounting. The proposed alternative would identify and clarify the components 

of fair value and improve the application and practice of the fair value accounting 

standards. Fair value estimates incorporate numerous observable data, such as the 

credit worthiness and paying capacity of the debtor, changes in interest rates and 

the volume of market liquidity. 

Under the proposed alternative accounting treatment, financial institutions would 

continue to report impaired investment securities at fair value. They would separate 

impairment losses into two components: credit and non-credit. They would continue 

to report the credit component as a reduction of earnings, but they would report the 

noncredit component as a direct reduction of equity. The significant result of this 

alternative accounting treatment is that only the credit loss portion would immediately reduce regulatory capital. It would also mitigate the effects of temporary 

market volatility on earnings. The non-credit component would result in a direct reduction in equity, but would not reduce earnings or regulatory capital unless the 

institution sells the security and realizes the loss. The credit component consists of 

probable declines in expected cash-flows. These declines represent a loss of contractual or estimated cash-flows anticipated by an investor, and should reduce earnings 

and regulatory capital immediately. 

OTS believes that this recommendation to recognize the credit loss component of 

the OTTI impairment through earnings improves the application of the fair value 

accounting standards. This improvement in the accounting standards will align the 

recognition of impairment for loans and securities more closely. Financial institutions already record an allowance for loan loss based only on the credit impairment. 

Because many investment securities held by financial institutions are mortgage- or 

asset-backed securities, it is reasonable to use a similar model to recognize losses 

on debt securities. 

Investor panic to sell certain investments immediately rather than take a longerterm view of their underlying value has exacerbated current market conditions. The 

desire to stop the decline in fair value fuels these sales because of the current OTTI 

accounting requirements. Bifurcation of the fair value components will permit investors to take a longer-term view of investments, by only recognizing declines in expected cash-flows in earnings. Other components of fair value adjustments will be 

87 

reported in a separate section of equity. When markets return to normalized activity, financial institutions can recover these components. 

IV. Regulatory Restructuring 

Lessons learned on risk management are helping to guide OTS’s position on regulatory restructuring. The events of the past several years have reinforced the need 

for a review of the framework for the regulatory oversight of financial services firms 

of all types. The importance of ensuring consistent regulation for similar products 

regardless of the issuer or originator has become evident, whether the product is 

a mortgage loan or a complex commercial instrument. One of the goals of creating 

a new framework should be to ensure scrutiny of all bank products, services and 

activities. There should be consistent regulation and supervision of every entity that 

provides bank-like products, services and activities, whether or not it is an insured 

depository institution. The ‘‘shadow bank system,’’ where bank or bank-like products 

are offered by nonbanks, should be subject to the same rigorous standards as banks. 

As one element of regulatory modernization, OTS recommends subjecting unevenly regulated or under-regulated mortgage brokers and independent mortgage 

companies to the same regulatory, supervisory and enforcement regime as insured 

institutions offering the same products. 

Another important element in regulatory modernization is establishing a systemic 

risk regulator. OTS endorses establishing a systemic risk regulator with broad regulatory and monitoring authority of companies whose failure or activities could pose 

a risk to financial stability. Such a regulator should be able to access funds, which 

would present options to resolve problems at these institutions. The systemic risk 

regulator should have the ability and the responsibility for monitoring all data 

about markets and companies, including, but not limited to, companies involved in 

banking, securities and insurance. 

V. Conclusion 

Effective enterprise risk management, commensurate with the size and complexity of a financial institution’s operations, is paramount. The lessons learned 

from this economic cycle support this conclusion. A holistic approach to identifying, 

assessing and managing risk is relevant not only for financial institutions, but also 

for the regulatory environment. The interdependency of each risk area warrants a 

comprehensive solution from financial institutions and the agencies that regulate 

them. 

Thank you, Mr. Chairman, Ranking Member Bunning and members of the Subcommittee for the opportunity to testify on risk management and the steps that OTS 

is taking to adjust its examinations based on the lessons learned during the economic crisis. 

Concentration risk, liquidity risk, capital adequacy, allowances for loan and lease 

losses and fair value accounting are critical areas where risk management deficiencies contributed to the recent turmoil. OTS is committed to refining and improving its oversight to ensure that financial institutions adopt stronger risk management programs. 

PREPARED STATEMENT OF ERIK SIRRI 

DIRECTOR, DIVISION OF TRADING AND MARKETS, 

SECURITIES AND EXCHANGE COMMISSION

MARCH 18, 2009 

Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee: 

I am pleased to have the opportunity today to testify concerning the insights 

gained from the SEC’s long history of regulating the financial responsibility of 

broker-dealers and protecting customer funds and securities. 

The turmoil in the global financial system is unprecedented and has tested not 

only the resiliency of financial institutions, but also the assumptions underpinning 

many financial regulatory programs. I have testified previously that the deterioration in mortgages spread to the capital markets through securitization, and to related derivative and insurance products. The knock-on effects broadened and deepened beyond those entities that deal in mortgages and mortgage-related financial 

products, including investment and commercial banks, insurance companies, and 

government sponsored enterprises, and finally to operating companies. 

Market participants relied on the thriving securitization process to disperse risk 

and provide more private capital raising and investing opportunities for investors, 

but as we have learned that process did not eliminate or, in many cases, even reVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00091 Fmt 6633 Sfmt 6621 S:\DOCS\52966.TXT SHERYL
88 

1 Hereafter the terms ‘‘fair value’’ and ‘‘mark-to-market’’ are used interchangeably. 

duce risk. Ultimately, the growing size and dispersion of risk, combined with deteriorating markets, has made clear to regulators the need for greater transparency 

and stronger risk management controls for financial institutions of all kinds. I believe, however, that hearings such as this one, where supervisors reflect on and 

share their experiences from this past year will enhance our collective efforts to continue to improve the risk management oversight of complex financial institutions. 

The CSE Program and BD Financial Responsibility 

Some changes in the capital markets and the broader economy have presented 

new challenges that are rightly the subject of Congressional review, notwithstanding the current regulatory system’s long record of accomplishment. The point 

is, we don’t need to start from scratch. Instead, we should build on and strengthen 

what has worked, while taking lessons from what hasn’t worked in order to adjust 

the current system to update our regulatory system to fit modern market practices, 

products, and conditions. 

Beginning in 2004, the SEC supervised five entities with large U.S. securities 

firms as subsidiaries on a consolidated basis, specifically, Goldman Sachs, Merrill 

Lynch, Morgan Stanley, Lehman Brothers and Bear Stearns. For such firms, known 

as consolidated supervised entities or ‘‘CSEs,’’ the Commission oversaw not only the 

U.S. registered broker-dealer, but also the holding company and all affiliates on a 

consolidated basis. The registered broker-dealers that were the core regulated entities within the CSE groups were supervised by staff both at the SEC and at the 

primary self-regulatory organization (SRO), FINRA—a system akin to bank supervision at the depository institution level as well as the holding company level. It 

should be noted that the U.S. broker-dealer subsidiaries of the CSE firms at all 

times during this credit crisis remained solvent and adequately capitalized. 

The CSE program was designed to be broadly consistent with Federal Reserve 

oversight of bank holding companies. Of note, the use of the Basel Standard to regulate holding companies of the broker dealer did not result in a diminution of capital 

at the broker-dealer. First, broker-dealers had to maintain a minimum of $5 billion 

tentative net capital to qualify for the calculation. Although phrased as an early 

warning level, the ‘‘5 billion’’ was and remained a hard limit. No firm fell below this 

requirement. The CSE regime was also tailored to reflect two fundamental differences between investment bank and commercial bank holding companies. First, 

the CSE regime reflected the reliance of securities firms on fair value, and where 

possible, mark-to-market accounting as a critical risk and governance control.1 Second, the CSE program requirements as to liquidity are explained below. Whereas 

commercial banks may use insured deposits to fund their businesses and have access to the Federal Reserve as a backstop liquidity provider, the CSE firms were 

prohibited, under SEC rules, from financing their investment bank activities with 

customer funds or fully paid securities held in a broker-dealer. Moreover, the SEC 

had no ability to provide a liquidity backstop to CSEs. 

The CSE program had five principal components: First, CSE holding companies 

were required to maintain and document a system of internal controls that had to 

be approved by the Commission at the time of initial application. Second, before approval and on an ongoing basis, the Commission staff examined the implementation 

of these controls. Third, CSEs were monitored for financial and operational weakness that might place regulated entities within the group or the broader financial 

system at risk. Fourth, CSEs were required to compute a capital adequacy measure 

at the holding company level that is consistent with standards set forth by the Basel 

Committee on Banking Supervision (Basel Committee). Finally, CSEs were required 

to perform stress tests on the liquidity computation and maintain significant liquidity pools at the holding company, for use in any regulated or unregulated entity 

within the group without regulatory restriction. 

To monitor the implementation of firms’ internal controls, the CSE program leveraged the firms’ internal audit functions, among other things. Our staff met regularly 

with internal auditors to review and explore issues identified by their risk assessment and audit program. The Commission’s rules for CSEs required internal auditors to review the functioning of major governance committees and all internal risk 

control functions and represent in writing to the SEC annually that this work has 

been done, with the results presented to the external auditor and the audit committee of the Board of Directors. Also, as circumstances required, or as risk management issues arose, senior officers of the SEC met with CEOs, CFOs, and other members of the firm’s senior management to raise issues for focus and resolution. 

The CSE program also included examination of and monitoring for key risk control areas, in particular market, credit, liquidity, and operational risk. The holding 

89 

company was required to provide the Commission on a periodic basis with extensive 

information regarding its capital and risk exposures, including market, credit, and 

liquidity risk. SEC staff met monthly with CSE firm risk managers and other personnel to review and discuss this information. 

Two fundamental components of the CSE program deserve special attention: capital and liquidity. In electing to operate under the CSE program, the holding company was required, among other things, to compute on a monthly basis its groupwide capital in accordance with the Basel standards. CSEs were expected to maintain an overall Basel capital ratio at the consolidated level of not less than the Federal Reserve Bank’s 10 percent ‘‘well-capitalized’’ standard for bank holding companies. CSEs were also required to file an ‘‘early warning’’ notice with the SEC in the 

event that certain minimum thresholds, including the 10 percent capital ratio, were 

breached or were likely to be breached. Commission rules for CSEs permitted the 

parent holding company to calculate its capital adequacy using an approach consistent with either of the two Basel standards, adopted by the Basel Committee. 

Investment banks relied on the ongoing secured and unsecured credit markets for 

funding, rather than customer deposits; therefore liquidity and liquidity risk management were of critical importance. In particular, the Commission’s rules required 

CSEs to maintain funding procedures designed to ensure that the holding company 

had sufficient stand-alone liquidity to withstand the complete loss of all sources of 

unsecured funding for at least 1 year. In addition, with respect to secured funding, 

these procedures incorporated a stress test that estimated what a prudent lender 

would lend on an asset under stressed market conditions (e.g., a haircut). Another 

premise of this liquidity planning was that any assets held in a regulated entity 

were unavailable for use outside of the entity to deal with weaknesses elsewhere 

in the holding company structure, based on the assumption that during the stress 

event, including a tightening of market liquidity, regulators in the U.S. and relevant 

foreign jurisdictions would not permit a withdrawal of capital. Thus, the liquidity 

pool at the holding company was comprised of unencumbered liquid assets. 

Beginning immediately in the wake of the Bear Stearns sale to JPMorgan Chase, 

the SEC broadly strengthened liquidity requirements for CSE firms. The Division 

of Trading and Markets, working with the Federal Reserve, implemented substantially more rigorous approaches to supervision of liquidity levels and liquidity risk 

management. We developed scenarios that were much more severe, including denial 

of access to short-term unsecured funding. Those more stringent scenarios assumed 

limited access to the Fed’s discount window or other liquidity facilities, although in 

fact such facilities became available to the major investment banks. As a matter of 

prudence, the investment banks were urged to maintain capital and liquidity at levels far above what would be required under the standards themselves. 

The SEC scrutinized the secured funding activities of each CSE firm, and advised 

the establishment of additional term funding arrangements and a reduction of dependency on ‘‘open’’ and ‘‘overnight’’ transactions. We also focused on the so-called 

matched book, a significant focus of secured funding activities within investment 

banks. We monitored closely potential mismatches between the ‘‘asset side,’’ where 

positions are financed for customers, and the ‘‘liability side’’ of the matched book, 

where positions are financed by other financial institutions and investors. Also, we 

discussed with CSE senior management their longer-term funding plans, including 

plans for raising new capital by accessing the equity and long-term debt markets. 

Observations and Lessons 

The Bear Stearns and Lehman Brothers’ experience as well as the continuing financial distress and government support of commercial banks and insurance companies has challenged a number of assumptions held by the SEC. We are working with 

other regulators to ensure that the proper lessons are derived from these experiences, and changes will continue to be made to the relevant regulatory processes 

to reflect those lessons. Long before the CSE program existed, the SEC’s supervision 

of investment banks recognized that capital is not synonymous with liquidity that 

a firm could be highly capitalized—that is, it can have far more assets than liabilities—while also having liquidity problems. While the ability of a securities firm to 

withstand market, credit, and other types of stress events is linked to the amount 

of its capital, the firm also needs sufficient liquid assets—cash, and high-quality instruments such as U.S. Treasury securities that can be used as collateral to meet 

its financial obligations as they arise. 

The CSE program built on this concept and required stress testing and substantial liquidity pools at the holding company to allow firms to continue to operate normally in stressed market environments. But what neither the CSE regulatory approach nor most existing regulatory models have taken into account was the possibility that secured funding, even that backed by high-quality collateral such as U.S. 

90 

Treasury and agency securities, could become unavailable. The existing models for 

both commercial and investment banks are premised on the expectation that secured funding, would be available in any market environment, albeit perhaps on 

less favorable terms than normal. 

Thus, one lesson from the SEC’s oversight of CSEs—Bear Stearns in particular— 

is that no parent company liquidity pool can withstand a ‘‘run on the bank.’’ Supervisors simply did not anticipate that a run-on-the-bank was indeed a real possibility 

for a well-capitalized securities firm with high quality assets to fund. Given that the 

liquidity pool was sized for the loss of unsecured funding for a year, such a liquidity 

pool would not suffice in an extended financial crisis of the magnitude we are now 

experiencing, where firms are taking significant writedowns on what have become 

illiquid assets over several quarters while the economy contracts. These liquidity 

constraints are exacerbated when clearing agencies seize sizable amounts of collateral or clearing deposits to protect themselves against intraday exposures to the 

firm. Thus, for financial institutions that rely on secured and unsecured funding for 

their business model, some modification, such as government backstop emergency 

liquidity support, may well be necessary to plug a liquidity gap on an interim basis, 

to guarantee assets over the longer term, or to provide a capital infusion. Indeed, 

as we have seen, such facilities can be necessary even for deposit-taking institutions. The role of the government in providing any such backstop liquidity should 

be carefully circumscribed, and the effects on incentives considered. 

Another lesson relates to the need for supervisory focus on the concentration of 

illiquid assets held by financial firms, particularly in entities other than a U.S. registered broker-dealer. Such monitoring is relatively straightforward with U.S. registered broker-dealers, which must disclose illiquid assets on a monthly basis in financial reports filed with their regulators. Also, registered U.S. broker-dealers must 

take capital charges on illiquid assets when computing net capital. As a result, illiquid assets often are held outside the registered U.S. broker-dealer in other legal 

entities within the consolidated entity. So, for the consolidated entity, supervisors 

must be well acquainted with the quality of assets on a group wide basis, monitor 

the amount of illiquid assets, and drill down on the relative quality of such illiquid 

assets. 

We currently inquire, through FINRA, about the amount of Level 3 assets at 

broker-dealers, but such information must be known with specificity about affiliates 

in the group as well. A thorough understanding of illiquid assets would be a more 

useful measure of financial health than a leverage metric that is broadly applied 

across a complex financial institution. The SEC has noted on numerous occasions 

that leverage tests are not accurate measures of financial strength, especially in 

firms with a sizable matched book or derivatives business. Leverage ratios do not 

account for the risk or liquidity of the underlying assets or associated hedging positions. Therefore, leverage ratios can overstate or understate actual risk due to leverage. For example: a 10-1 leverage ratio involving Treasury bills involves little risk 

of loss; however, the same 10-1 leverage ratio applied to uncollateralized loans 

would be extremely risky, and would not be prudent in a broker-dealer. The same 

could be said of repo transactions involving treasuries versus mortgages. Rather 

than rely on such overly simplistic measures of risk, regulators of financial firms 

have gone to great lengths to develop capital rules that are risk sensitive and act 

as limiters on the amount of risk that can be taken on by a firm. 

While the SEC knew the importance of supervisory focus on illiquid assets, I do 

not believe any regulator truly understood that market perception of the integrity 

of the financial statements, which involves both the amount of illiquid assets and 

the valuation of such assets, could erode so precipitously and ignite a run on a securities firm. This brings me to a related point—and lesson. 

A knowledge of illiquid assets also requires supervisors to review valuation thoroughly, and understand how mark-to-market (MTM) is executed within the firm— 

with a particular focus on the strength of control processes, the independence of the 

price verification function, and the disclosures made by the firm on its valuation 

processes. The challenges of valuing illiquid or complex structured products should 

not cast doubt on the process of marking-to-market, however. In fact, marking-tomarket is part of the solution. This is another lesson from the events of 2008. 

MTM informs investment bank senior managers of trading performance and asset 

price and risk factor volatilities, supports profit and loss (p/l) processes and hedge 

performance analyses, facilitates the generation and validation of risk metrics, and 

enables a controlled environment for risk-taking In short, the MTM process helps 

ensure consistency between p/l reporting, hedging, and risk measurement. Without 

this, discipline across these activities would be more difficult to maintain and risk 

management would be significantly weaker. The act of marking-to-market provides 

91 

necessary information and can impose discipline on risk-taking and risk management. 

At securities firms and elsewhere, to protect the accuracy and integrity of the financial institution’s books and records and to support the CFO’s attestation concerning the fair value of the firm’s inventory as of a certain date, an independent 

group of financial controllers verifies monthly that traders’ marks are accurate and 

unbiased. Once the price verification is completed, summary mark review reports 

are provided to senior managers at investment banks which provides insight into 

the composition of the portfolio, as different methods signal different degrees of liquidity, complexity or model risk. Internally, one of the primary aims of the control 

function performed by price verification is to reduce the risk of a position or portfolio 

being mis-marked. Obviously, this risk rises with the degree of subjectivity that may 

be applied to a given mark or position (and gets multiplied by the exposure). Given 

its critical contribution to the integrity of valuation and books and records, supervisors must engage fully in understanding the price verification controls at financial 

institutions, ensure that it is well-resourced, has independent authority to push 

back on the business line valuations, and is in ready communication with and has 

the active support and involvement of firm senior management. 

Recent events have proven the limitations of certain risk metrics such as Valueat-Risk (VaR) and the necessity of rigorous stress testing of financial models. VaR, 

among other things, assumes certain historical correlations, which may be inapplicable during times of extreme stress. In addition, VaR does not measure liquidity 

or concentration risk. Therefore, a lesson learned is while VaR and other risk 

metrics may be useful during normal market conditions, risk managers and supervisors must recognize their imbedded limitations and assumptions and plan accordingly. That is, supervisors and risk managers must supplement their usage with 

stress testing that incorporates not only likely economic scenarios, but also low 

probability, extreme events. In addition, the market-wide failure to appreciate and 

measure the market risk of mortgage-related assets, including structured credit 

products, has shown that the Basel market risk standards as then in force were not 

adequate. Each is in need of serious improvement. 

Another important lesson is that critical financial and risk management controls 

cannot just exist on paper. They must be staffed appropriately and well-resourced. 

Whether a supervisory program maintains staff onsite at regulated entities, or engages in frequent in-person meetings, the quality of the program must combine an 

ability to focus and follow up on risk management issues as they develop with an 

ability to gain the attention of senior management of the firm. Within the firm, senior management must engage with firm risk managers and support them as an 

independent function. Firm boards of directors must participate actively in setting 

the risk appetite of the firm, hold senior management accountable for following the 

board’s direction on risk taking, and force management to take action, as appropriate. For instance, risk managers should have some degree of authority over trading decisions, and any decision by senior management to deviate from their recommendations should be documented and reviewed by the board. 

One final observation relates to the challenges any single regulator has in overseeing an entity—in the SEC’s case, sizable broker-dealers—that reside within a 

complex institution with multiple material affiliates, regulated or not, in numerous 

countries. Any regulator must have an ability to get information about the holding 

company and other affiliates, particularly about issues and transactions that could 

impact capital and liquidity. For instance, whether directed by a holding company 

supervisor here or abroad, a poorly capitalized and not very liquid affiliate could require infusions from the parent and become the source of financial weakness for the 

entire organization. This could occur while the registered U.S. broker-dealer is wellcapitalized and liquid. As was true in the case of Lehman Brothers, the bankruptcy 

filing of a material affiliate has a cascading effect that can bring down the other 

entities in the group. Also, in some instances, affiliates try to involve the well-capitalized broker-dealer in their business in a manner that is not prudent. For these 

reasons, and to protect the broker-dealer and its customer assets, the SEC would 

want, not only to be consulted before any such liquidity drain occurs at the parent, 

but to have a say, likely in coordination with other interested regulators, in the capital and liquidity standards the holding company must maintain. Our experience 

last year with the failure of Lehman’s UK broker-dealer, and the fact that the U.S. 

registered broker-dealers were well-capitalized and liquid throughout the turmoil, 

has redoubled our belief that we must rely on and protect going forward the soundness of the regulatory regime of the principal subsidiaries. Nothing in any future 

regulatory regime, or systemic regulator, should operate to weaken the regulatory 

standards of these subsidiaries. 

92 

Having learned all of these lessons, we at the SEC are focusing on how best to 

deploy our broker-dealer expertise in a new regulatory paradigm. As Congress considers the financial services regulatory structure, we believe that regulatory expertise should be recognized and deployed efficiently. For a certain set of large brokerdealer holding companies that are not affiliated with banks, the SEC supports a 

program that would permit us to also set capital standards at the holding company 

level (perhaps, in consultation with a holding company supervisor, if any), and to 

obtain financial information about, and examine, the holding company and material 

affiliates. Such broker-dealer holding companies may also have an emergency liquidity provider (not the SEC). The SEC would determine the universe of broker-dealer 

holding companies that would be subject to parent company capital standards. The 

remaining broker-dealer holding companies not affiliated with banks would be subject to material affiliate reporting requirements, similar to the reporting regime 

under Section 17(h) of the Exchange Act. 

Given the recent dialog about systemic regulation, I must note that our experience 

with the bankruptcy filing of a foreign affiliate of Lehman Brothers has demonstrated the innate difficulties of any multijurisdictional approach to regulation. 

While cross border coordination and dialog is important, jurisdictions nonetheless 

have unique bankruptcy and financial regulatory regimes—and creditors wherever 

they are located shall always act in their own interest during a crisis. Thus, a U.S. 

liquidity provider might be faced with the difficult choice of guaranteeing the assets 

of the holding company globally, or else risk creditors exercising their rights against 

foreign affiliates or foreign supervisors acting to protect the regulated subsidiaries 

in their jurisdictions, either of which could trigger bankruptcy of the holding company. These are thorny issues that Congress should consider carefully. 

GAO Review of Regulators’ Oversight of Risk Management Systems 

I want, finally, to mention that, recently, we were provided a copy of the GAO’s 

draft Review of Regulators’ Oversight of Risk Management Systems. Based on our 

review of that draft, I can make a few personal observations. First, I appreciate the 

work that GAO did to review the supervision of financial institutions’ risk management programs across the various regulators and find GAO’s observations about 

those programs helpful. I can also make a few comments about the draft of GAO’s 

review of regulators’ oversight of risk management systems at various financial institutions. Staff of the Division of Trading and Markets has discussed these and 

other comments on the draft directly with GAO staff. 

The GAO draft states that banking regulators (the Federal Reserve, OCC, and 

OTS) use a combination of supervisory activities, including informal tools and examination-related activities to assess the quality of institutional risk management systems. It then describes the securities regulators’ approach as revolving around regularly scheduled target examinations. This is not, however, an apt description of the 

SEC’s CSE risk management supervisory program. We believe it is important to 

stress that SEC’s supervision included continuous monitoring throughout the year 

of the CSEs for which we were the consolidated supervisor. While SEC staff conducted formal meetings with firms on a regular schedule (e.g., monthly risk meetings), SEC staff had continuous contact with the firm. These formal meetings were 

supplemented by additional follow-up meetings to discuss issues further. This often 

led to further monitoring by staff and, if warranted, included cross-firm reviews conducted by SEC monitoring staff and later SEC inspection staff for CSEs. We also 

received regular risk, financial, and liquidity reporting from the CSE firms, including some information on a daily basis. Particularly with respect to the liquidity reporting, we had frequent discussions, often daily or weekly, with the firms’ treasurers during much of 2007 and 2008. In addition, during times of extreme market 

stress we had on-site coverage as well. While not continuously onsite, the SEC’s approach was one of continuous supervision, a point not evident in the draft GAO report. 

SEC staff’s continuous supervision was directly aimed at addressing risk management weaknesses. While we fully understand that SEC’s process for ensuring that 

firms take corrective action was not as formal as some of the banking regulators, 

the substance was the same. There have been many instances in which, based on 

our supervisory approach, firms made changes to their risk management to address 

weaknesses that the SEC highlighted. 

We concur in the GAO’s observation that although financial institutions manage 

risks on an enterprise basis or by business lines that cut across legal entities, functional regulators may oversee risk management at the legal entity level, resulting 

in a view of risk management that is limited or in overlap in efforts by regulators. 

Under the CSE program, the SEC continued its focus on the functionally regulated 

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mented within the holding company structure. This is necessary in order to gain an 

accurate assessment of the effectiveness of these risk management controls. 

Thank you again for this opportunity to discuss these important issues. I am 

happy to take your questions. 

94 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM ROGER T. COLE 

Q.1. How many banks have asked to return TARP funds officially? 

Unofficially? 

A.1. As of April 22, 2009, the Federal Reserve had been informed 

by Treasury Department staff of 16 companies that had formally 

asked to return TARP funds. 

Q.2. Have you told any banks that they cannot return TARP 

funds? 

A.2. The Federal Reserve has established a uniform process to analyze and respond to requests to redeem TARP funds by bank holding companies and State member banks. This process includes consideration of the following elements: 

• Whether the redemption request raises any question about the 

company’s ability to maintain appropriate capital levels over 

the next one to two years, even assuming worsening economic 

conditions. 

• Whether the holding company will still be able to serve as a 

source of financial and managerial strength to its subsidiary 

bank(s) after the redemption. 

• The level and composition of capital, earnings, asset quality, 

the allowance for loan and lease losses (ALLL), and liquidity, 

among other factors. 

• Whether management’s capital planning projections are appropriate given the current financial condition and risk profile of 

the organization. 

• Expectations for communication with management and/or the 

Federal banking regulator of the subsidiary bank(s) as needed. 

At this time, the Federal Reserve has not denied the request of 

any banking organization to return TARP funds. However, there 

have been some informal inquiries from organizations involved in 

the Supervisory Capital Assessment Program (CAP) stress test regarding returning funds they received from the TARP Capital Purchase Program. We have communicated to these institutions that 

such requests will not be considered, and should not be formally 

submitted, until the CAP stress test process has been completed. 

Q.3. What is the process to return TARP funds? Do they just mail 

it back to Secretary Geithner? 

A.3. Institutions must formally notify the Treasury of their intention to return TARP funds. Treasury staff then notifies the appropriate banking agency of the request and the agency then completes an analysis of the request (as detailed above) and indicates 

to Treasury whether they object to the repayment Treasury staff 

has asked that this analysis process be completed within two 

weeks, if possible. If the appropriate Federal banking agency notifies Treasury staff that it has no objection to the repayment, the 

Treasury Department immediately contacts the requesting company and coordinates the details and scheduling of the redemption 

with the issuer. This includes coordinating the exchange of both 

cash and securities, as well as the redemption of warrants, if applicable. 

95 

1 12 U.S.C. 56 and 59 (national banks and extended to State member banks by 12 U.S.C. 324); 

12 U.S.C. 1828(i)(l) (State nonmember banks). 2See 12 CFR part 225, Appendix A, section II, (iii). 3 12 CFR 225.4(b)(1). See Board SR Letter 09–04. ‘‘Applying Supervisory Guidance and Regulations on the Payment of Dividends, Stock Redemptions, and Stock Repurchases at Bank Holding Companies’’ for a description of the standards applied by the Federal Reserve in evaluating 

a BHC’s capital position. 4See 12 U.S.C. 1818(b). 

Q.4. If a bank asked to return TARP funds, why would they be denied? 

A.4. As detailed in the responses to questions 2 and 5, those supervisory agencies may object to a request to repay the TARP funds 

if such repayment would raise questions about the adequacy of capital at a supervised institution and its ability to operate in a safe 

and sound manner. 

Q.5. What provision of law would justify a regulator or treasury denying a bank’s request to return TARP funds? 

A.5. Capital plays a critical role in ensuring the safety and soundness of a banking organization. For this reason, Federal banking 

laws and regulations have long provided the Federal banking agencies several important tools to ensure that banking organizations 

maintain strong capital levels and that an organization’s capital is 

not depleted through redemptions or similar transactions in a manner or amount that would have materially adverse consequences on 

the organization’s financial condition or resources. For example, 

under the ‘‘prompt corrective action’’ provisions of the Federal Deposit Insurance Act (12 U.S.C. 1831o) (FDI Act), all insured depository institutions are prohibited without their Federal banking 

agency permission from redeeming capital if the institution would 

be undercapitalized as a result of the redemption. The Federal 

banking laws, also expressly require that an insured bank obtain 

the approval of its Federal banking regulator to redeem its equity 

capital,1 such as the preferred equity generally issued by banks in 

exchange for TARP funds. 

The risk-based capital rules applicable to bank holding companies (BHCs) directs BHCs to consult with the Federal Reserve before redeeming any equity or other capital instrument included as 

certain components of regulatory capital prior to stated maturity, 

if such redemption could have a material effect on the level or composition of the organization’s capital base.2 Certain BHCs also 

must provide the Federal Reserve with notice prior to making a redemption that would reduce a BHC’s consolidated net worth by 10 

percent or more.3

In addition, Federal law provides the Federal banking agencies 

important enforcement tools to ensure that banking organizations 

remain safe and sound, including by maintaining adequate capital. 

For example, under section 8 of the FDI Act, a Federal banking 

agency may impose a cease-and-desist order on a banking institution requiring the institution to take corrective actions if the institution engages in an unsafe or unsound practice.4 The International Lending Supervision Act also provides that a Federal 

banking agency may issue a directive to a banking institution that 

fails to maintain capital at or above the level required by its Federal banking regulator, which may require the institution to submit 

96 

5See 12 U.S.C. 1818. 

and adhere to plan acceptable to the agency describing the institution’s plan for restoring its capital. 

Q.6. What changes, if any, to the law would have to be made to 

prevent a regulator from forcing a bank to keep TARP funds? 

A.6. As discussed above, Congress has provided the Federal banking agencies several important tools to ensure that redemptions of 

capital by a banking organizations do not materially weaken a 

banking organization or cause it to be in an unsafe or unsound condition. To prevent a regulator from taking steps to prevent a banking organization from redeeming TARP capital when necessary to 

protect the financial health of the organization, Congress would 

have to provide that the safety and soundness laws and regulations 

discussed in question 1 shall not prevent or restrict a banking organization from redeeming TARP capital. Moreover, Congress 

would need to adopt a law that specifically prevents the Federal 

banking agencies from taking any action under section 8 of the FDI 

Act to prevent a bank from making redemptions even if the redemption is determined to be an unsafe or unsound practice or 

would result in the institution being undercapitalized in violation 

of law. 

Q.7. What would be possible negative implications of allowing any 

bank/company to give back TARP funds at their discretion? 

A.7. As discussed above, depending on the current and projected 

condition of a TARP recipient, the immediate repayment of TARP 

funds could result in capital levels that are inadequate to support 

the risk of loss at the banking institution and result in an unsafe 

and unsound condition. 

Q.8. Do the regulators have the necessary authority to deal with 

the consequences of TARP funds being returned over regulator objections? 

A.8. If a banking organization were to redeem the capital instruments issued to the TARP over a regulator’s objections, and such 

action constituted an unsafe or unsound practice or violated any 

law or regulation, the appropriate Federal banking agency would 

have a range of options under the FDI Act to address the infraction.5 For example, the banking organization’s Federal banking 

regulator could impose a cease-and-desist order on the organization 

under section 8 of the FPI Act. Such an order could require the 

bank to take steps to correct or remedy the acts or practices giving 

rise to the order. The regulator also could impose civil money penalties on the organization if it violated a law or regulation, failed 

to comply with a cease and desist order imposed by the regulator, 

or engaged in a recklessly unsafe or unsound practice. 

The ‘‘prompt corrective action’’ provisions also require the appropriate Federal banking agency to take prompt correction action to 

resolve capital issues at insured depository institutions. The statute requires the Federal banking agencies to establish capital requirements for the institutions they regulate together with measures of when the institution would be considered well-capitalized, 

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6See 12 U.S.C. 1831o. 

capitalized under those standards. If an insured depository institution is undercapitalized, the statute lays out the steps that must 

be taken by the institution and the relevant agency to address the 

capital deficiency. Moreover, the statue provides that if the appropriate Federal banking agency determines that an insured depository institution is in an unsafe or unsound condition or is engaging 

in an unsafe or unsound practice, the agency may reclassify the institution’s capitalization status to the next lower category and impose requirements on that institution in accordance with its revised 

capitalization status. For example, if a bank were considered adequately capitalized and is engaged in an unsafe or unsound practice, the bank’s Federal banking regulator could reclassify the bank 

as undercapitalized. As a result the bank, among other things, 

would not be allowed to redeem equity securities, would have to 

submit an acceptable capital restoration plan to its regulator, and 

could be subject to restrictions on its asset growth.6

A bank that is significantly undercapitalized or is undercapitalized and fails to submit a satisfactory capital restoration plan also 

could be subject to a range of requirements or restrictions under 

the prompt corrective action provisions of the FDI Act, such as a 

recapitalization plan imposed by its regulator or restrictions on activities, transactions with affiliates, interest rates paid, or asset 

growth, or other similar restrictions that address the bank’s capital 

situation. 

Q.9. Are you requiring banks to hold capital above the statutory 

definition of well capitalized, and if so why? Anecdotal reports indicate that examiners are requiring an additional 200 basis points of 

capital on top of the well capitalized requirements—is that true, if 

so why? 

A.9. It has been longstanding policy that banking institutions are 

expected to hold capital commensurate with their overall risk profiles. Regulatory capital requirements are designed to establish a 

minimum level of capital that is relatively comparable across institutions, and are limited in their ability to reflect an institution’s 

full risk profile. Accordingly, all banking institutions need to understand their risks and hold capital commensurate with those 

risks—at levels above regulatory minimums—to ensure overall capital adequacy. 

With respect to the composition of capital, supervisory expectations are outlined in the BHC Supervision Manual: 

The Board’s long-standing view is that common equity (that is, common 

stock and surplus and retained earnings) should be the dominant component of a banking organization’s capital structure and that organizations 

should avoid undue reliance on capital elements that do not form common 

equity. Common equity allows an organization to absorb losses on an ongoing basis and is permanently available for this purpose. Further, this element of capital best allows organizations to conserve resources when they 

are under stress because it provides full discretion as to the amount and 

timing of dividends and other distributions. Consequently, common equity 

is the basis on which most market judgments of capital adequacy are made. 

Q.10. What are you communicating to the examination force on 

these issues of TARP repayment and capital requirements? Please 

provide any relevant documents or training materials related to 

98 

how your agency is instructing examiners to treat capital. In H.R. 

1, Congress has said the TARP money can be repaid, please provide information which documents how your agency is getting that 

legal change out into the field. 

A.10. The Federal Reserve has developed written guidelines for Reserve Bank staff to follow and a Redemption Request Decision 

Memo for Reserve Banks to complete when processing and analyzing redemption requests. The guidelines require Reserve Bank 

staff to analyze the sufficiency of an institution’s capital planning 

process and capital levels and ensure that any approvals that may 

be required under Federal or State law or regulation are received 

before the redemption can proceed. The guidelines and Redemption 

Request Decision Memo were provided to the Reserve Bank TARP 

CPP contacts on March 13, 2009, and have been modified as appropriate as experience has been gained with the redemption process. 

The redemption analysis guidelines are consistent with longstanding Federal Reserve policies addressing the assessment of 

capital adequacy and the redemption of material amounts of capital 

and direct examiners to consider the factors outlined in SR letter 

09–4, Applying Supervisory Guidance and Regulations on the Payment of Dividends, Stock Redemptions, and Stock Repurchases at 

Bank Holding Companies, when evaluating redemption requests. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM TIMOTHY W. LONG 

Q.1. How many banks have asked to return TARP funds officially? 

Unofficially? 

A.1. As of April 23, 2009, six national banks have officially asked 

to return their CPP TARP funds. Four of those banks, Old National 

Bancorp, Sun Bancorp, First Merit Corporation, and TCF Financial 

Corporation have repaid their funds. We do not have a mechanism 

to track banks that may be considering or asking unofficially to return TARP funds. However, based on inquiries we have received 

from national banks about the process for returning TARP funds, 

we estimate that the total number, as of April 23, is probably fewer 

than 15. We would caution, however, that participation and interest in the TARP CPP program has become very fluid in the past 

month as an increasing number of banks have withdrawn their 

CPP applications either before or after they received preliminary 

approval from Treasury to receive TARP funding. Based on these 

trends, a greater number of banks could ultimately decide to attempt to return their TARP funding. 

Q.2. Have you told any banks that they cannot return TARP 

funds? 

A.2. As of April 23, we have not told any national banks who have 

inquired that they cannot repay their TARP CPP funds. Any requests that we would receive from the largest TARP recipients 

(those with assets over $100 billion) that are currently undergoing 

a comprehensive forward looking assessment (stress tests) would 

be considered after the completion of the assessment analysis. 

Q.3. What is the process to return TARP funds? Do they just mail 

it back to Secretary Geithner? 

99 

A.3. Banks wishing to repay their TARP CPP funds have been instructed to notify Treasury at CPPRedemption@do.treas.gov and 

their primary Federal regulator of their desire to redeem their securities. Banks will need to follow their primary Federal banking 

regulators’ existing guidelines governing reductions of capital. Once 

the appropriate Federal banking regulator notifies Treasury that 

the regulator has no objection, Treasury will work with the bank 

to schedule the bank’s repayment. It is our understanding that 

Treasury is executing repayment requests on a weekly basis. 

For national banks that have a holding company, the Federal Reserve Board will be the regulator that formally provides consent to 

Treasury. This is because the TARP securities were issued and 

funds injected at the holding company level. The OCC and Federal 

Reserve, however, are closely coordinating on any such requests. 

In cases where TARP CPP funds have been down-streamed to a 

national bank, OCC approval will likely be needed to allow the 

bank to reduce capital, pursuant to 12 CFR 5.46 and 12 USC 59, 

or to pay a dividend in excess of the amount allowed under 12 USC 

60(b). 

Q.4. If a bank asked to return TARP funds, why would they be denied? 

A.4. This determination will be made based on the condition of the 

bank and the amount of capital it has in relation to the risks it 

confronts. For example, there could be cases where a bank’s condition has deteriorated significantly since its receipt of TARP CPP 

funds and where repayment of those funds could impair the bank’s 

safety and soundness or would trigger the capital provisions of the 

Prompt Corrective Action regime (12 CFR 6, 12 USC 1831o). 

Q.5. What provision of law would justify a regulator or treasury denying a bank’s request to return TARP funds? 

A.5. As noted above, under Prompt Corrective Action, the banking 

agencies are required to take increasingly severe supervisory actions should a bank’s capital levels fall below specified regulatory 

minimums. Those requirements are specified in section 38 of the 

Federal Deposit Insurance Act, 12 USC 1831o, and OCC implementing regulations, 12 CFR 6. In such cases, the agencies may 

deny a bank’s request to return TARP funds until and unless it developed and implemented an effective capital restoration plan. 

More generally, if repayment would result in capital levels that are 

inconsistent with the bank’s overall risk profile or with other OCC 

directives to the bank, such as an individual minimum capital requirement under 12 CFR 3.15 due to the bank’s risk profile, or the 

terms of a cease and desist order under 12 USC 1818(b), the OCC 

may require additional actions or commitments from bank management before repayment would be allowed. 

Q.6. What challenges, if any, to the law would have to be made to 

prevent a regulator from forcing a bank to keep TARP funds? 

A.6. As described in our answers above, if the OCC objected to a 

bank’s repayment of TARP funds, our objection would be based on 

supervisory concerns about capital adequacy or safety and soundness. To override those concerns, Congress would have to provide 

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100 

ness authorities the law currently provides (including the statutes 

mentioned in our answers to Questions 3 and 5) to preclude the repayment of TARP funds, regardless of the effect that repayment 

would have on the bank’s ability to meet its capital requirements, 

on its financial condition, or on its safety and soundness. The clear 

downside of such an approach is that it would deprive the OCC of 

the tools it currently has to ensure that repayment of TARP funds 

does not welcome a national bank’s condition or adversely affect its 

safety and soundness. 

Q.7. What would be possible negative implications of allowing any 

bank/company to give back TARP funds at their discretion? 

A.7. We would be concerned about cases in which a TARP repayment would cause a bank to become undercapitalized or otherwise 

reduce capital to a level that is inconsistent with its risk profile, 

thus threatening its on-going viability and its ability to meet the 

credit needs of its community. 

Q.8. Do the regulators have the necessary authority to deal with 

the consequences of TARP funds being returned over regulator objections? 

A.8. We do not anticipate this will be an issue as Treasury will be 

requesting a ‘‘no objection’’ from the appropriate Federal banking 

agency before allowing an institution to repay its TARP CPP funds. 

Q.9. Are you requiring banks to hold capital above the statutory 

definition of well capitalized, and if so why? Anecdotal reports indicate that examiners are requiring an additional 200 basis points of 

capital on top of the well capitalized requirements—is that true, if 

so why? 

A.9. The OCC and other Federal banking agencies have long 

stressed that the regulatory risk-based and leverage capital ratios 

(12 CFR 3) are minimums and that banks are expected to hold capital commensurate with the level and nature of all risks. As noted 

in 12 CFR 3, Appendix A, section 1(b)(1), ‘‘ . . . since this measure 

[risk-based capital ratio] addresses only credit risk, the 8 percent 

minimum ratio should not be viewed as the level to be targeted, 

but rather as a floor. The final supervisory judgment on a bank’s 

capital adequacy is based on an individualized assessment of numerous factors, including those listed in 12 CFR 3.10.’’ Among the 

factors listed in 12 CFR 3.10 are: banks with significant exposures 

due to the risks from concentrations of credit; banks exposed to a 

high volume or, particularly severe, problem loans; banks that are 

growing rapidly, either internally, or through acquisitions; or banks 

exposed to a high degree of asset depreciation. 

Many banks currently have substantial concentrations in various 

commercial real estate segments, have been involved in recent 

mergers, or have experienced recent asset depreciation that warrant capital levels above the risk-based capital regulatory minimums. 

Q.10. What are you communicating to the examination force on 

these issues of TARP repayment and capital requirements? Please 

provide any relevant documents or training materials related to 

how your agency is instructing examiners to treat capital. In H.R. 

1, Congress has said the TARP money can be repaid, please proVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00104 Fmt 6602 Sfmt 6601 S:\DOCS\52966.TXT SHERYL
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1The word institutions as used in this letter may refer to both thrifts and thrift holding companies. 

vide information which documents how your agency is getting that 

legal change out into the field. 

A.10. We issued internal guidance to our examiners on the TARP 

program, including requests for repayment of TARP funds, on 

March 26, 2009. A copy of those materials is attached. 

Our general guidance to examiners on capital and dividends can 

be found in: 

• The Interagency ‘‘Uniform Financial Institutions Rating System,’’ where capital adequacy is one of the component ‘‘CAMELS’’ rating assigned to every financial institution. (See Appendix A in ‘‘Bank Supervision Process’’ booklet of the Comptroller’s Handbook (http://www.occ.gov/handbook/ 

banksup.pdf).) and 

• The ‘‘Large Bank Supervision,’’ ‘‘Community Bank Supervision,’’ and ‘‘Capital Accounts and Dividends’’ booklets of the 

Comptroller’s Handbook. Copies can be found at: http:// 

www.occ.gov/handbook/lbs.pdf; http://www.occ.gov/handbook/cbsh2003intro.pdf; and http://www.occ.gov/handbook/ 

Capital.pdf. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM SCOTT POLAKOFF 

Q.1. How many banks have asked to return TARP funds officially? 

Unofficially? 

A.1. As of May 5 2009, OTS has received official requests by five 

institutions 1 to return TARP funds received as part of the Capital 

Purchase Program (CPP). Also as of May 5, 2009, OTS has received 

one unofficial notice from an institution that may return its CPP 

funds. 

Q.2. Have you told any banks that they cannot return TARP 

funds? 

A.2. No. OTS, as of May 5, has not informed any institutions under 

its supervision that they cannot return TARP funds. 

Q.3. What is the process to return TARP funds? Do they just mail 

it back to Secretary Geithner? 

A.3. An institution that would like to redeem its CPP investment 

will notify its primary regulator of its desire to redeem. The institution also notifies Treasury at CPPRedemption@do.treas.gov. After 

receiving the institution’s notice, Treasury and the institution’s primary regulator will consult about the request. When all consultations have been completed, Treasury will contact the institution to 

discuss the redemption request. Details of the redemption and completion of all necessary documentation will be handled by the institution’s original Treasury counsel. 

Please refer to the link below for the Treasury’s listing of Frequently Asked Questions (FAQs) addressing Capital Purchase Program (CPP) redemptions. The linked-to document is also included 

102 

with this letter as an attachment. http://www.treasury.gov/press/ 

releases/reports/CPP-FAQs.pdf. 

Q.4. If a bank asked to return TARP funds, why would they be denied? 

A.4. An institution’s request to return TARP CPP funds may be denied by its primary regulator if the repayment of the TARP CPP 

funds would result in insufficient capital and/or liquidity to support 

the operations of a thrift holding company or in an unsafe and unsound financial condition for its subsidiary thrift. 

Q.5. What provision of law would justify a regulator or treasury denying a bank’s request to return TARP funds? 

A.5. The OTS’s primary statutory authority is the Home Owners’ 

Loan Act (HOLA). HOLA provided the OTS with authority to impose capital requirements on thrifts as well as supervisory and enforcement authority to contain and resolve problem institutions. 

The OTS may deny a TARP repayment request if it determines 

that the repayment would result in an insufficient level of capital 

and/or liquidity necessary to support the operations of either the 

thrift holding company or its subsidiary thrift. 

Q.6. What changes, if any, to the law would have to be made to 

prevent a regulator from forcing a bank to keep TARP funds? 

A.6. The Home Owners’ Loan Act includes a specific section, section 10(f), that requires notice to OTS before a savings association 

subsidiary of a savings and loan holding company may pay a dividend to its holding company. There is also a specific restriction on 

dividends under the prompt corrective action statute in the Federal 

Deposit Insurance Act (generally, a dividend may not be paid if it 

causes a savings association to become undercapitalized). In addition, OTS has consistently taken the position that it has the authority to object to a dividend by a savings association based on 

safety and soundness grounds. In order to ensure that the agency 

could not object on any basis to a dividend by a savings association 

in connection with a redemption TARP securities, the HOLA would 

need to be amended to provide ‘‘The Director, notwithstanding any 

safety and soundness concerns regarding a savings association, and 

notwithstanding any other provision of law, may not object to a 

dividend by a savings association to the extent the dividend is declared in connection with a redemption of TARP securities.’’ 

Q.7. What would be possible negative implications of allowing any 

bank/company to give back TARP funds at their discretion? 

A.7. If an institution is allowed to return TARP funds at its discretion, without obtaining its primary regulator’s approval, the possible negative implications could include a resulting insufficient 

level of capital and/or liquidity necessary to support the operations 

of either the thrift holding company or its subsidiary thrift. 

Q.8. Do the regulators have the necessary authority to deal with 

the consequences of TARP funds being returned over regulator objections? 

A.8. We consider this to be a hypothetical question because an 

OTS-supervised institution may not presently return TARP funds 

over the objection of the OTS. Institutions supervised by the other 

103 

Federal banking regulatory agencies are likewise subject to the approval of their relevant primary regulator for returning TARP 

funds. 

If an institution is allowed to return TARP funds over the objection of its primary regulator, the possible negative implications 

could include a resulting insufficient level of capital and/or liquidity 

necessary to support the operations of either the thrift holding 

company or its subsidiary thrift. In the event of such an undesired 

outcome, the OTS has the supervisory authority to direct the institution to address its resulting weakened condition and to correct it. 

Q.9. Are you requiring banks to hold capital above the statutory 

definition of well capitalized, and if so why? Anecdotal reports indicate that examiners are requiring an additional 200 basis points of 

capital on top of the well capitalized requirements—is that true, if 

so why? 

A.9. The OTS expects its supervised thrifts to maintain capital 

buffers above the minimum defined amount necessary to be wellcapitalized, and also expects its supervised holding companies to 

maintain prudent levels of capital necessary to support their operations. The OTS does not direct its examiners to require institutions to maintain a ‘‘one-size-fits-all’’ amount of additional capital 

above the minimum defined amount necessary to be well-capitalized. 

Q.10. What are you communicating to the examination force on 

these issues of TARP repayment and capital requirements? Please 

provide any relevant documents or training materials related to 

how your agency is instructing examiners to treat capital. In H.R. 

1, Congress has said the TARP money can be repaid, please provide information which documents how your agency is getting that 

legal change out into the field. 

A.10. The OTS’s Regional Supervisory Staff reviews each institution’s request to repay its CPP investment and recommends approval or denial of the request to OTS Washington. OTS Washington makes the final decision to approve or deny each institution’s request and then informs Treasury of its decision. 

The process that the OTS follows in its decision to approve or 

deny an institution’s CPP repayment request is completed outside 

of the OTS’s examination process. Regardless of the OTS’s decision 

on the repayment request, examiners follow required review procedures that are necessary to determine the capital adequacy of the 

institution. Please refer to the website link below for the OTS’s Examination Handbook section on Capital. The linked-to document is 

also included with this letter as an attachment. http:// 

files.ots.treas.gov/422319.pdf. 

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RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM ERIK SIRRI, AS ANSWERED BY DANIEL GALLAGHER 

Q.1. How many banks have asked to return TARP funds officially? 

Unofficially? 

Q.2. Have you told any banks that they cannot return TARP 

funds? 

Q.3. What is the process to return TARP funds? Do they just mail 

it back to Secretary Geithner? 

Q.4. If a bank asked to return TARP funds, why would they be denied? 

Q.5. What provision of law would justify a regulator or treasury denying a bank’s request to return TARP funds? 

Q.6. What changes, if any, to the law would have to be made to 

prevent a regulator from forcing a bank to keep TARP funds? 

Q.7. What would be possible negative implications of allowing any 

bank/company to give back TARP funds at their discretion? 

Q.8. Do the regulators have the necessary authority to deal with 

the consequences of TARP funds being returned over regulator objections? 

Q.9. Are you requiring banks to hold capital above the statutory 

definition of well capitalized, and if so why? Anecdotal reports indicate that examiners are requiring an additional 200 basis points of 

capital on top of the well capitalized requirements—is that true, if 

so why? 

Q.10. What are you communicating to the examination force on 

these issues of TARP repayment and capital requirements? Please 

provide any relevant documents or training materials related to 

how your agency is instructing examiners to treat capital. In H.R. 

1, Congress has said the TARP money can be repaid, please provide information which documents how your agency is getting that 

legal change out into the field. 

A.1–A.10. Thank you for the opportunity to respond to questions 

for the Hearing concerning ‘‘Lessons Learned in Risk Management 

Oversight at Federal Financial Regulators,’’ held March 18, 2009. 

To better explain our role in the context of TARP activities, it may 

be helpful to first describe the SEC’s jurisdiction in the current regulatory system. 

As you know, several statutes, primary among them, the Securities Act of 1933, Securities Exchange Act of 1934, Investment Advisers Act of 1940, and the Investment Company Act of 1940, grant 

the SEC authority to regulate, among other things, public disclosure to investors, governance and accounting standards, securities 

exchanges, securities broker-dealers, municipal securities dealers, 

clearing agencies, investment companies, and investment advisers. 

To promote fair markets and to protect against fraud, the SEC conducts examinations through its Office of Compliance, Inspections, 

and Examinations (OCIE) and investigations of misconduct 

through its Division of Enforcement. 

The Exchange Act is the primary statute governing broker-dealers and covers a wide range of issues, including broker-dealer regVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00179 Fmt 6602 Sfmt 6601 S:\DOCS\52966.TXT SHERYL
176 

istration, sales practices, trading practices, and financial responsibility. In addition, the Exchange Act confers legal status upon selfregulatory organizations (SRO), such as the Financial Industry 

Regulatory Association (FINRA), to enforce compliance by their 

broker-dealer members with SRO as well as Exchange Act rules, 

subject to SEC oversight. The SEC has long promulgated and administered financial responsibility rules for broker-dealers, including the Net Capital Rule, Hypothecation Rule, Customer Protection 

Rule, the Commission’s books and records rules, reporting requirements, and the early warning rule for broker-dealers regarding 

their capital levels. 

The Consolidated Supervised Entity (CSE) regime and Appendix 

E of the Net Capital Rule that were largely the subject of Dr. 

Sirri’s testimony stem from the SEC’s authority to regulate the financial responsibility of broker-dealers. The SEC was prompted to 

establish the CSE regime in 2004 by the perceived need for groupwide risk monitoring. The firms were concerned about the requirements of the European Union’s Financial Conglomerates Directive, 

which essentially requires non-EU financial institutions doing business in Europe to be supervised on a consolidated basis. As discussed in Dr. Sirri’s testimony, Goldman Sachs, Merrill Lynch, 

Lehman Brothers, Morgan Stanley, and Bear Stearns consented to 

consolidated supervision at the holding company level by the SEC 

as a condition of the use by their U.S. registered broker-dealers of 

the alternative net capital (ANC) computation under Appendix E. 

Of note, the Commission has not otherwise altered the net capital 

rule for broker-dealers. 

As a result of the unprecedented level of distress in the financial 

markets that began in the Summer of 2007 and has continued 

through the present, each of the remaining investment banks 

(other than Lehman) that had been part of the CSE program have 

been reconstituted within a bank holding company and are now all 

subject to statutory supervision at the holding company level by 

the Federal Reserve Board. Under the Bank Holding Company Act, 

the Federal Reserve Board has statutory authority to impose and 

enforce supervisory requirements on those entities. 

The SEC continues to work closely with the Federal Reserve 

Board and other banking regulators concerning risk management 

oversight of these large financial conglomerates, but focuses on our 

statutory obligation to regulate their broker-dealer subsidiaries. 

Since the SEC no longer oversees the holding company as a consolidated supervisor, the SEC typically would defer to the relevant 

consolidated supervisor on matters concerning the holding company, such as holding company capital, liquidity, leverage, risk 

models and methodologies, stress testing, and contingency funding. 

The receipt, use, handling, and repayment of TARP funds generally 

would fall under this category. 

In addition, as you know, the TARP was created pursuant to authority granted to the Secretary of the Treasury under the Emergency Economic Stabilization Act of 2008. Since then, a number of 

programs have been developed under the TARP with the goal of 

stabilizing the financial system and restoring the flow of credit to 

consumers and businesses. As administrator of the TARP, Treasury 

has the authority to determine eligibility and allocations for interVerDate Nov 24 2008 14:09 Nov 19, 2009 Jkt 000000 PO 00000 Frm 00180 Fmt 6602 Sfmt 6601 S:\DOCS\52966.TXT SHERYL
177 

ested parties and sets terms and conditions for participants in 

TARP programs. I understand that this is done in consultation 

with the appropriate Federal banking supervisors. Further, on 

June 9, 2009, Treasury announced that 10 of the largest U.S. financial institutions participating in the Capital Purchase Program 

(CPP) had met the requirements for repayment established by the 

primary Federal banking supervisors, and that Treasury had notified the institutions that they are now eligible to complete the repayment process. Many of these institutions have now made their 

repayment. 

Under Section 104(e) of the EESA, the Chairman of the Commission is one of five members of the Financial Stability Oversight 

Board, which is responsible for reviewing the exercise of Treasury’s 

authority with regard to the lending program and making recommendations to Treasury regarding the use of that authority. The 

Commission, however, has no direct authority over the terms of the 

lending program and does not functionally oversee any of the fund 

recipients. The SEC continues to monitor and take interest in activities of the holding company or other affiliates that would materially impact the financial stability of the broker-dealer.