Ben S Bernanke: Regulatory restructuring
Testimony of Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, before the Committee on Financial Services, US House of
Representatives, Washington DC, 10 July 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
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Chairman Frank, Ranking Member Bachus, and other members of the Committee, I am
pleased to be here today to discuss financial regulation and financial stability.
The financial turmoil that began last summer has impeded the ability of the financial system
to perform its normal functions and adversely affected the broader economy. This experience
indicates a clear need for careful attention to financial regulation and financial stability by the
Congress and other policymakers.
Regulatory authorities have been actively considering the implications of the turmoil for
regulatory policy and for private-sector practices. In March, the President's Working Group
on Financial Markets (PWG) issued a report and recommendations for addressing the
weaknesses revealed by recent events.1 At the international level, the Financial Stability
Forum has also issued a report and recommendations.2 Between them, the two reports
focused on a number of specific problem areas, including mortgage lending practices and
their oversight, risk measurement and management at large financial institutions, the
performance of credit rating agencies, accounting and valuation issues, and issues relating
to the clearing and settlement of financial transactions. Many of the recommendations of
these reports were directed at regulators and the private sector and are already being
implemented. These reports complement the blueprint for regulatory reform issued by the
Treasury in March, which focused on broader questions of regulatory architecture.3
Work is also ongoing to strengthen the framework for prudential oversight of financial
institutions. Notably, recent events have led the Basel Committee on Banking Supervision to
consider higher capital charges for such items as certain complex structured credit products,
assets in banks' trading books, and liquidity guarantees provided to off-balance sheet
vehicles. New guidelines for banks' liquidity management are also being issued. Regarding
implementation, the recent reports have stressed the need for supervisors to insist on strong
risk-measurement and risk-management practices that allow managers to assess the risks
they face on a firmwide basis.
In the remainder of my remarks I will comment briefly on three issues: the supervisory
oversight of primary dealers, including the major investment banks; the need to strengthen
the financial infrastructure; and the possible need for new tools for facilitating the orderly
liquidation of a systemically important securities firm.4
Prudential supervision of investment banks
Since the near-collapse of The Bear Stearns Companies, Inc., in March, the Federal Reserve
has been working closely with the Securities and Exchange Commission (SEC), which is the
functional supervisor of each of the primary dealers and the consolidated supervisor of the
four large investment banks, to help ensure that those firms have the financial strength
needed to withstand conditions of extreme market stress. To formalize our effective working
relationship, the SEC and the Federal Reserve this week agreed to a memorandum of
understanding.5
Cooperation between the Fed and the SEC is taking place within the existing statutory
framework with the objective of addressing the near-term situation. In the longer term,
however, legislation may be needed to provide a more robust framework for the prudential
supervision of investment banks and other large securities dealers. In particular, under
current arrangements, the SEC's oversight of the holding companies of the major investment
banks is based on a voluntary agreement between the SEC and those firms. Strong holding
company oversight is essential, and thus, in my view, the Congress should consider requiring
consolidated supervision of those firms and providing the regulator the authority to set
standards for capital, liquidity holdings, and risk management.6 At the same time, reforms in
the oversight of these firms must recognize the distinctive features of investment banking
and take care neither to unduly inhibit innovation nor to induce a migration of risk-taking
activities to less-regulated or offshore institutions.
Strengthening the financial infrastructure
The potential vulnerability of the financial system to the collapse of Bear Stearns was
exacerbated by weaknesses in the infrastructure of financial markets, notably in the markets
for over-the-counter (OTC) derivatives and in short-term funding markets.
The Federal Reserve, together with other regulators and the private sector, is engaged in a
broad effort to strengthen the financial infrastructure. For example, since September 2005,
the Federal Reserve Bank of New York has been leading a major joint initiative by both the
public and private sectors to improve arrangements for clearing and settling credit default
swaps and other OTC derivatives. The Federal Reserve and other authorities also are
focusing on enhancing the resilience of the markets for tri-party repurchase agreements, in
which the primary dealers and other large banks and broker-dealers obtain very large
amounts of secured financing from money funds and other short-term, risk-averse investors.
In these efforts, we aim not only to make the financial system better able to withstand future
shocks but also to mitigate moral hazard and the problem of "too big to fail," by reducing the
range of circumstances in which systemic stability concerns might prompt government
intervention.
More generally, the stability of the broader financial system requires key payment and
settlement systems to operate smoothly under stress and to effectively manage counterparty
risk. Currently, the Federal Reserve relies on a patchwork of authorities, largely derived from
our role as a banking supervisor, as well as on moral suasion to help ensure that the various
payment and settlement systems have the necessary procedures and controls in place to
manage the risks they face. By contrast, many major central banks around the world have an
explicit statutory basis for their oversight of payment and settlement systems. Because
robust payment and settlement systems are vital for financial stability, the Congress should
consider granting the Federal Reserve explicit oversight authority for systemically important
payment and settlement systems.
Preventing or mitigating future crises
The financial turmoil is ongoing, and our efforts today are concentrated on helping the
financial system return to more normal functioning. It is not too soon, however, to think about
steps that might be taken to reduce the incidence and severity of future crises.
In particular, in light of the Bear Stearns episode, the Congress may wish to consider
whether new tools are needed for ensuring an orderly liquidation of a systemically important
securities firm that is on the verge of bankruptcy, together with a more formal process for
deciding when to use those tools. Because the resolution of a failing securities firm might
have fiscal implications, it would be appropriate for the Treasury to take a leading role in any
such process, in consultation with the firm's regulator and other authorities.
The details of any such tools and of the associated decisionmaking process require more
study. One possible model is the process currently in place under the Federal Deposit
Insurance Corporation Improvement Act (FDICIA) for dealing with insolvent commercial
banks. The FDICIA procedures give the Federal Deposit Insurance Corporation the authority
to act as a receiver for an insolvent bank and to set up a bridge bank to facilitate an orderly
liquidation of the firm. The FDICIA law also requires that failing banks be resolved in a way
that imposes the least cost to the government, except when the authorities, through a
welldefined procedure, determine that following the least-cost route would entail significant
systemic risk. To be sure, securities firms differ significantly from commercial banks in their
financing, business models, and in other ways, so the FDICIA rules are not directly
applicable to these firms. Although designing a resolution regime appropriate for securities
firms would be a complex undertaking, I believe it would be worth the effort. In particular, by
setting a high bar for such actions, the adverse effects on market discipline could be
minimized.
Thank you. I would be pleased to take your questions.