Alert July 15, 2008

FRB Chairman Bernanke, Secretary of the Treasury Paulson Testify Before House Committee Regarding Oversight of Investment Banks and Revisions to Financial Regulation

Ben S. Bernanke, Chairman of the FRB, and Henry M. Paulson, Secretary of the Treasury, testified on financial regulatory reform before the U.S. House Committee on Financial Services.  In general, Chairman Bernanke and Secretary Paulson agreed that (although Congress should not enact a hurried-through response to financial regulatory reform) regulators should be provided with additional regulatory tools to deal with financial crises and stronger oversight over the largest financial institutions.

  • Chairman Bernanke’s Recommendations.
    • Prudential Supervision of Investment Banks.  Chairman Bernanke stated that since the near collapse of Bear Stearns in March 2008, the FRB and SEC have worked closely to see that the four largest investment banks “have the financial strength needed to withstand conditions of extraordinary market stress.”  The FRB and SEC have signed a Memorandum of Understanding to formalize their arrangement (see the July 8, 2008 Alert).  In the longer term, however, said Chairman Bernanke, legislation may be needed to strengthen prudential supervision of investment banks and other large securities dealers.  Chairman Bernanke suggested that Congress consider “requiring consolidated supervision”  of investment banks and other large securities dealers and providing regulators with the “authority to set standards for capital, liquidity holdings, and risk management.”
    • Strengthening the Financial Infrastructure.  Chairman Bernanke stated that the threat to the financial system posed by the potential collapse of Bear Stearns was exacerbated by weaknesses (i) in the market for over-the-counter derivatives and (ii) in the short-term funding market.  Chairman Bernanke recommended that Congress consider granting the FRB explicit authority to oversee and supervise systematically important payment and settlement systems because, at this time, the FRB must rely on a “patch-work” of authorities, derived from its role as a banking regulator, plus moral suasion to oversee payment and settlement systems risk.
    •  Preventing or Mitigating Future Crises.  Chairman Bernanke stated that new tools are required to ensure an orderly liquidation of a “systematically important securities firm that is on the verge of bankruptcy…”  Moreover, regulators need to have a more formal process for deciding when and how to intervene and use the foregoing regulatory tools. Chairman Bernanke stated that one example for Congress to consider in designing such legislation is the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) process used for dealing with insolvent commercial banks.  The FDICIA process requires that the resolution process selected involve the lowest cost to the government (and thereby the U.S. taxpayer) except where using the least-cost solution would entail significant systemic risk.
  • Secretary Paulson’s Recommendations

Secretary Paulson, in his remarks, summarized certain of the key elements of the Treasury’s Blueprint for a Modernized Financial Regulatory Structure that was issued in March 2008 (see the April 1, 2008 Alert).  He then noted three near-term steps that he believes would move U.S. financial regulation in the direction of the Treasury’s Blueprint for reform:

    • Give the FRB the clear statutory authority to prevent events that pose unacceptable systemic risk.  Specifically, said Secretary Paulson, the FRB needs the authority to access necessary information from complex financial institutions of all types: commercial banks, investment banks, hedge funds and others.  Moreover, said Secretary Paulson, the FRB needs the tools to intervene “to mitigate systemic risk in advance of a crisis.”
    • Secretary Paulson stated that for market discipline to be effective, market participants “must not expect” that government support “is readily available.”  In particular, said Secretary Paulson, financial institutions must be allowed to fail.
    • Secretary Paulson also asserted that when the government is required to provide financial support, it should be required that the Treasury Department be involved and, to the extent possible, taxpayer costs should be minimized.
  • Subsequent Related Developments
Over the weekend following the delivery of Chairman Bernanke’s and Secretary Paulson’s remarks, the FRB announced that it would open its discount window to Fannie Mae and Freddie Mac, if needed.  Borrowings would be at the primary credit rate and be required to be collateralized by U.S. government and federal agency securities.  The Bush Administration also announced that it would amend the legislation it is backing to reform the regulation of government-sponsored enterprises (“GSEs”), including Fannie Mae and Freddie Mac, to give the FRB a consultative role in the setting of capital requirements for GSEs.  Furthermore, the OTS closed IndyMac Bank, a $32 billion bank in Pasadena, California and turned IndyMac Bank over to the FDIC as receiver.  IndyMac Bank’s failure has been attributed primarily to issues in its residential real estate loan portfolio.  The FDIC opened the successor bank, IndyMac Federal Bank, FSB on July 14, 2008.  The OTS said that IndyMac Bank was the largest OTS-regulated thrift ever to fail and that it was, according to FDIC records, the second largest institution to close in U.S. history.