prepared for delivery
WASHINGTON - Chairman
Bachus, Ranking Member Frank, and members of the Committee, thank you for the
opportunity to testify today regarding the Financial Stability Oversight
Council’s (the “Council”) annual report.
Each year, the Council is required
to prepare a public report reviewing financial market and regulatory
developments, potential threats
to financial stability, and recommendations to strengthen the financial
system. My testimony today reviews the conclusions and recommendations
made by the Council in its second annual report, which is being submitted in
full alongside this testimony.
Measures of Strength in the
The strategy adopted by the United
States to repair and reform the financial system after the crisis has helped
produce a stronger and more resilient system.
have forced banks to substantially increase the amount of capital they
hold, so that they are able to provide credit to the economy and absorb
losses in the future. Tier 1 common capital levels at our country’s
banks are up by $420 billion, or 70 percent, from three years ago.
The ratio of tier 1 common equity to risk-weighted assets at these
institutions increased from 6 percent to over 11 percent during this
have forced a significant reduction in overall leverage in the financial
system. Financial sector debt has dropped by more than $3 trillion
since the crisis, and household debt is down $900 billion.
are funding themselves more conservatively, relying less on riskier
size of the “shadow banking system”—which had been a key source of
financial stress during the crisis—has fallen substantially, by several
government has closed most of the emergency programs put in place during the
crisis and recovered most of the investments made into the financial system,
which were originally expected to result in a loss to taxpayers of several
hundred billion dollars. The TARP bank investments have already produced
a profit for the taxpayer of over $19.5 billion, and on current estimates will
generate an overall profit of approximately $22 billion.
is expanding, and the cost of credit has fallen significantly from the peaks of
the crisis. Commercial and industrial lending at commercial banks
increased 10 percent in 2011 and increased at an annual rate of 11 percent in
the first five months of 2012.
The overall impact of these changes
is very important. They have made the financial system safer, less
vulnerable to future economic and financial stress, more likely to help rather
than hurt future economic growth, and better able to absorb the impact of
failures of individual financial institutions.
Threats to Financial Stability
The Council’s report identifies a
number of potential threats to the stability of the financial system.
Among the most important of these is the fact that the financial system still
confronts a challenging and uncertain overall economic environment.
The ongoing European crisis
presents the biggest risk to our economy. The economic recession in
Europe is hurting economic growth around the world, and the ongoing financial
stress is causing a general tightening of financial conditions, exacerbating
the global slowdown.
Over the past two years, U.S.
financial institutions have significantly reduced their exposure to the most
vulnerable economies of Europe, and they hold substantial levels of capital
against the remaining exposures. The combined economies of the euro area
constitute the second largest economy in the world and are home to many of the
world’s largest and most interconnected financial institutions. As a
result, a severe crisis in Europe would necessarily have very substantial,
adverse effects on the United States.
Europe’s leaders are putting in
place a package of long-term reforms—economic reforms to restore
competitiveness, improve fiscal sustainability, and restructure their financial
systems, and governance changes to transfer more responsibility to European
institutions for oversight of national financial systems and how much nations
can borrow. For these reforms to work, they need to be complemented by
actions in the near term to restore financial stability and support economic
growth, including strengthening the stability of the banking systems and
bringing sovereign borrowing rates down in the countries implementing reforms.
Global economic growth has slowed
and forecasts for future economic growth have been reduced. Europe is
responsible for much of this, but not all of it. Growth in China, India,
Brazil and other large emerging economies has slowed for a variety of reasons
unique to those countries.
In the United States, the economy
is still expanding, but the pace of economic growth has slowed during the last
two quarters. In addition to pressures from Europe and the global
economic slowdown, U.S. growth has been hurt by the rise in oil prices earlier
this year, the ongoing reduction in spending at all levels of government, and
slow rates of growth in income.
The slowdown in U.S. growth could
be exacerbated by concerns about approaching tax increases and spending cuts,
and by uncertainty about the shape of the reforms to tax policy and spending
that are necessary to restore fiscal responsibility. As the Council’s
report discusses, the United States faces fiscal deficits that are
unsustainable over the long run.
The failure of policy makers to enact reforms in a timely and credible
manner will be damaging to future
These potential threats underscore
the need for continued progress in repairing the remaining damage from the
financial crisis and enacting reforms to make the system stronger for the long
Progress Implementing Financial
Regulators have made important
progress over the past two years designing and implementing the regulations
necessary to implement financial reform. Nine out of 10 rules with
deadlines before July 2, 2012, have been proposed or finalized. The key
elements of the law will largely be in place by the end of the year. The
financial system is already in the process of adapting to these reforms.
- We have taken important
steps to limit risk-taking at the largest financial institutions. The
Federal Reserve and other supervisors have negotiated new, stronger global
capital and liquidity requirements. As part of this effort, federal
banking regulators will impose even higher requirements on the largest
- We now have the ability
to put the largest financial companies under enhanced supervision and
prudential standards, whether they are banks or nonbanks, and the ability
to subject key market infrastructure firms to heightened risk-management
- We are implementing the
provisions of the law designed to protect taxpayers and the financial
system from the failure of a large financial firm. Regulators, led
by the FDIC, have established the new “orderly liquidation authority,” a
mechanism to unwind responsibly large, complex financial companies.
This authority will help make sure that culpable management is fired and
that investors pay for the failure of a firm, not taxpayers. Nine of
the largest banks have now submitted “living wills,” providing contingency
plans for an orderly bankruptcy.
- The SEC and CFTC are
putting in place a new framework for derivatives oversight, providing new
tools for combatting market abuse and bringing the derivatives markets out
of the shadows. Their recent joint adoption of a swaps definition
will trigger the effectiveness of more than 20 key rulemakings and marks a
major milestone in the implementation of derivatives reforms.
- Regulators are working
to strengthen protections for investors and consumers. The CFPB has
worked to simplify and improve disclosure of mortgage and credit card
loans to help consumers make more informed financial decisions. The
CFPB has also launched its supervisory program for very large depository
institutions (in coordination with prudential regulators) and for certain
we put in place these reforms in the United States, we are working with
supervisors and regulators in Europe, Japan, and around the world to
provide a more level playing field. In addition to the new global
standards for capital and liquidity requirements, we are negotiating
global margin requirements for derivatives. On these and a range of
other issues, we are trying to improve the prospect of tougher and broadly
equivalent global standards and requirements, so that financial risk cannot
simply move to where it cannot be seen or effectively constrained.
These are complicated
reforms. This process is challenging because our financial system is
complex, because we want to target damaging behavior without damaging access to
capital and credit, because we want the reforms to endure as the market
evolves, and because we need to coordinate the work of multiple agencies in the
United States and many others around the world.
Recommendations to Improve
In addition to these important
reforms, the Council has put forward recommendations in a variety of other
areas to help strengthen our financial system.
Risks in Wholesale Short-Term
The Council recommends a set of
reforms to address structural vulnerabilities, particularly in wholesale
short-term funding markets such as money market funds (MMFs) and the tri-party
repo market. As we saw during the crisis, these sources of funding were
particularly vulnerable to disruption that can quickly spread through the
The SEC adopted a number of reforms
to money market funds in 2010, but they remain vulnerable to runs. The
Council supports SEC Chairman Schapiro’s efforts to address certain weaknesses,
including (1) the lack of a mechanism to absorb a sudden loss in value of a
portfolio security and (2) the incentive for investors to redeem at the first
indication of any perceived threat to the value or liquidity of the MMF.
The Council recommends that the SEC publish structural reform options for
public comment and ultimately adopt reforms that address money market funds’
susceptibility to runs. The Council further recommends that, where
applicable, its members align regulation of cash management vehicles similar to
MMFs within their regulatory jurisdiction to limit the susceptibility of these
vehicles to run risk.
In tri-party repo markets, the
Council supports additional steps toward reducing intraday credit exposure
within the next six to 12 months. In addition, the Council recommends
that regulators and industry participants work together to define standards for
collateral management in the tri-party repo market, particularly for lenders
(such as MMFs) that have certain restrictions on the instruments that they can
highlights the importance of establishing and enforcing strong standards for
protecting customer funds deposited for trading. For example, the Council
recommends that regulators consider strengthening regulations governing the
holding and protection of customer funds deposited for trading on foreign
futures markets. The Council also recommends that regulators seek ways to
strengthen risk-management standards for clearinghouses and to develop and
monitor best practices across their respective jurisdictions.
Risk Management and Supervisory
The Council recommends continued
work to improve risk-management practices, highlighting a number of specific
challenges facing firms and their supervisors. The Council supports
continued attention to strengthening capital buffers and stress testing.
Firms also need to continue to guard against potential disruptions in wholesale
short-term funding markets and bolster their resilience to interest rate
Firms need to continue to
strengthen internal disciplines and safeguards in underwriting standards, the
development of new financial products, and complex trading strategies.
The report also notes that high-speed trading is an area where increased speed
and automation of trade execution may require a parallel increase in trading
risk management and controls.
Housing Finance Reform
The Council continues to support
progress toward comprehensive housing finance reform. The U.S. housing
finance system has required extraordinary government support since the
financial crisis, and the market continues to lack sufficient private
capital. As recognized in the framework for housing finance reform
developed by certain member agencies of the Council, the return of private
capital is crucial to reestablishing confidence in the integrity of the market
and better aligning incentives.
However, in order for private
capital to come back into the market, there needs to be greater clarity from
regulators and Congress on new rules for all participants in the market.
Challenges include the lack of broadly-agreed upon standards for mortgage
underwriting (which are necessary to support the valuation and liquidity of
mortgage-backed instruments), non-uniform foreclosure practices across
different states, and uncertainty surrounding the potential liability of
mortgage loan securitizers.
In addition, reform should address
servicer compensation models and the need for national mortgage servicing
standards, and it should strengthen protections for borrowers. Members of
the Council are addressing many of these challenges through existing authority
and the implementation of Wall Street Reform, yet comprehensive reform will
require significant legislation, and the leadership of this Committee will be
central to the effort. As we move forward, we must take care not to
undermine the housing market, which is showing signs of recovery but is still
weak in many areas.
Transparency and Financial Data
One of the weaknesses in our old
system of regulation was a lack of information—information that could be used
to help identify threats and more effectively understand the financial
system. Gaps in data and analysis remain a threat to financial stability,
and an important part of reform efforts will continue to be the improvement and
availability of financial data and information.
This project is being spearheaded
by the Office of Financial Research (OFR), which was established by Wall Street
Reform. The OFR’s work is crucial to improving transparency, our
understanding of how the financial system supports the economy, and our
capacity to identify threats to financial stability. The OFR has done
tremendous work over the past year, undertaking a number of initiatives,
including steps to create a “legal entity identifier” for financial contracts,
which will help us understand exposures in the market. Last week, the OFR
released its first annual report, which analyzes threats to financial stability
along with ways to address data gaps and promote data standards.
The member agencies of the Council
have made considerable progress over the past few years in making our financial
system safer and stronger—more resilient and less vulnerable to crisis, with
better protections for investors and consumers.
We still have a lot of work ahead
of us, however. We need your support to make these rules strong and
effective. And we need your support to make sure the enforcement agencies
have the resources they need to prevent fraud, manipulation, and abuse.
I want to thank the other members
of the Financial Stability Oversight Council, as well as the staff of the
members and their agencies, for the work they have done over the past year and
their efforts to produce this annual report.
We look forward to working with
this Committee, and with Congress as a whole, to build on the substantial
progress we have made to create a stronger financial system.